Small-caps: Energy weakness spills over into industrials

The panellists:

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. His discipline is to buy wealth-creating companies at a discount 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.

Stephen Arpin, vice-president and portfolio manager at Beutel, Goodman & Co. Ltd. A value manager, Arpin’s responsibilities include Beutel Goodman Small Cap, which he co-manages with William Otton.

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.

Q: Like financials, some industrial stocks have felt the cold blast from a weak oil price. At the end of 2014, industrials represented 10.8% of the BMO Index.

Carscallen: They represent 25% of the portfolio. But I have a holding in FirstService Corp. (TSX:FSV), which my system classifies as industrial. If you take this out, I’m closer to 22%. I have traditionally had a heavy weight in industrials and have been finding decent value here, of late. There are a wide variety of businesses in the sector. One core position is Boyd Group Income Fund (TSX:BYD.UN), which operates collision-repair centres. It’s a consolidator in this business. It has a heavy exposure to the United States, where it has been aggressively buying up businesses. Its largest customers are insurance companies.

Whitehead: I own Boyd. Manulife Growth Opportunities has 15% in industrials. Yes, there has been a spillover from energy’s weakness into Canadian industrials. My holdings in this sector include Black Diamond Group Ltd. (TSX:BDI), which provides housing for workers offsite. Its customers include energy companies. Another holding is Aecon Group Inc. (TSX:ARE). This construction company has also been affected by the weakness in energy.

Arpin: Beutel Goodman Small Cap has 6.3% in industrials. The biggest holding continues to be WestJet Airlines Ltd. (TSX:WJA). It has business across Canada, but given its origins, there is leverage to Western Canada. It continues to be a good environment for consumers to fly and it is benefitting from lower fuel costs. We’ve been adding a little to industrials focusing on those stocks that have been hurt by their western Canadian exposure.

Ferguson: The Mawer Canadian small-cap portfolio has 19% in industrials in 10 names. The largest holdings in this sector are Stantec Inc. (TSX:STN) and Morneau Shepell Inc. (TSX:MSI). I’ve been adding to both at the margin. Stantec, a professional-services company focusing on engineering, has significant U.S. exposure, but there has been some pressure on the stock due to its western Canadian exposure. Morneau Shepell provides advice on pensions, benefits and other employee matters. It has some exposure to the United States.

Q: Consumer-related stocks? Let’s concentrate on auto-related businesses, which is a focus in all your portfolios. These stocks fall under the consumer-discretionary banner, which represented 12.8% of the BMO Small Cap Index at the end of December.

Arpin: Beutel Goodman Small Cap has big positions in auto-parts manufacturer Linamar Corp. (LNR) and in Uni-Select Inc. (UNS), a North American distributor of auto parts.

Whitehead: Linamar is the biggest weighting in Manulife Growth Opportunities. The recovery in the auto cycle is still under way.

Carscallen: I also own Linamar. It’s a top-10 holding. Management has been steadily improving the company’s margins.

Arpin: Linamar has a significant exposure to the United States. Uni-Select has been an underperformer for a long time. It recently sold its U.S. auto-parts distribution business to Carl Icahn at a very good price and the company has de-levered. It is a turnaround situation.

Carscallen: An auto-related stock that has been hit because of the company’s significant exposure to Western Canada is AutoCanada Inc. (ACQ). I own the stock. It’s the only publicly traded auto dealership in Canada.

Ferguson: I have only a small weighting in the consumer-discretionary sector at 2.7%.

Q: The weakness in the natural-resource sectors has been identified as a factor in the underperformance of small-caps versus large-caps in recent times. Let’s start with materials, which represented 26.2% of the BMO Index, at the end of December.

Whitehead: We are underweight materials at 18%. Manulife Growth Opportunities has one gold stock and it’s B2Gold Corp. (TSX:BTO). We also continue to own Stella-Jones Inc. (TSX:SJ), a producer and marketer of industrial pressure-treated wood products. It’s a consolidator in this area and it’s seeing its markets improve, especially in California.

