After several years of outperforming their large-cap peers, sizzling small-cap stocks are cooling. But although the traditional valuation gap between the two asset classes has been eliminated, fund managers are confident small-caps will heat up again.

“It’s the first year small-caps haven’t beaten large-caps in five years,” says Peter Hodson, manager of CI Signature Canadian Small-Cap Class Fund (formerly Synergy Canadian Small-Cap Class Fund) and vice president of investments at Toronto-based CI Investments Inc. The asset class is being held back by market fears of rising interest rates, high oil prices and exogenous factors such as terrorist attacks, he says: “Until we see some market stability, it’s unlikely small-caps will outperform.”

But there is one thing that could change that: cash-rich large companies are on the prowl for smaller firms. “Even though small-caps are more expensive than large-caps, they continue to grow at a faster rate,” Hodson says, adding that small-caps recently traded at 26 times earnings vs 20 times for large-caps. “The big companies can buy growth faster than creating it themselves.”

GlaxoSmithKline PLC’s acquisition of ID Biomedical Corp. is an example. The London-based pharmaceutical giant Glaxo paid 35% more than the market price to obtain the Vancouver-based biotech firm. “Companies are willing to spend money, but the market is unsure of itself,” he says.

An 18-year veteran of the asset class and a growth investor, Hodson thinks the market is overreacting. Despite rising interest rates and catastrophic natural disasters, he expects U.S. economic growth to be 3.5%-3.7% for 2005. “That’s very strong growth in the face of a tough backdrop,” he says. “The health of corporations is quite secure.”

Fully invested, Hodson undertook a strategic shift in June toward U.S. holdings, which now account for 40% of the 50-name fund. On a sectoral basis, the largest change concerns Hodson’s decision to lower the formerly 26% weighting in energy stocks to 11%. He has reinvested some of the proceeds in industrial products (now 15% of the fund, up from 10%), biotechnology (8%, previously zero) and materials (25.5%, up from 20%). Information technology stocks retain a 26% weighting in the fund, with the rest invested in smaller holdings, including 4% in consumer discretionary stocks.

One of his recent acquisitions is California-based Ceradyne Inc., a manufacturer of specialized ceramic equipment — such as body armour and drill bits — used by the military and the oil and gas industry. “Earnings continue to grow in the 40%-plus range,” says Hodson, who acquired the stock at around US$29 a share in June after concerns about its military sales. “It’s made a very determined effort to diversify its business. Non-military applications are around 45% now,” he adds, noting the stock recently traded at US$42.90 a share, or about 19 times 2006 estimated earnings. Hodson believes the stock will hit US$48 within the next 12 months.

Another recent favourite is Talx Corp., a U.S. firm that provides data verification for employers and creditors. Bought in September at US$33 a share, the stock recently traded at US$42, or about 30 times 2006 earnings. His upside target is US$50 over the next 12 months.

Small-caps are only midway through a secular cycle, argues Alexander Lane, co-manager of Dynamic Power Small-Cap Fund and a portfolio manager at Toronto-based Goodman & Co. Investment Counsel Ltd. He draws parallels to the 1970s, when small-cap growth stocks were the best-performing asset class. “Large-caps averaged about 5.9% on an annualized basis, while small-caps averaged about 11.5% — a substantial outperformance for the whole decade,” he notes.

Lane — who works with Rohit Sehgal, Goodman’s chief investment strategist — acknowledges small-caps lagged large-caps in the 1980s and 1990s. “Everything moves in cycles,” he says, “and this cycle began in 2002. We are three years into it and have another three to go.”

Like Hodson, he notes the market has been jittery about rising rates, putting pressure on small-caps dependent on external capital. He expects multiples will fall for the next six to nine months, in tandem with an end to the rate hike cycle. “That doesn’t mean small-caps will go down,” Lane says. “But they will need to have superior earnings growth characteristics and good returns.”

