Small cap, big opportunity

To find opportunities in the Canadian small cap space, we interviewed three experts:

• Ian Cooke, portfolio manager, IA Clarington Canadian Small Cap Fund
• Peter Imhof, investment strategist, Sprott Small Cap Equity Fund
• Jennifer Law, portfolio manager, Renaissance Canadian Small-Cap Fund, CIBC Global Asset Management Inc.

Forecasts

Many clients may reject the small-cap sector outright, given less-than-stellar returns over the past two years. But as valuations rise in the large-cap sector, so does interest in small caps, say experts.

Peter Imhof: While investors aren’t jumping on the small-cap bandwagon, there’s a positive shift in sentiment underway. As investors start to feel more comfortable with the market, “typically this starts to trickle down to the smaller companies in the small-cap sector,” says Imhof.

Imhof also foresees more consolidation activity as U.S. equity players eye opportunities in the Canadian small-cap technology sector, since Canadian companies often trade at lower valuations than similar American firms.

“We’ve started to see U.S. private equity come in and buy these Canadian companies, such as the recent bid [by Birch Hill Equity Partners] for Softchoice Corporation at a good premium [$20 per share, or 27%],” he says. “If the market isn’t going to reward these companies [then] larger-cap companies or private equity will, because they see the value.”

Jennifer Law: “The small-cap space had fantastic 10-year numbers, with huge [returns] for Canadian small caps in 2009-2010 as resource stocks bounced off the bottom of the great financial crisis,” Law says, “followed by a not-so-great last couple of years.” This means Canadian small caps have underperformed relative to their large-cap peers, as well as on a global basis.

“If you look at the last couple of quarters, in Q4 2012, small caps on a global basis were up 15.6% (in US$) with Europe leading the pack at 25.9%. More recently, Q1 performance was very similar with global small caps up 10% and Japan leading at 14.9% return,” explains Law. “When we come out of a recessionary period, small caps tend to do better than large caps.” But her team didn’t see that in Canada this time. “What really hurt us over the past few years could help us going forward,” says Law. “If you are a patient investor, the time will come for Canadian small caps. For example, with some of the small-cap Canadian energy names, many have been neglected. They are dying by lack of interest but their asset bases and asset quality are good. They’re trading at attractive valuations but investors aren’t interested because they are fearful of volatility in Canadian crude, which affects the cash flow of these producers.”

Allocations to consider

JL: “Typically with our pension, endowment and institutional investors, the Canadian small-cap sector represents between 5% and 10% of their Canadian equity portfolio. Depending on an investor’s risk tolerance and age—as part of a diversification strategy—this range is often appropriate for them, too,” says Law.

“Still, given the past couple of years, which have been difficult for the small-cap sector, advisors might have to hold the hands of investors more, especially if the client is looking through a short-term lens.”

Law adds advisors might want to show clients relevant data to highlight the potential rewards of diversification through small caps.

The BMO Nesbitt Burns index started tracking Canadian small caps versus large caps from 1968 onward. “If you used a buy-and-hold strategy, including the differences in dividends, the Canadian small-cap sector outperformed large cap by 24%,” explains Law. “That’s why this asset class has a place in an investor’s portfolio.”

Ian Cooke: “Study after study has shown that small capitalization companies of high quality, trading at low valuations, have outperformed the market as a whole over long periods. [Regardless,] You have to be a cautious investor. The stakes and the risks are higher as companies tend to be earlier stage, and business models tend to be more sensitive and often less established.”

Company recommendations

PI: Special situations in niche areas are likely to outperform if a company’s done well operationally. As examples:

AutoCanada Inc. (TSX:ACQ):

One of Canada’s largest multi-location automobile dealership groups. The management team is quite conservative and has done a great job of under-promising and over-delivering.

Recently, the company reported a record quarter and raised its dividend again. It is still at the infancy stage of dealership consolidation in Canada and has a huge head start on any competition.

Sylogist Ltd. (TSX Venture:SYZ):

Underfollowed software company with no analyst coverage. Sylogist continues to drive shareholder returns through increasing dividends and rapidly growing cash flow. The management team has been astute in growing cash flow organically and through acquisitions. Management owns a large percentage of the company and is aligned with shareholders. The next few quarters should exemplify the earnings power potential of this company.

JL: Valuations of Canadian small caps have improved. Now they are trading at discounts relative to global peers and U.S. small-cap equities in the S&P SmallCap 600 Index. As examples:

Symbility Solutions Inc. (TSX Venture:SY):

Software company for insurance groups that does claims-processing estimates. There’s a lot of leverage to this business model as it adds more insurance customers and suppliers to its ecosystem. We expect SY to gain market share because its claims technology is superior to the incumbent. At an $85-million market cap, I see revenue-growth expectations of 40% in 2013 and 25% in 2014. Risk profile is above-average as an emerging company.

MBAC Fertilizer Corp. (TSX:MBC):

MBAC owns the Itafos phosphate project located in Brazil’s Cerrado agricultural region. The stock has come off recently as the company ran into construction-cost overruns and project delays.

This is a quality asset in a region where domestic phosphate supply can displace imports due to transportation cost advantages. We expect its fertilizer plant will be commissioned in the summer. Given where the stock is trading relative to its $4 per share NAV, an investor can get in at an attractive level.

IC: The further you get into the economic cycle, the more small caps get picked over. Look into underappreciated areas for companies that still offer value.

E-L Financial Corp (TSX:ELF):

It’s an insurance company that owns Dominion Insurance and part of Empire Life Insurance. It also has a stake in Algoma Central, a shipping company. E-L Financial insiders are its largest shareholders, which is especially important in the complex world of insurance.

And despite the financial crisis, book value per share has grown from less than $300 in 2000 to close to $800 per share today. With the stock trading at $585, the price-to-book-value multiple is around 0.75, while the S&P/TSX as a whole is trading at approximately 1.8x book value.

Paladin Labs Inc. (TSX:PLB):

The Paladin team has a record of deploying capital and generating returns that far outstrip most small caps out there. Their investments have also generated a lot of cash. As a result, about a quarter of their market capitalization is in cash.

All it takes is a few astute opportunities to deploy that and the stock should benefit. Insiders are also aligned with us at Paladin, owning more than 20% of the shares outstanding. The company has a market capitalization of approximately $1 billion.

Bev Cline is a Toronto-based financial writer.