Some jittery clients are steering clear of volatile equities markets. But more intrepid investors have been savouring the stronger returns being delivered by mutual funds focusing on small-capitalization stocks.

Although the recent performance of Canadian small-cap indices has been hampered by their heavy exposure to resources-based companies in the energy and mining sectors, many small-cap funds have achieved returns superior to the index through astute stock-picking.

While the BMO small-cap weighted index fell by 3.6% in the year ended March 31, the average Canadian focused small-/mid-cap equity fund, as measured by Toronto-based Morningstar Canada, gained 3.4%. Returns varied widely among the 128 small- and mid-cap funds, with the best gaining by 42.3% and the worst dropping by 40%.

And history shows that on average, the highest returns come from the stocks with the lowest market capitalizations. While larger companies frequently are more stable and offer better downside protection in turbulent markets, small-cap stocks have a history of long-term outperformance – although they also offer a wilder short-term ride with their penchant for displaying enhanced volatility.

Figures provided by Chicago-based Morningstar Inc.-owned Andex Charts show U.S. small-cap stocks outperforming every other investment category in the 62 years between 1950 and 2012, with an average annual gain of 13.4% in Canadian dollars – beating 11% for large-cap stocks, 7.7% for government bonds, 5.6% for treasury bills and 3.7% for inflation (as measured by the consumer price index). However, the worst five-year period for U.S. small-caps saw an average annual loss of 14.1%, while the worst five-year period for large stocks saw an average annual loss of 7.5%.

“If an active manager can add value anywhere, it’s in choosing smaller companies,” says Dan Hallett, vice president and director of asset management with HighView Financial Group of Oakville, Ont. “There is limited research out there and more need to do your own digging. It’s often easier to call up the senior executives at a small company, as they’re more accessible than large-cap management.

“There is quite a spread in performance compared to the broader market,” he adds, “and a lot comes down to exposure to materials. It’s a lot less common to find index-huggers in the small-cap field. Even if a small-cap [portfolio] manager likes resources commodities, the fund may not look anything like the small-cap indices. [The small-cap space] is a vast hunting ground, with a broad choice of companies that managers of large-cap funds can’t even dream of.”

Wil Wutherich, president of Montreal-based investment boutique Wutherich & Co. and portfolio manager for Steadyhand Small-Cap Equity Fund, which is sponsored by Vancouver-based Steadyhand Investment Funds Inc., has achieved a healthy 8.8% return for the fund since its inception in 2007, handily beating the 2.1% return of the BMO small-cap index.

“I spend all my time on small-caps, and that’s where all my personal money is invested,” Wutherich says. “Opportunities are far richer in the small-cap space, where there are a lot of stocks that are orphaned, overlooked, undercovered or not covered at all. I can’t add any value by buying Royal Bank [of Canada]. I might have done well with it during the past 15 or 20 years, but there’s nothing that’s not uncovered.”

Wutherich prefers companies with a market cap of $50 million-$5 billion and likes to run a concentrated portfolio. The Steadyhand fund holds 16 stocks – high for Wutherich, who prefers to hold around 10 companies. He looks for companies whose shares could double in value over five years or achieve an average annual compounded return of at least 15%. As these firms become bigger and better known, he adds, they often benefit by expansion in their price/earnings multiples, revenue and profit growth. They also are more likely to be takeover targets than large companies.

Ralph Lindenblatt, senior vice president and portfolio manager with Calgary-based Bissett Investment Management, a division of Toronto-based Franklin Templeton Investments Corp., and lead manager of the Bissett MicroCap and Bissett Small Cap funds, is on the lookout for companies that are strong generators of free cash flow and not reliant on capital markets to finance growth. Companies in the consumer discretionary, technology and industrial sectors have been outperforming recently, Lindenblatt says; but, as a value manager, he now is ferreting out opportunities in the beaten-down energy sector. Bissett Small Cap focuses on companies with a market cap of $300 million-$1.7 billion, while Bissett MicroCap seeks firms with a market cap of $300 million or less.

“Small-caps are not necessarily more risky than large-caps,” Lindenblatt says, “but they can be more volatile. It’s important to distinguish between stock price volatility and volatility in earnings and free cash flow. Price volatility gives us the opportunity to transact at favourable prices; to buy low or sell high. Overall, if you position yourself selectively in high-quality, small-cap businesses, you can definitely outperform.”

Demand for income has boosted the values of dividend-paying, small-cap stocks recently, Lindenblatt says, resulting in superior performance relative to “no yield” stocks. However, some small-caps now are fully valued; others are paying out more in dividends than is healthy. Lindenblatt is seeing better opportunities in the lower-yielding small-caps.

High dividends are not always a good thing for small companies, says Aubrey Hearn, vice president and senior portfolio manager with Toronto-based Sentry Investments Inc. and lead manager of Sentry Small/Mid Cap Income Fund. Ideally, he adds, a company is paying out some cash in dividends and investing some in expanding the business, says Hearn: “We look for balance, and don’t want companies that are paying out too much in dividends. Sometimes, a company with a low dividend yield that has good growth prospects and the potential to pay higher dividends in the future is a better opportunity.”

The main valuation metric used by Jason Whiting, vice president, Trimark Investments division, with Invesco Canada Ltd., is “healthy free cash flow,” whether the company is paying it out in dividends, using it to repurchase its own stock or investing in attractive growth opportunities. Whiting, lead manager of Trimark Canadian Small Companies Fund, is currently holding almost half the fund’s portfolio in non-Canadian stocks.

“Canada is concentrated in resources,” Whiting says. “But, if you go foreign, there is a bigger ocean and you find better fishing.”

Small-caps tend to be less liquid than large-caps, and small- cap fund portfolio managers are always keeping their eyes on liquidity, assessing their ability to get in and out of a stock without distorting the price.

“The good companies grow over time, pick up more analyst coverage and become more widely followed,” says Martin Ferguson, director and portfolio manager of small-cap equities with Calgary-based Mawer Investment Management Ltd. “This leads to liquidity picking up and valuation metrics improving – it all works in small-caps’ favour.

“The larger the company,” he adds, “the more its growth is tied to growth in the general economy and the more difficult it is to grow faster. But small companies are more flexible, and can grow by finding new niches, expanding market share within their industry or creating a new product.”

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