Lane is also bullish on the macroeconomic front, expecting 2.7%-2.8% GDP growth in Canada in 2005. The U.S. interest rate hike cycle will end some time in early or mid-2006, he says, which will restart the small-cap cycle. “Earnings growth still looks pretty good,” he says. The larger-cap companies that make up the S&P/TSX composite index are expected to grow their earnings by about 12% next year, vs 13.5%-15% for small-caps.

@page_break@Lane, a growth investor who manages a 45-name portfolio, seeks companies displaying characteristics such as pricing power, expanding margins and strong management. Utilizing a blend of top-down and bottom-up styles, and focusing on sectors that show the strongest growth characteristics, he has allocated about 47% of the portfolio to energy stocks, 33% to metals and minerals, 11.3% to consumer discretionary, 6% to IT, with small allocations to sectors such as health care.

One of the top names in his fund is coil tubing manufacturer Technicoil Corp. A leader in the so-called “fracking” activity in Western Canada that allows gas to escape from rock channels below ground, it is taking advantage of the trend toward exploiting unconventional shallow gas reservoirs.

“These more unconventional plays, which require these services, have become more economical,” says Lane, who bought stock in the company in February when it was trading at $2.55 a share; it recently traded at $3.20, around nine times 2006 projected earnings, which, he says, is very reasonable. His target is $5 within 12 to 18 months.

Another favourite is Palladin Resources Ltd., an Australian firm that’s in the process of developing a uranium mine in Namibia that will be in production in 2006. “It’s the only junior uranium company with production coming on in the next five years,” Lane says. Initially, the firm will produce 2.6 million pounds of uranium annually, gradually increasing production. And while uranium has already risen to US$34 per pound from US$10 over the past two years, he expects it to continue to climb, hitting US$50 over the long term.

Acquired last January at AUS$2 a share, the stock is unchanged. But Lane expects its shares to rise to AUS$3 within 12 to 18 months.

Although current valuations are not excessive, they are not as attractive as they were a few years ago, admits Christopher Fernyc, a portfolio manager at Calgary-based Bissett Investment Management Ltd. who oversees Bissett Small-Cap Class.

“Back then, you could buy a quicker-growing company at a 20% discount. Today, there are fewer opportunities,” he says. “For the most part, you are relying on the underlying fundamentals, which will be key drivers in stock performance. This will take any multiple expansion out of the equation. That game is done.”

Fernyc has seen market extremes, including the 1998 small-cap meltdown. But looking ahead, he expects moderate returns. “Longer term, returns will be commensurate with the growth of the underlying businesses; we tend to target 10%-12% a year,” says Fernyc. As a guideline, he points to the S&P/TSX’s average annual return of 10.7% for the 10 years ended Oct. 31, vs 10.8% for the Nesbitt Burns small-cap index. “Stocks tend to revert. You can’t grow continuously at the rate [it has been] for the past five years.”

A bottom-up, growth at a reasonable price investor, Fernyc has about 31% of the fund in energy stocks, vs 21% for the NB small-cap index; 21% is in consumer discretionary (vs 10.5% in the index); 14.4% in industrial products (vs 9.3%); 9.4% in financials (vs 9.9%); and smaller weightings in sectors such as health care. Noticeably, only 2% of the fund is in materials, vs 30% for the index, because of his aversion to deep cyclical stocks.

One of the top names in the 34-stock fund is Mullen Group Income Fund. An Alberta-based trucking firm, it has long served the oil and gas industry, as well as hauled goods across the country. “It has generated a consistent 15% return on equity for the past 14 years. It’s highly profitable, stable, has a clean balance sheet and management owns a large stake,” says Fernyc. Acquired at a split-adjusted price of $5.50 a share, it recently traded at $24.50. It has a 7% yield.

Another one of his favourites is Alliance Atlantis Communications Inc. A specialty broadcaster that boasts popular channels such as Showcase, it derives considerable revenue from the CSI “franchise,” which it shares with the U.S. network CBS Broadcasting Inc. Fernyc bought the stock in 1998 around $25 a share, saw it plunge to $11 in 2003, then rode it back up to $34.40. His upside target is to surpass $40 over the next 12 to 18 months. IE