Will small-cap stocks lag in 2013?

Stephen Arpin, vice-president at Beutel, Goodman & Co. Ltd. A value manager, Arpin is the lead manager of Beutel Goodman Small Cap Fund.

Ted Whitehead, senior managing director and senior portfolio manager at Manulife Asset Management. A growth manager, Whitehead uses both quantitative and fundamental analysis. His responsibilities include Manulife Canadian Opportunities and Manulife Growth Opportunities Fund.

Martin Ferguson, director and portfolio manager at Calgary-based Mawer Investment Management Ltd. His mandates include Mawer New Canada Fund, which is closed to new investors, and BMO Guardian Enterprise Fund. His discipline is to buy wealth-creating companies at a discount to their intrinsic value.

Q: Canadian small-cap stocks underperformed their big-cap counterparts in 2012. This is the second year in a row of underperformance. In 2012, the BMO blended (weighted) small cap index, the benchmark for the Canadian small-cap universe, had a total return of 2.5% vs 7.2% for the S&P/TSX composite index. Why?

Whitehead: The flow of funds at both the institutional and retail investor level is still toward dividend-paying and higher-quality stocks. In the small-cap area, the market has punished those natural-resource stocks that are in the exploration and development stage. The BMO small cap index has a heavy weighting in both materials and energy. Materials produced a negative total return of 8.8% in 2012 and the total return on energy was a negative 11.5%.

Arpin: There was a flight to quality by small-cap investors in 2012. Non-dividend payers were penalized. But, you have to look closely at the performance of the dividend payers, not all of them did well. We screened the stocks in the BMO blended (weighted) small cap index. This showed that the market differentiated between those companies where the dividends were perceived to be sustainable and those where they were not.

Dividend-paying companies with payout ratios of less than 70% dramatically outperformed the Canadian small-cap universe, with an average price increase of 11.2%. Those with payout ratios of greater than 70% had an average price increase of 2.6%. Finally, the stocks of those companies which paid no dividends were down 9.2% on average.

Ferguson: The flight to quality will be one of the underlying investment themes for 2013, but this will lessen as the year unfolds. Investors will remain fearful because of the slow-growth economy and the risks out there. But, we are starting to see some enthusiasm for growth stocks. Investors have shored up their portfolios with bonds and blue-chip, high-yielding equities. Now they are realizing that in a slow-growth economy you need some growth in the portfolio to add excitement. By the second-half of 2013, this enthusiasm for growth will start to eclipse the flight to quality, as one of the underlying themes.

Arpin: A lot of the safe-haven areas of the Canadian equity market are expensive, like real estate and utilities. There are not many utilities in the small-cap universe. But if you look at a company like AltaGas Ltd. (TSX:ALA) , it is trading at an enterprise value to EBITDA [earnings before interest, taxation, depreciation and amortization] multiple that is at an all-time high versus its historic trading range.

As value managers, we are finding it more challenging to find new ideas. We have a high return threshold. Our objective is to identify stocks that will give us 100% over three or four years. Coming out of the global financial crisis, there was a lot of opportunity in small-caps, now less so.

In the case of small-cap natural resources stocks, while the energy and materials sectors as a whole did poorly in 2012, there is a need to look at the performance of the different sub-groups within these sectors.

Whitehead: Yes. Even though the small-cap materials sector had a negative total return in 2012, paper and forest-products stocks did exceptionally well, thanks to the improvement in the U.S. economy. By contrast, gold stocks did poorly and metals and minerals stocks were even more disappointing.

Q: How did the sectors other than energy and materials perform in 2012?

Arpin: Of the eight remaining sectors, seven did well. Industrials, consumer-discretionary stocks and financials, which have sizeable weightings in the BMO small cap index, produced total returns in their high teens. So, the non-commodity small-caps generally did well. Only the health-care stocks, which represent a small weight in the index, had a modest negative total return. These are essentially non-cash-flow-positive and non-dividend-payers.

Total-return index	1Yr.	3Yr.	5Yr.	10Yr.
BMO Small Cap Blended (Weighted)	2.5	6.8	2.6	10.2
S&P/TSX Small Cap	-2.2	3.4	-0.5	5.7
S&P/TSX Composite	7.2	4.8	0.8	9.2
Source: Morningstar

Q: What about the valuations of small-cap stocks vs their large-cap counterparts?

Ferguson: In order to compare the S&P/TSX composite index with the BMO small cap index, we look at companies with positive earnings only. In the small-cap universe, there are so many companies that have no positive earnings. Currently, our research shows that large-caps and small-caps are generating similar returns on equity, yet small-cap stocks are trading at a discount both on a price-earnings multiple and a price-to-book basis. There is a noticeable difference.

Q: Will small-caps outperform large-caps in 2013?

Ferguson: You have to put me on the bullish side of the ledger. From a valuation perspective, small-caps are starting from an advantageous position. Then there is the possibility of an investor flight to growth, which would be good for small-caps. We are also still in a post-economic crisis recovery. Small-caps tend to do well early in an economic recovery. We are not at the early stage, but if there is an adolescent growth spurt, it will be good for small-caps. Within the small-cap universe, there are a lot of companies with high dividend yields and strong free cash flows. There is no shortage of quality ideas. So far, in 2013, we have added two new names to the portfolio, after adding 10 in 2012.

Whitehead: A lot of smaller-cap companies are now instituting dividends. Also, many companies in the BMO small cap index were formerly income trusts. They have continued their dividend policies.

Ferguson: The dividend yield on the BMO small cap blended (weighted) index was 2.56% at the end of the year. In 2012, 28 out of the 57 companies in the portfolio at year-end had either initiated or increased a dividend, including several that increased a dividend more than once. This shows that the companies are competent cash-flow generators. They were also cognizant of investor pursuit of dividend yield in 2012. This approach would ensure that they were top of mind, should they need access to capital.

Whitehead: The better economic environment gives the small-caps access to capital. The commodity producers will be dependent on the economic growth in China and other emerging markets in 2013. Also, energy producers with assets in Western Canada will need to see a narrowing of the wide differential in oil prices versus those in other jurisdictions. There needs to be an improvement in infrastructure to accomplish this. We see this happening in the second half of 2013. We think that there is a good chance that energy will do better this year and see opportunities in the sector.

We are generally optimistic about small-caps. I have 47% in small-cap stocks in Manulife Growth Opportunities Fund. My mandate requires at least 40%. We are generally around 50%.

Q: Steve has said it is more challenging, as a value manager, to find opportunities among Canadian small caps. Ted, what about you as a growth manager?

Whitehead: We are generally adding to the names that we already own in Canada. Unlike Martin and Steve, my mandate allows for foreign content. I have been substantially increasing my weighting in U.S. stocks. They now represent more than 20% of the portfolio versus 5% or 6% last year. The U.S. economy will likely outperform the Canadian economy in 2013. By year-end, we will probably see U.S. GDP growth at 2.5%. We also think that the U.S. dollar will outperform the Canadian dollar.

Coming on Wednesday: A flight to growth?