Canadian small- and mid-cap equity funds have made a stunning comeback after last year’s rout, which was triggered by the credit crisis and fears of a global economic slowdown. Yet, fund managers seem divided on near-term prospects, with some arguing that valuations are fair, while others say that speculative excesses are starting to appear.

One of those in the former camp is Stephen Arpin, lead manager of Beutel Goodman Small-Cap Fund, and vice president at Toronto-based Beutel Goodman Investment Counsel, part of Beutel Goodman & Co. Ltd. Looking at data going back to 1990, Arpin notes that small-caps have generally traded at a modest discount to large-cap stocks, with brief exceptions, such as the 10% premium in 1996.

The discount reached as high as 40% in 2000, during the technology bubble, when investors put money into large-caps and pulled out of other asset classes. “That was probably when we had the best valuations for small-caps — at least, equivalent to what we’ve seen in this cycle,” recalls Arpin, basing his comments on price-to-sales multiples. “But, once again, we have a pretty substantial discount — about 25%.”

Arpin notes that as the economy picks up, margins should grow and price/sales multiples should also improve. “We just went through a pretty bad economy, and margins are depressed. If we get a return to economic growth, things should improve and we should continue to have good performance in the small-cap space,” says Arpin, adding that he’s reluctant to make a call on the economy but is confident that the scope of the fiscal stimulus is bound to have a positive impact. “On a relative basis, small-caps are attractive. On an absolute basis, most people would say the market looks ‘interesting.’ Given how low bond yields are, that will push money into the market.”

A bottom-up value investor who works closely with portfolio manager William Otton, Arpin favours companies that have strong management and whose stocks are trading at significant discounts to the value of their businesses. Arpin and Otton also look to double their money over three to four years, mainly because of liquidity risks and the fact that some investments do not always work out. “It may take some time for the value to surface,” says Arpin. “It’s important to have that discount-to-business value. Downside risk control is an important part of what we do.”

One top name in the Beutel fund’s 38-stock portfolio is CCL Industries Ltd. Primarily a contract label-maker for consumer products manufacturers, CCL has cleaned up its balance sheet and improved its margins. “The valuation is low: it is trading 0.9 times price-to-book and 13 times 2010 earnings,” says Arpin, adding that the stock has a 2.7% dividend yield. “Obviously, the consumer sector has been soft. There has also been a lot of destocking by companies such as Procter & Gamble, which tried to lower the amount of working capital and get cash in the door. It’s starting to turn around in the U.S., but Europe is really soft. As a result, the stock is trading at five-year lows.” Acquired about a year ago, the stock is $22.50 a share. Arpin’s target is $40 a share within three years or so.

Another top holding is Uni-Select Inc. The auto-parts distributor, which has expanded into the U.S. market, has fallen out of favour because of the perception of poor internal growth. “It’s very well managed and one of the better-quality companies in the small-cap universe,” says Arpin, adding that the firm has the balance sheet strength to make more acquisitions. “Historically, the stock has traded up to around 15 times earnings. But it’s now trading at nine times earnings, and its price-to-book value is also low — 1.4.” Acquired about a year ago, the stock is $26.75 a share, although Arpin believes it could be $50 a share within three years.



Speculative excesses are starting to appear, argues Jennifer Law, manager of Renaissance Canadian Small-Cap Fund, and vice president at Toronto-based CIBC Global Asset Management Inc. Law expresses concerns that the market recovery could be fuelled by factors other than the economic fundamentals. “A lot of recovery is driven by money flows,” she says “The economic data is improving, but the market has gone up so much. It’s overshooting the fundamentals.”

@page_break@Law points out that there was a great deal of cash on the sidelines as investors became very pessimistic in the autumn of 2008. Since the market recovery this past March, sentiment has gone to the other extreme and investors have flocked to risky assets. “Yes, we got really beaten up last year, and there was no access to credit. But, this year, a lot of it is speculative. We’re seeing some very big numbers,” says Law, noting that subsectors such as metals and minerals are up by more than 130% year-to-date and gold and precious metals are up by 77%. “A lot of money is coming into the market. It’s getting a little overdone. We’re pulling a lot of the returns for 2010 into 2009.”

