Gold stocks lead small-cap revival

Scott Carscallen, vice-president and portfolio manager, Mackenzie Investments. A value manager, his responsibilities include Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class.

Stephen Arpin, vice-president and portfolio manager, Beutel, Goodman & Co. Ltd. A value manager, his responsibilities include Beutel Goodman Small Cap.

Michael Chan, vice-president and senior portfolio manager, Fiera Capital Corp. A growth manager, his responsibilities include Fiera Capital Equity Growth.

Q: After a long drought in the Canadian small-cap universe, there are signs of green shoots among natural-resource stocks. These represent a heavy weight in the S&P/TSX SmallCap Index.

Carscallen: In the first quarter of 2016 and for the 12 months to the end of March 2016, the S&P/TSX Small Cap Index outperformed the S&P/TSX Composite Index. This outperformance is a first in many years. When you dive into the sectors to see where you’re getting the bulk of the returns from, a large portion is from the materials sector, in particular gold. The materials sector represents the biggest sector weight in this small-cap index. If you look back in time, the worst place to be would have been materials and gold. There are green shoots showing up for gold stocks.

We’re also starting to see green shoots in energy. Energy represents the second biggest sector weight in this small-cap index. It hasn’t had nearly the same bounce as the metals. Yet, the energy sector is continuing to move up. There’s room for more. Looking at all the sectors, everything that worked last year isn’t working so far this year. Everything that was disastrous last year is having a great time, in particular the gold stocks.

Arpin: Over the last decade to the end of March, the S&P/TSX Small Cap Index had an annualized total return of 0%, and over the past five years the total return was an annualized -5%.

Q: Did active management outperform the small-cap benchmark in the first quarter of 2016?

Carscallen: The total return for the S&P/TSX Small Cap Index for the first quarter of 2016 was 8.5%, whereas the median manager in this small-to-mid-cap space produced a total return of 1.6%. In 2015, the median manager handily outperformed the small-cap index. That was also the case at least over the past five years.

Arpin: You’ve seen a lot of portfolio managers disappear in the small-cap space. Many managers that had portfolios with heavy resource weightings, which were doing well as long as China-themed stories worked, have since folded. The survivors have focused on sustainable businesses. You can’t underestimate the importance of natural-resource stocks to the small-cap space. At the end of March, materials represented 31.9% of the S&P/TSX Small Cap Index and energy was 15.9% for a total of 47.8%. Gold and silver stocks represent 24.5% of the index, with gold at 17.9%.

Q: Can we talk about small-cap gold stocks? Scott, you do not own any gold stocks.

Carscallen: I consider that mining is a capital-intensive, long drawn-out process that barely provides a decent return on capital and adds volatility to the portfolio. In the small-cap space, a large number of junior metal and mining companies are not self-sustaining. That means that they can’t generate internal cash flows sizeable enough to keep themselves going for a long period of time. They tend to need access to the capital markets. Also, the fundamentals that drive the gold price can be pretty tough to figure out.

Q: Michael, you have B2Gold Corp. (BTO) among the top-10 holdings in Fiera Capital Equity Growth?

Chan: We apply the same criteria in assessing a gold company as we do to a company in any other sector. We look for best-in-breed companies and entrepreneurial management teams that have a large equity stake in the company. In the gold sector, we’re finding about six attractive opportunities. These companies have low cash costs and excellent volumetric growth, which is important for us. The industry is changing. It’s placing increasing emphasis on return on investment. If you looked at the same opportunity list four years ago, it would be difficult to find one attractive bottom-up opportunity in gold. There has been a four-year down-cycle in gold stocks. There’s a reasonable chance that we’re seeing the beginning of an up-cycle. This is not a call on the gold price. B2Gold is a low-cost growth company. It produces 500,000 ounces per annum. This could grow to 800,000 ounces by 2018.

Arpin: I have a significant holding in Alamos Gold Inc. (AGI). It’s a low-cost producer with a good balance sheet and has operations in Mexico and Ontario. We look for companies that have producing assets in stable jurisdictions. Our emphasis, in general, is on low-cost producers. The companies must have decent balance sheets. The biggest issue for us with gold stocks, as a value manager, is that the gold companies don’t tend to trade at a discount to their net asset value.

Chan: This arguably could be one of the best times to build a gold mine. The top engineering teams are available. The equipment suppliers are eager for business, as are the geologists. This increases the probability of the operation being successful.

Arpin: Take Asanko Gold Inc. (AKG), which is a gold company that we own. It has had a successful start-up of a mine.

Chan: I own the stock.

Arpin: Asanko is a company that has been able to bring a mine into production and do it on time and on budget. It’s a quality management team with significant equity in the company.

Q: What about the small-cap energy sector. Why do you think it is on the road to recovery?

Chan: We’re excited about the opportunities that are presenting themselves in high-quality, oil-producing companies. The industry has been in tough shape after the oil price dropped from US$100 per barrel to US$26. The industry is shrinking. There are bankruptcies, and profitability margins are at troughs. This is the reason why long-term, this sector is attractive. Given the low oil price, supply is coming off in the United States, Canada and South America. There is a supply response and demand is still robust. We believe that the oil market will rebalance over time and the long-term price should be US$60 to US$75 per barrel. Over the last 33 years, the oil price has only dropped two years in a row twice. The first time was 1997-1998 during the Asian financial crisis. The last time was in 2014-2015. We don’t believe it will drop three years in a row, because of the supply response.

Carscallen: I concur with this. There has been a significant pick-up in the oil price since February to around US$44 to US$45. Furthermore, the junior energy companies have become more efficient. They’ve taken a lot of costs out of the equation, particularly in the costs of oil services. These oil-producing companies can be more self-sustaining in a lower oil-price environment. We don’t need US$100 a barrel for these companies to thrive. The energy-services companies are currently under pressure. The oil producers are continuing to push them to cut their prices. At this point in the energy cycle, I am focusing on the producers and am underweight the services companies. If you want to find the deepest value in the energy sector, you’ll find it among the fraccers and the drillers. Some of these companies are trading at half their book value.

Q: We have talked about oil. What about natural gas?

Arpin: The bulk of drilling in Western Canada is for natural gas. The non-oil-sands business is natural gas. The commodity price is too low to encourage investment by natural-gas producers. It’s even more challenging in natural gas than in oil.

Chan: The situation is challenged. Inventories are high both in Canada and the United States. Medium-term it looks interesting. Supply is still at a high level. The price of natural gas today may be similar to the situation when oil was US$26 a barrel. The natural-gas price, at these levels, is not sustainable. We’re looking at attractively priced natural-gas companies with liquids.

Carscallen: The short term is difficult for natural gas; 2017 could be a much better year for the commodity.

Q: Can we sum up the discussion on energy?

Chan: We’ve been adding to energy in our portfolio over the last six months. Among the different sectors in the Canadian small-cap universe, it’s right up there in terms of attractive opportunities. We can see our portfolio move energy to our largest sector weight.

Carscallen: We’ve been steadily increasing our weighting in energy this year. We were buying most aggressively in February and March. It’s tilted toward producers and underweight service companies.

Part one of a three-part roundtable.

Coverage of the roundtable, which was convened and moderated by Morningstar columnist Sonita Horvitch, continues on Wednesday and concludes on Friday.