Ferguson: We own Stella-Jones. It’s our largest name in this sector. We are underweight materials at 13%. Another of my holdings in this sector is Winpak Ltd. (TSX:WPK), a packaging company. It’s conservatively run, it has net cash on the balance sheet and is a consistent producer of double-digit return on equity.

Carscallen: Winpak is the largest holding in Mackenzie Canadian Small Cap Value. The fund is underweight materials at 10.7%.

Arpin: I own Winpak.

Ferguson: Another packaging holding in the portfolio is Intertape Polymer Group Inc. (TSX:ITP).

Carscallen: I also own Intertape Polymer.

Arpin: I also own this stock. We have a fair exposure to packaging companies in Beutel Goodman Small Cap. A significant gold holding in the fund is Alamos Gold Inc. (TSX:AGI). In all, I have 23% in materials versus 26.2% for the BMO Small Cap Index.

Whitehead: In paper and forest products, I own a significant weight in West Fraser Timber Co. Ltd. (TSX:WFT).

Carscallen: I own Western Forest Products, Inc. (TSX:WEF). I have no gold holdings and no base-metals holdings. For base metals to do well, I need to see more life coming out of China.

Q: The energy sector’s recent weakness has been a major contributor to the poor performance of the Canadian small-cap universe. What are your significant holdings in this sector, which represented 16% of the BMO Index at the end of 2014?

Ferguson: I have an 18% weighting in energy. The majority of this is in energy services rather than in energy producers. The largest holdings include Canadian Energy Services & Technology Corp. (TSX:CEU) and AltaGas Ltd. (TSX:ALA). We have small positions in a number of energy producers. For example, on the oil side, we have exposure to Raging River Exploration Inc. (TSX:RRX), and on the natural- gas side we have exposure to Delphi Energy Corp. (TSX:DEE) and Paramount Resources Ltd. (TSX:POU).

Arpin: We own Paramount. It’s our largest energy position.

Carscallen: I own Raging River.

Arpin: I have 11.8% in energy. Other energy names include NuVista Energy Ltd. (TSX:NVA) and Crew Energy Inc. (TSX:CR). I also own Total Energy Services Inc. (TSX:TOT), which is a diversified energy-services provider.

Whitehead: I own Crew.

Carscallen: I own Total. The management team is conservative. It could spin out Total’s compression business. It has a strong balance sheet to weather the energy storm.

Ferguson: I also own some Total. CEO Dan Halyk and his team have done a good job of putting together some high-returning assets.

Carscallen: I have about an 11% weight in energy, geared more toward the services companies. I own a basket of various stocks. This includes Canadian Energy Services and PHX Energy Services Corp. (TSX:PHX), which is a directional driller.

Whitehead: I have 14% in energy with about 9% in producers, mainly oil producers and 5% in services. The biggest holdings include DeeThree Exploration Ltd. (TSX:DTX). Two of our energy holdings, Painted Pony Petroleum Ltd. (TSX:PPY) and Crew, have raised money in the last three months so their balance sheets are in good shape. We’re starting to see secondary offerings by Canadian energy producers. If energy prices do rebound, this is something that will cap the rebound in the stocks.

Arpin: Issuing equity at low stock prices results in dilution of ownership in the business.

Ferguson: These share issues protect on the downside should the low-energy-price environment persist. But these issues also provide the opportunity for upside if acquisition opportunities present themselves. The issuing companies will have the capital.

Q: Summary and 2015 outlook for small-caps?

Carscallen: There is too much short-term uncertainty in the Canadian energy sector to become aggressive in energy. Yet, there are some compelling valuations. For Canadian small-caps to do well in 2015 and outperform large-caps, you need to see the oil price stabilize and start recovering. Energy juniors should do particularly well in this situation, as they have been hit harder. They comprise a fairly sizeable portion of the index. You will also probably see a lot of energy-related companies, some industrials and financials, doing well. When you add it all up, this is where you could see a sizeable outperformance of small-caps.

Ferguson: There also needs to be a change in investor psychology. This is a big hurdle facing small-caps. Investors are fearful. Small-caps do well when investors are bullish.

Part one of this three-part series was published on Monday and part two appeared on Wednesday.