Barring a hiccup last summer during the liquidity crisis that cast a temporary pall over the market, Canadian small- and mid-cap stocks have generated strong returns year-to-date. Fund managers believe that based on solid fundamentals and attractive valuations, the asset class should continue to perform well.

For Jamie Horvat, co-manager of AGF Canadian Small Cap Fund and a portfolio manager at Toronto-based AGF Funds Inc., it is reminiscent of a secular cycle in the past. “This is a secular story that we haven’t seen since the late 1960s and into the early 1980s,” Horvat says. “It was driven by the industrialization of the emerging economies of Japan and South Korea. A lot of materials and commodities were consumed back then.”

Adds his co-manager, Charles Oliver, AGF’s senior vice president: “Now it’s driven by the global growth from the industrialization of China and other emerging economies, which have become major consumers of commodities.”

During the previous cycle, global GDP growth was around 4% or better, Oliver says. That resulted in a 7%-9% year-over-year average growth in commodity and energy consumption.

“Since 2003, global GDP growth has once again been 4% or better. We need to focus on that global growth,” says Horvat, adding that global growth should be supported by a trend that has seen countries such as China convert some of their massive, U.S.-dollar reserves into hard assets such as pipelines and refineries.

Moreover, Horvat argues, small- and mid-cap stocks should do well because the subprime mortgage fiasco did not affect their balance-sheet strength.

Finally, he believes small- and mid-caps stocks are driven by liquidity. Liquidity has improved, thanks to the recent rate-cutting move by the U.S. Federal Reserve Board, resulting in a corresponding reduction in risk. This has led to outperformance relative to large-cap stocks.

From a strategic standpoint, Horvat is leveraging off the global growth story by focusing on the materials and energy sectors. The AGF fund holds 35% in materials, overweighted compared with 29% in the benchmark BMO small-cap index, and a neutral 24% in energy stocks. Notably, the materials weighting includes about 10% of the fund that is in gold stocks, which is attributable to Horvat’s belief that the falling US$ and rising inflation will push bullion higher than its recent US$823 an ounce.

Conversely, because Horvat believes it is difficult to forecast cash flows for stocks in other sectors, there are single-digit weightings in health care, financials and consumer discretionary.

Running a portfolio with more than 120 names, with an average market capitalization of $550 million, Horvat selects companies according to four factors: they have strong management teams with an ownership stake; they have a competitive advantage; they operate within an industry with good prospects; and they are trading at attractive valuations.

One recent acquisition is Centenario Copper Corp., which has a $266-million market cap and was launched by resources specialist Richard Colterjohn. The firm, which has acquired a large block of land in Chile, will soon start up its Franke copper deposit that will produce 65 million pounds of copper a year beginning in mid-2008. Horvat bought the stock during the initial public offering in October at $7 a share; it was recently trading at $6.40 a share.

Although Horvat has no stated target, he says holdings are usually kept three to four years.

Horvat also likes CHC Helicopter Corp., a firm that specializes in serv-icing offshore oil rigs. It has been out of favour largely because earnings have been hurt by some restructuring. Horvat acquired the stock about a year ago, assuming that the worst is behind it. It was recently trading at $22.83 a share, close to its acquisition price.

“It’s trading at less than one times sales,” he says. “It’s a forgotten stock. But it’s a play on global growth and the fact that we’re going to the ends of the earth to find oil and gas.”



The outlook for the balance of this year and into 2008 remains positive, says Roger Dent, manager of Mavrix Small Companies Fund and vice president of Toronto-based Mavrix Fund Management Inc. “We expect resources stocks to remain strong, and the Canadian economy will be healthy. There are clearly some pressures caused by the high Canadian dollar, but that’s not a great issue for the majority of the companies we’re looking at.”

@page_break@Dent adds that he tends to focus on firms that have pricing power and avoids industries such as auto parts that are too reliant on exports.

Conversely, there is less worry about technology, telecommunications and resources stocks. “One of the key reasons why the C$ is strong,” he says, “is because resources are strong. In our view, that is something that goes hand in hand. We’re happy to tolerate the strong dollar if it means strong commodity prices.”

He maintains that many interesting opportunities exist, especially after the August sell-off that affected some small- and mid-caps. “We’re having no trouble putting money to work,” says Dent, a bottom-up investor who runs a portfolio of about 75 holdings that he describes as “undiscovered growth stocks that are reasonably priced.” Most of the stocks are micro-caps, with market caps of less than $100 million. From an asset-allocation viewpoint, 17.9% of the Mavrix portfolio is in information technology, 23.5% in industrials, 21.5% in materials, and 11.9% in biotechnology and health care, with the remainder in sectors such as consumer discretionary.

