Small-cap valuations improving

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: The building blocks appear to be in place for a strong performance from Canadian small-caps in 2016.

Carscallen: The stocks of companies exposed to Western Canada in areas such as financials, real estate and industrials that came under intense selling pressure because of this exposure to energy, are now coming back. Should the price of oil and of metals continue to improve, it will augur well for Canadian small-caps.

Chan: We haven’t seen as much upside for our portfolio in a long time. The reason why the small-cap universe will be interesting over the next few years is valuation. There was a piece put out by Scotia Capital Inc., which pointed out that at the beginning of 2016, about half of the stocks in the S&P/TSX Small Cap Index were trading below book value. Two-thirds of those were resource stocks. The index as a whole was, at the time, trading below book value at 0.91 times. The last time these stocks were that inexpensive was during the global financial crisis in 2008-2009. So, the valuations in the Canadian small-cap space are attractive.

Also, the U.S. Russell 2000 Index, the small-cap benchmark south of the border, has outperformed the Canadian small-cap index over the last five years. It’s now the first time in five years that this is reversing. This is a good leading indicator of the prospects for the Canadian small-cap market. Finally, confidence in the recovery in oil will help to encourage investors to focus on the Canadian equity market and on Canadian small-caps.

Carscallen: Over the past few years, with risk aversion in play, larger small-caps did better than the smaller small-caps. A lot of the micro-caps are in the resource space. Now, with the turnaround in energy and other resources, you’re probably going to see the smaller small-caps outperforming the larger small-caps.

Q: Can we briefly discuss recent initial public offerings (IPOs) in the Canadian small-cap universe?

Chan: We like IPOs, but are selective. During 2015, we did participate in a few IPOs. One of the more meaningful ones was Spin Master Corp. (TOY), a major player in the toy industry globally. There have been some IPOs this year, but we haven’t participated in any.

Carscallen: We don’t traditionally participate in IPOs. There was an appetite last year for IPOs of non-resource, consumer-product-related companies.

Arpin: There was considerable enthusiasm for these companies. They came public with high valuations. As we’ve discussed, the S&P/TSX Small Cap Index is heavily resource-related. Investors were looking to put their money into non-resource related small-caps. We at Beutel Goodman seldom participate in IPOs. Statistically, IPOs are a difficult way to make money. A large percentage of Canadian IPOs end up trading below their issue price.

Chan: There have been some great IPOs in the past. For example, Dollarama Inc. (DOL).

Arpin: Yes.

Q: Mergers and acquisitions?

Arpin: This is always an important theme in the small-cap space.

Carscallen: Expectations for M&A in the oil patch are high. The banks are putting the squeeze on some of the struggling companies. They may be pushed to put themselves up for sale. A challenge is that acquiring companies tend to want to buy companies with one asset. Publicly traded companies with multiple assets might not be that attractive to them.

Arpin: There has been very little merger and acquisition activity in the North American oil and gas business. The challenge for the acquiring companies in the energy sector is that the equity prices have been way ahead of the commodity prices.

Chan: I think that the probability of M&A activity in energy has increased. Over the past 12 months, it was hard for the buyer and seller to agree on the outlook for the commodity price. Recently, the current price of oil has become largely similar to the expected future price of oil at around US$45 a barrel. So there is a better chance of buyers and sellers coming together in a transaction.

Q: Briefly, your definitions of small-caps and number of names in your portfolios.

Arpin: Beutel Goodman follows MSCI guidelines and invests in securities that are ranked at the bottom 15% of the cumulative float-adjusted market capitalization of all TSX-listed stocks, at time of purchase. Currently, this would be a market float of $190 million to $2.5 billion. We have 41 names in Beutel Goodman Small Cap.

Carscallen: We tend to buy stocks with a market capitalization that is below the BMO Small Cap market capitalization threshold of about $1.9 billion, at present, and we can hold them up to $7.5 billion. We will let the stocks ride. We can go as low as $50 million. We have 50 names in Mackenzie Canadian Small Cap Value.

Chan: For new investments, our definition is $150 million to $750 million. As they grow, we can continue to hold them, as long as we like the stocks, up to a $3-billion market cap. We have 60 companies in Fiera Capital Equity Growth. Of these 40 are core positions, 10 are being built slowly and we are slowly crystallizing our gains in 10.

Q: Time to discuss your non-resources holdings.

Carscallen: Winpak Ltd. (WPK) and CCL Industries Inc. (CCL.B) are among the top-10 holdings in Mackenzie Canadian Small Cap Value.

Arpin: I own Winpak. It’s a high-quality food-packaging company that is taking market share from competitors. The company generates an exceptional return on invested capital. I own CCL as well. It’s a leading provider of pressure-sensitive labels globally. It has improved its returns and its free-cash-flow characteristics of the business over time. We’ve owned CCL and Winpak for at least a decade.

Q: Steve, these two stocks were among your top-10 holdings at the end of March.

Chan: Winpak is an innovator and industry leader. I also own it.

Carscallen: Winpak has been a name in the portfolio for many years. It’s a steady grower and has an excellent management team. It’s embarking on some sizeable capital-expenditure programs, at present, which should continue to propel the company’s growth.

Chan: We sold CCL. It’s a stock we bought as a small-cap, probably about seven years ago. Management has done a great job. When a company becomes a large-cap, we reinvest the funds in the next generation of high-quality companies.

Carscallen: CCL has a strong track record of making good acquisitions and generating sizeable synergies from the targets. Another specialty packaging company that is in the portfolio is Intertape Polymer Group, Inc. (ITP).

Arpin: We own it too.

Chan: We invested in Intertape quite a few years ago and we sold our position about a year ago, as it had reached our estimate of fair value.

Q: Michael, any other name you’d like to mention?

Chan: Stella-Jones Inc. (SJ) is a long-term holding in the portfolio. It’s a leader in niche businesses such as railway ties and utility poles. The company generates good free cash flow and high returns on invested capital. Management has been excellent at acquisitions and integration.

Carscallen: I also own Stella-Jones.

Arpin: A stock that I would like to mention is Major Drilling Group International Inc. (MDI). We bought it last year, as everyone sold it.

Chan: It was a good time to buy it.

Arpin: At the time we bought it, the company traded at historically low valuations. Major Drilling is dominant in the mining drilling space. It has a strong balance sheet. About 50% of its business is gold drilling. That activity should improve.

Part two of a three-part Canadian small-cap roundtable.

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