Small-cap roundtable: High valuations pose challenge

Scott Carscallen, vice-president and portfolio manager at Mackenzie Investments. A value manager, Carscallen is responsible for Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class.

Martin Ferguson, director and portfolio manager at Calgary-based Mawer Investment Management Ltd. His mandates include Mawer New Canada and BMO Enterprise, both of which are closed to new investors. Ferguson’s discipline is to buy wealth-creating companies at discounts to their intrinsic value.

Ted Whitehead, senior managing director and senior portfolio manager at Manulife Asset Management. A growth manager, Whitehead’s responsibilities include Manulife Growth Opportunities.

Q: Where are you finding opportunities?

Carscallen: The valuations on some of these high-quality small-caps are approaching nosebleed territory. A valuation metric that I use is EV to EBITDA (enterprise value to earnings before interest, taxation, depreciation and amortization.) At the beginning of 2013, this was at six to seven to eight times on average. Now it is, say, nine to 10 or 11 times and some companies are even at 12 times. Most high-quality companies have continued to deliver on earnings growth and have provided reasonably optimistic forecasts. But there are high expectations built into the valuations. I consider that the upside is capped on a lot of non-resource stocks. To Ted’s point, I am seeing a lot of positive data on energy. Natural-gas prices have been doing well, as have oil prices. There is the potential liquefied natural-gas build-out that is getting the market excited. In particular, I like energy-service companies.

Ferguson: So do I.

Whitehead: Many companies are beating analysts’ earnings expectations, they are guiding their earnings higher and they are outperforming. A lot of these are names that we already own. We are always looking to add new names. Being bullish on the energy sector, this is one area that we are focusing on. The tailwinds for energy prices are stronger than anticipated and the weaker Canadian dollar is a plus. There has been a big drawdown in natural-gas inventories due to this cold winter, which is positive for the service companies.

Ferguson: The market has moved up, but we are finding companies that offer good relative value. There is no rhyme or reason to the sectors. There is still value to be found, and sometimes changing your time horizon can give you an advantage over the market. Our job is to find returns while managing risk. Small-caps are a higher-risk asset class. We focus on determining what a company is worth. We do 15-year discounted-cash-flow analysis on all our companies and look for relative value.

Arpin: We have added new names and added to existing names. It is in all different sectors; it is company-specific. The biggest issue that we have come across is the one that Scott identified. If you look at higher-quality businesses in general, you are seeing EV to EBITDA multiples in the nine-plus range. This is high by historic standards. A lot of the technology companies are trading at 15 times EV to EBITDA and the smaller-cap tech names are trading at premiums to larger-cap names and also to some of their U.S. counterparts. This is an issue.

Q: Are there any high-quality stocks that still offer value?

Arpin: Looking at financial services, the sub-prime-mortgage providers, which we have discussed at previous roundtables, continue to offer value. An example is Equitable Group Inc. (TSX:EQB), which we own. It trades at nine times forward earnings per share and has a return on equity in the 17% to 18% range. The price-to-book multiple is at a substantial discount to what it would trade at if there were not concerns in the market about the sustainability of its earnings and growth.

Q: Time to talk sectors. Let’s start with financial services, which represented 15.6% in the BMO Small Cap Index at the end of February.

Carscallen: I have traditionally been overweight financials in my small-cap portfolio, which averages 50 to 60 names. We use the BMO Small Cap formula to define small-caps, which currently results in a maximum market cap of almost $2 billion. The fund must have 80% in companies within this range. In financials I own Equitable. That was a valuation call versus another major alternative mortgage provider, Home Capital Group Inc. (TSX:HCG).

These stocks have had good run, but the fundamentals for both companies are good. They are examples of growth companies that pay dividends and continue to increase them. I look for companies that generate strong cash flow and that have potential catalyst events that can help move the stock, such as increasing the dividends or the paying of a special dividend.

Another of my financial holdings is investment manager Gluskin Sheff + Associates Inc. (TSX:GS). The stock has had a big run and its valuation is not as attractive as it was. It has been paying special dividends on a regular basis.

Arpin: I don’t particularly like special dividends. The company is putting the capital back to the shareholders. I would rather see management use the capital in the company or if it believes that it’s in a great financial position, increase the dividend modestly over time.

Q: Steve, your financial holdings?

Arpin: We have 22.9% in this sector. We consider that valuations still remain reasonably attractive relative to the return on equity that these companies generate. Our definition of small-caps is a market float of up to $1.5 billion. We average 40 to 45 names in our small-cap portfolio.

We have been overweight financials for some time. We recently bought a position in InnVest Real Estate Investment Trust (TSX:INN.UN), which holds one of Canada’s largest hotel portfolios. It’s the first REIT that we have owned in years. InnVest has had some management issues and was trading at a discount to intrinsic value. There have been some positive changes, which we think will help to surface value.

A long-standing holding is Industrial Alliance Insurance and Financial Services Inc. (TSX:IAG). It’s a well-run insurance company that has been able to generate good returns for shareholders. Industrial Alliance has been more prudently managed than other Canadian insurers, even the larger companies.

Ferguson: My portfolio currently has 56 companies, with exposure to eight of the 10 sectors. I am overweight the financial sector at 27%. Our definition of small-caps is 75% of the BMO formula, which brings us to shy of $1.5 billion. Equitable Group and Home Capital Group are still my largest weights in this sector. Equitable is a high-quality company. It has a high return on equity, good management, low valuation and it is well positioned given the dearth of competition. The housing market may weaken, but it’s not going to fall off the face of the earth.

Whitehead: We also own Home Capital. We’ve held it for years and it has done very well. Another holding in this sector is leasing company Element Financial Corp. (TSX:EFN), which is run by Steve Hudson, former founder of Newcourt Credit Group.

Carscallen: We also own Element Financial. The stock has had a big run. Steve Hudson grew a company in the past. Maybe he can do it again. The stock doesn’t look cheap on any traditional metric.

	Element Financial Corp.	Equitable Group Inc.	Home Capital Group Inc.
March 31 close	$14.89	$57.84	$44.65
52-week high/low	$15.50-$8.28	$60.24-$35.30	$45.29-$24.83
Market cap	$2.8 billion	$888 million	$1.6 billion
Total % return 1Y*	65.4	53.8	54.0
Total % return 3Y*	n/a	26.0	17.5
Total % return 5Y*	n/a	40.6	30.2
*As of March 31, 2014
Source: Morningstar

Ferguson: I own Element Financial, too. We bought it on the IPO (initial public offering) and we have participated in some, but not all, of the equity issues since then. In a short period of time, Steve has created the largest leasing company in Canada and it continues to grow through acquisitions. The stock is expensive on traditional measures. The question is: What is the company worth? Steve has kept an overcapitalized balance sheet and is preparing for future growth. The company is looking at huge growth in leasing originations in 2014 versus 2013.

Whitehead: In contrast to the three of you, I am underweight the financial-services sector. I can hold between 60 and 100 names. There are currently about 67. I can invest in larger-cap companies. The average market cap of the portfolio is $2.9 billion. Using $2 billion as the cut-off between small and mid-caps, we have roughly 50% in each. On foreign content, last year we were as high as 30%. We now are about 11%. We are finding good opportunities in Canada, as I mentioned in the energy sector, for example.

This is part two of a three-part series on Canadian small-cap stocks.

Part three appears on Friday.