Small- and mid-cap Canadian stocks have had a very strong run for the past four years, which would imply valuations could be getting expensive and attractive stocks difficult to find. Fund managers admit stocks are no longer cheap but say the market still offers opportunities.

“We are still able to find companies that are growing very quickly and trading at modest valuations,” says Allan Jacobs, manager, Sceptre Equity Growth Fund, and managing director of Toronto-based Sceptre Investment Counsel Ltd.

Jacobs says companies in his portfolio are expanding earnings at an estimated 26.6% for 2007, vs 15.4% for the S&P/TSX composite index. On a price-to-earnings basis, however, the stocks in the portfolio are cheaper than the index, trading at 15.9 times earnings vs 16.3 times for the index. “But it is getting harder to find really cheap companies,” he says.

A bottom-up growth manager, Jacobs screens a universe of 300 companies, but owns only about 65. “We can be very selective and raise the bar quite high,” he says. Currently, he is also running at about 9% cash, which is somewhat higher than usual. “I probably hit a peak of 12%, but have been buying some things in the past few months.”

One of the latest acquisitions is Wi-Lan Inc., which has a portfolio of patents in the wireless telecom industry. “As much as the company was once in serious financial difficulty, it has licensed patents to firms such as Cisco Systems, Philips and Fujitsu,” says Jacobs, adding that the company is run by Jim Skippen, a former executive at Mosaid Technologies Inc. “It has a lot of people on notice for infringement and gives people an incentive to sign up in six months. It also has a very low cost structure.”

Bought at the start of the year around 92¢ a share, Wi-Lan is now around $2.02. “We still like it and believe it has significant upside,” says Jacobs, who has no stated target price.

Another favourite, which has been in the fund since the stock’s initial public offering in late 2004, is HudBay Minerals Inc. A spinoff from mining giant Anglo-American Corp., it is a leading Canadian producer of zinc and copper.

“It has benefited hugely from the run-up in commodity prices,” says Jacobs, noting that zinc has risen to US$3 a pound from US$1. Bought at an average cost of $2.60, the stock is now trading at $17.40, or about five times earnings.

“We still own it, even though we have trimmed some of the position. While I am cautious on material prices, this company is making a ton of money and the fundamentals behind zinc are fabulous,” says Jacobs, noting the firm is a low-cost producer. “It’s a core base-metals holding and reasonably good value. I’m happy to hold it.”

Jacobs also likes Petrobank Energy & Resources Ltd. The firm has natural gas production and oilsands operations in Canada, and oil production sites in Colombia. It also owns the so-called THAI patented technology, which could significantly lower costs in oilsands operations.

“The market is somewhat skeptical about THAI and paying very little, if anything, for it,” says Jacobs. “But even if it doesn’t work, the oilsands are pretty valuable based on various transactions.”

Bought in October 2005 at an average cost of $10.52, the stock is now trading at $15.90.



Some managers, however, are concerned about the market.

“Our model tells us the market is generally overpriced,” says David Graham, manager, Renaissance Canadian Small Cap Fund, and vice president of Toronto-based CIBC Global Asset Management Inc. “We have found that the market is expensive because companies have been more profitable than they have been in five years.”

Graham notes that the average return on equity for small companies is at the top end of the historical range. Consequently, the model is signalling that if conditions return to the norm, earnings will drop and push prices lower. This model is based on data from Toronto-based Computerized Portfolio Management Services.

In September, Graham became defensive and lowered weightings in two sectors: oil and gas, and materials. Oil and gas stocks account for 12% of the fund, vs 23% in the benchmark BMO Nesbitt Burns small-cap index. Materials represent 18% in the fund, vs 24% in the index.

Graham also added to some income trusts and increased the overall income trust weighting to 14%. It turned out to be a poorly timed move, however, as it occurred before the federal government lowered the boom on income trusts.

@page_break@“But I still think income trusts are good business models,” he says, adding that he is trying to avoid cyclical stocks and favour situations that are more stable as the economy slows. “I’m trying to have more of a balance, so the portfolio doesn’t tumble if we become nervous about the market.”

One of his favourites in the 40-name fund is Liquor Stores Income Fund, which runs 102 retail stores in Alberta.