Law believes that much of the market rebound is the result of the flight away from the weakening U.S. dollar. That is, investors have been piling into asset classes, such as emerging markets and commodity-oriented stocks, as a hedge against the greenback. And yet, there is also a risk, Law argues, that the US$ could strengthen and undermine the market rebound: “What could spoil the party is a reversal of the US$. I don’t know what will cause it, but things don’t go straight down — or up. Next year, a strengthening US$ could hurt the performance of half the small-cap sector, which is in natural resources. That makes me really worried.”

A growth-at-a-reasonable price investor, Law is fully invested and focused on quality income trusts and stable businesses that are not too vulnerable to economic cycles. One large holding in the 70-name Renaissance portfolio is Vicwest Income Fund, a metal fabricator that manufactures building products and Westeel-labelled storage bins for agriculture (about half of its business). “It has an 11% yield, which is one reason we like it,” says Law, adding Vicwest has a new management team that has delivered better earnings than its predecessor.

The income trust trades at $14 a unit, a multiple of seven times enterprise value to earnings before interest, taxes, depreciation and amortization. Based on Law’s view that Vicwest will catch up to comparable companies that fetch higher multiples, she believes the unit price could reach $19.50 in about two years.

Another favourite is Glentel Inc. A retailer with 280 outlets, it sells a broad range of cellphones and smartphones. The race for retail space has heated up, as companies such as Bell Canada have bought The Source, notes Law. “[Glentel is] the largest independent multicarrier in Canada. Everyone wants to get their phones to the end-customer. Sure, the competition has always been severe. But [Glentel has] run its business very well. If you, as a customer, want to see several brands, this the only place you can go to,” says Law, adding that Glentel is starting to derive more revenue from high-margin smartphones. The stock is trading at $14 a share, and has a 2.6% dividend yield. Law has a target of $18-$19 a share within two years.



Alot of the easy money has been made, argues Jason Gibbs, portfolio manager with Toronto-based Goodman & Co. Investment Counsel, a division of Dundee Corp., and co-manager of Dynamic Focus + Small Business Fund: “A lot of companies were trading as if they were bankrupt. [Their shares] have doubled and tripled [in value]. So, many stocks are fairly valued now. And there isn’t a lot of reaction to companies meeting or beating earnings estimates. The only way to get a positive reaction is to beat the estimates by a wide margin.”

But as the market has improved so much, it’s becoming a stock-picker’s market, argues Gibbs, who works alongside vice president Oscar Belaiche. “You can find stocks that are incredibly cheap — if you dig far enough,” says Gibbs. Indeed, this meshes with his view that markets could be range-bound for some time because valuations are not dirt cheap to begin with, as they were 10 years ago. “It’s common to have these kinds of markets, and they can go on for 10,15 years,” he adds. “This means you have to pick the right themes.”

Running a 60-name fund, Gibbs and Belaiche have allocated almost 50% to income trusts and the balance to dividend-paying common stocks. They also favour two distinct themes: gold and energy companies that represent hard assets in a world of eroding currencies; and infrastructure plays that leverage off the rebuilding of North America’s roads and bridges and transportation links.

One example of the first theme is Osisko Mining Corp. A Montreal-based junior gold play that is developing its Malartic property in northern Quebec, it has about 6.3 million ounces of proven reserves. “[It is] going to see significant growth,” says Gibbs, noting that the firm has attracted senior producer Goldcorp Inc., which has a 12.9% stake in the company. Acquired in January, when it was $3.60 a share, Osisko stock is now $7.70 a share. Gibbs has no stated target.

On the infrastructure side, Gibbs likes firms such as Churchill Corp., a general contractor that builds schools, hospitals and waterlines in Western Canada. “Over the next decade or two, there will be a significant increase in infrastructure spending. These companies will do very well over the long term,” he says, adding that the stock is trading at a very cheap nine times 2010 earnings, and three times enterprise value-to-EBITDA. “Our infrastructure is very old, and we’ve let it stagnate. On top of that, we’re in one of the worst recessions and governments are spending money hand over fist to deal with that.” Acquired this past August, at $12.40 a share, the stock is $17.70 a share. “I think there is still a lot of upside.” IE