Manager Monitor: Cheap stocks, poor fundamentals

Carscallen, who is a value manager, says that at the beginning of 2013 there was value to be had in most small-cap sectors. “Over the year, money has been flowing out of the mines and metals, in particular, into non-resource stocks.” Many resource stocks are now cheap by historic standards, while non-resource stocks “are starting to be fully valued.”

Themes that have done well this year, he says, are sub-prime mortgage lenders, home-building-related companies, forest-products companies and auto-related stocks. Technology, which represents 5.5% of the index, was by far the strongest performer followed by consumer-discretionary stocks (8.3% of the index).

Carscallen is remaining on the sidelines when it comes to metals and mining stocks, even though they are cheap. “The fundamentals for these companies are poor.” Gold stocks have plummeted since the beginning of the year and the macroeconomic environment is unlikely to boost the bullion price, he says. Stocks of metals producers are also down sharply, he says, given the uncertainty surrounding China’s economic-growth prospects.

Carscallen is also “shying away from energy producers.” The past several years have been “tough” on them. “Their access to external capital has effectively been shut off, making growth difficult.” Also, he says, cash flows have been squeezed by both low natural-gas prices and the discount on the Canadian oil price versus the U.S. and international oil prices.

At Mackenzie, Carscallen is responsible for managing some $350 million in small-cap mandates, including Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class funds. “Cash is higher than normal in my mandates. There is a dearth of opportunities in the non-resource sectors.”

The small-cap portfolio averages 50 to 70 names and its benchmark is the S&P/TSX Small Cap Index. The mandates use the BMO Small Cap formula to define the capitalization limits on individual stocks. This limit is currently between $1.6 billion and $1.7 billion, says Carscallen.

The mandates, he says, allow for a maximum of 20% in stocks with market capitalizations that are double this formula, or currently $3 billion. “The median market caps of the portfolios are, at present, $600 to $700 million.”

The Mackenzie small-cap portfolio is decidedly underweight in the natural-resource sectors at 27.6%, at recent count, versus 51.7% of the index. The portfolio has 18.9% in energy (25.7% of the index), “with a focus on energy- services companies,” and 8.7% in materials, a substantial underweight versus the index at 26%.

In materials, the portfolio’s focus is on packaging companies and forest products. In the latter category, Carscallen likes Western Forest Products, Inc. (TSX:WEF), a West Coast producer of lumber and wood-based products used mainly in residential home construction.

Western Forest Products, says Carscallen, has a strong balance sheet and is “steadily improving” its EBITDA (earnings before interest, taxation, depreciation and amortization). “Its margins have been expanding thanks to the modernization of its lumber mills, the application of technology and the rising prices for its products.” This company is, he says, “a good way to play the U.S. housing recovery and the ongoing rebuilding of homes in Japan, in the wake of the tsunami.”

With its strong and growing cash flow, “the company has introduced a share buy-back program and initiated a dividend.” Western Forest Products trades at an EV (enterprise value) to EBITDA of 5.6 times based on 2014 estimates.

Carscallen sold his holding in Major Drilling Group International Inc. (TSX:MDI), which operates in the mining industry globally, with significant exposure to gold mining. With its customers deferring their drilling projects, Major Drilling’s revenues have dropped significantly, he says. “Given the mining industry’s poor fundamentals, it is not the time to be in this stock.”

In the energy-services industry, a long-standing and current top-10 holding is Akita Drilling Ltd. (TSX:AKT.A). It provides drilling rigs to the energy industry, primarily in Alberta.

The company has no debt, he says, and is a strong cash-flow generator. A high percentage of its rigs are “pad rigs or rigs that can easily be moved in a field, which has a high concentration of wells.” Pad rigs are in demand and this demand will grow, he says. “They are ideally suited for the popular unconventional drilling projects.”

Akita’s stock has done well, “but is still cheap,” says Carscallen. The company trades at an EV to EBITDA of three times, based on 2014 estimates. Akita pays a dividend.

In the renewable-energy industry, a long-time favourite of Carscallen’s is Boralex Inc. (TSX:BLX). The company operates a number of wind, hydroelectric, thermal and solar facilities in Canada, the United States and France. The stock is classified in the utilities sector.

Boralex has phased out its shorter-term power contracts, says Carscallen. Now about 96% of its total contracts are long term. “This translates into steady, predictable cash flow.” The company does not pay a dividend, he says, but instead uses its cash flow to build new power facilities.

	Akita Drilling Ltd.	Boralex Inc.	Western Forest Products Inc.
Sept. 25 close	$15.10	$10.30	$1.44
52-week high/low	$15.66-$9.99	$11.84-$8.50	$1.70-$1.03
Market cap	$271.3 million	$388.8 million	$688.0 million
Total % return 1Y*	23.6	20.9	32.7
Total % return 3Y*	7.1	8.6	69.5
Total % return 5Y*	4.1	-2.2	9.0
*As of Sept.25, 2013
Source: Morningstar

Projects under way are “expected to roughly double its EBITDA to almost $200 million in 2016 from about $98 million in 2012.” The company, he says, “is well funded to support these new projects; it currently has $122 million in cash on its books.” In essence, he says, “Boralex is a growth-oriented power company.”

With Boralex’s cash-flow pick-up, there is, says Carscallen, the possibility of the introduction of a modest dividend. “But the company would like to continue to devote a substantial portion of its cash flow to further expansion.”

The company currently trades at an EV/EBITDA of 7.7 times 2014 estimates, “a substantial discount to its peer group where the average is 10.6 times.” Should Boralex initiate a dividend, “this valuation discount could shrink.”