Diamond in the rough

In the small-cap market, there are many overlooked, undervalued gems.

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But, at the same time, “you’re not going to have a lot of direction and you’re going to have a lot of volatility. So you do need active managers,” explains Jennifer Law, vice-president and portfolio manager for CIBC Asset Management. She manages the Renaissance Canadian Small-Cap Fund.

In terms of current opportunities, she says, “I haven’t been in REITs for the last couple years. But [their] valuations look quite attractive [since] we believe interest rates won’t go up dramatically in Canada.”

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“In all probability,” she predicts, “we’ll see another interest rate cut in the next two to three months. So from the growth, dividend, stability and earnings perspective,” REITs are attractive.

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Law currently favours companies such as Killam Properties, which owns multi-residential properties in regions such as Atlantic Canada. At a market cap of $668 million, it currently offers a 5.4% dividend yield and 85% payout ratio.

Also, “if you think about urban ship building contracts, and pulp and paper investments in Atlantic Canada,” she adds, investing in companies like Killam means tapping into that region’s economic growth.

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Law also holds Element Financial, a financing company that has about a $3.8-billion market cap. “It doesn’t offer [dividend] yield, but has very nice earnings growth,” says Law. “This year, we’re looking for more than 60% growth and next year, close to 30%.”

Read: Don’t overlook mid-cap stocks

She wants to increase her exposure to the U.S. business and consumer spending sectors, and she finds Element Financial derives most of its revenue from the U.S. So, “given the strength in the U.S. dollar, [adding exposure] is a play on the U.S. economy.”

Read: Why you should invest in U.S. specialty retail

Look to the energy sector

Investors with longer time horizons should consider commodities, says Law. “In order for small caps to outperform, energy will have to do well, and base metals and gold will have to do well. Right now, if you’re an investor with a two-year horizon, then you’ll likely make money in energy.”

She adds, “Commodity prices are pretty close to bottom and maybe we’ll re-test our previous lows, but we had a nice rebound in [early 2015]. Two years out, we do see stronger energy prices.” The price for oil may not go back to $100 per barrel, she notes, but “we should see a new normal range of between $70 and $80.”

The key to small-cap success in the energy sector, she adds, is knowing companies well. Start by finding out where their balance sheets sit, and research whether companies have sustainable long-term assets. Also make sure they’ll continue to generate reasonable cash flow when commodity prices fall.

Read: Can central Canada prop up Alberta?

Law suggests finding companies such as TORC Oil, Spartan Energy Corp and Whitecap, which all have strong core resource bases. She explains, “We’ve done a lot of stress testing in different commodity price assumptions and we believe these are the companies that will survive, given where they are in terms of cost structure.”

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Originally published on Advisor.ca

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