“It’s a consolidator in the province and, every once in a while, buys a few companies that are up for sale,” says Graham, adding that there are more than 2,000 liquor stores in the province, giving the company lots of opportunity to grow. “With Albertans making more money, I can see them spending more money on liquor. It’s a consumption story.”

He notes that the firm’s same-store sales are up 8.3% for the third quarter vs the same quarter a year ago. Bought about a year ago at around $16, the stock trades at $17.30 and has a distribution yield of 7.98%. Graham has no stated price targets.

In a similar vein, Graham likes Lakeport Brewing Income Fund. The brewer and distributor has grown dramatically in the past few years and its market share of so-called “value” beer has risen to 11% in Ontario.

“It’s a similar story to Cott Corp., the no-name soft-drink maker,” says Graham, adding the brewer could expand its market share in Ontario and move into other provinces. “The question is: when will the big guys draw a line in the sand? But that day is some ways off, because the big players are also producing value beer and don’t want to sabotage their sales.”

Acquired in October 2005 on the IPO, the brewer’s income trust has risen to $18.65 from $11. It yields 8.2%.

Graham also favours Groupe Laperriere & Verrault Inc. The firm specializes in solid- and liquid-separation technologies used in the mining industry, and has also expanded into water treatment.

“It’s hard to know which copper or nickel stock to buy, so I think it’s better to buy a company that provides the infrastructure. It is gradually doing better and diversifying into water treatment,” says Graham, adding that L&V is in the top three in its niche. “If this industry does well, companies will spend more money on capital projects, so this company should do well.”

Bought a year ago at about $18, it now trades at $26.50. Graham notes that the stock trades at 15 times next year’s earnings.



The investment environment is still a positive one, argues Martin Ferguson, manager, Mawer New Canada Fund, and director of Canadian equities for Calgary-based Mawer Investment Management Ltd.

“The opportunity to find companies that are grossly undervalued is very limited, but there are still opportunities to buy companies at reasonable prices,” he says.

Ferguson, who relies on discounted cash-flow models to select stocks, is running a 55-name portfolio. “We are looking for wealth-creating companies and, as such, we want to grow with them,” he says, adding that he tends to keep stocks for several years. “Lately, the sweet spot has been stocks with a market cap below $100 million.”

One such recent addition has been Grey Horse Capital Corp. The firm is an equity transfer agent that serves about 500 of the 4,000 publicly traded companies in Canada. Last summer, it received its federal trust charter, which allows it to expand its services and product line.

“This is an industry with high barriers to entry,” says Ferguson, adding that the sector is dominated by players such as CIBC. Grey Horse firm got into the business when it bought the operations of Equity Transfer Services in late 2004, and has grown rapidly since then. “It’s starting to take customers from CIBC and is also getting its fair share of new companies that have gone public.”

Ferguson bought the stock in October for $5, or a multiple of less than 2.5 times book value. Its ROE is in excess of 20%, which, Ferguson says, is sustainable. In contrast, he notes, the weighted average price/book value ratio for the BMO Nesbitt Burns small-cap index is 2.2, and the index’s average ROE is 7%. Ferguson has no stated 12- to 18-month target price.

Another favourite is EGI Financial Holdings Inc. A spinoff of The Co-operators Group Ltd., EGI offers non-standard automobile insurance for high-risk drivers and competes against established players such as Kingsway Financial Services Inc.

Ferguson took a position in EGI in the fourth quarter of 2005 at $10, when the firm went public, and he has since added to his holding. The stock is now trading at $9.15, but the decline is attributable to a sector that is out of favour.

“EGI was hurt not because it un-derwrote bad business but because it did not underwrite as much as it was expected to,” Ferguson says.

Yet EGI’s fortunes are improving. In the third quarter, the company reported its combined ratio (the ratio of net losses incurred to net earned premiums, plus the ratio of underwriting expenses to net earned premiums) declined to 78% from 95% a year earlier.

“These results show that the EGI has maintained its disciplined underwriting ability,” he says.

Just as important, the stock is trading just above its book value and the company has a $200-million cash float.

“It’s looking good again,” Fer-guson says, adding that the stock’s fair value is about $12.75. IE