One recent acquisition is Western Wind Energy Corp., a developer of private electricity projects mainly in the U.S. The firm has set up a 35-megawatt facility in California, with plans to build a solar-power facility on its wind properties.

“It’s looking at some significant expansion of its wind activities,” says Dent. “From a wind and solar perspective, California has very good conditions. And the state government is also extremely supportive of green energy projects.”

Dent believes Western Wind’s valuation is attractive compared with its peers, based on a multiple of its 35-MW output relative to its $50-million market cap. The stock was recently trading at $2 a share. Dent believes it could hit $5 a share within 12 to 18 months.

On the technology side, Dent favours PEER 1 Network Enterprises, which provides Internet infrastructure services to companies around the world. “It has a very attractive growth rate and, for the most part, recurring business,” says Dent. “It’s also much cheaper than its comparable stock, Q9 Networks Inc.”

PEER 1, which has a market cap of $180 million, trades at seven times enterprise value to EBITDA, based on 2008 earnings, compared with 10 times for Q9 Networks. “[PEER 1] is being discovered by institutional investors,” Dent says. Acquired two years ago, the stock recently traded at $1.45 a share. Dent believes it has about a 50% upside.



There is still reason to be bullish, says Matthew Baillie, co-manager of Sceptre Equity Growth Fund and managing director with Toronto-based Sceptre Investment Counsel Ltd.

“As the U.S. lowers interest rates, that will add liquidity to the market, which will help the small- and mid-cap names,” says Baillie. “The growth in Canada will come from the smaller companies.”

Although small-caps and large-caps are trading at about the same price/earnings ratio of 15 times forward earnings, he notes that small- and mid-caps have superior growth profiles. “Canadian small- and mid-caps have higher growth rates and are more levered to the commodities story,” says Baillie, who works with managing director Tim Hylton.

“We’re very positive on that and think it’s a fantastic way to play the industrialization in emerging markets,” says Baillie, adding that global economies will continue to be strong despite the slowing U.S. economy.

From an asset-allocation viewpoint, some sectors have been overweighted in the Sceptre fund relative to the benchmark: 33% of the portfolio is invested in materials, 27.5% in the energy sector, 16% in financial services and 8.5% in technology. Baillie and Hylton have underweighted industrials at 2.5%; consumer discretionary at 3%; and health care at 2.5%. There is also 9% cash. The weighted average market cap of the fund is $1.5 billion, bumped up by large holdings in firms such as HudBay Minerals Inc.

Although Baillie and Hylton have maintained the bottom-up style of their predecessor, Allan Jacobs (who left to run a hedge fund for Sprott Asset Management Inc.), they have added a few new names to the 65-name fund. One is Canadian Western Bank, which has assets of $9 billion. It was acquired this past summer.

“It has been growing at double-digit rates for more than 20 years — the fastest-growing Canadian bank,” says Baillie. The stock was recently trading at $29.80 a share; Baillie and Hylton have a target of $35 a share within 12 months.

Evertz Technology Ltd. is another new acquisition. The firm is a leading provider of digital broadcasting equipment and is leveraging off the switch to digital broadcasting and high-definition television in the U.S. “It is regarded as the BMW of the sector,” says Hylton, adding that the firm has gross margins of 60%.

Bought initially during the IPO in mid-2006 at $10.25 a share and added to this past summer, Evertz stock recently traded at $39.25 a share. The target within 12 months is $46-$48 a share, based on its 50% earnings growth. Says Hylton: “It is in the sweet spot to sell to broadcasters.”

On the materials side, the Sceptre fund’s co-managers favour Thompson Creek Metals Co. Inc., one of the largest publicly traded primary molybdenum producers in the world. Thompson Creek operates mines in British Columbia and Idaho, and a metallurgical roasting facility in Pennsylvania.

“Molybdenum is a pretty tight commodity right now,” says Hyl-ton, noting there is strong demand for the anti-corrosive metal, which sells at US$32 a pound, from the oil and gas, aerospace and nuclear power industries. “There’s a scarcity issue, so [Thompson Creek is] in a wonderful position.”

Acquired about two years ago for roughly $5.50 a share, the stock was recently trading at $25 a share. The share price target is $32 in 18 months. “It was unknown at the start of the year, and then it made a nice acquisition in Idaho,” says Hylton. “Now it has a following, and it has been helped by the strong price for molybdenum.” IE