Martin Ferguson, who manages the $177.8-million Mawer New Canada Fund and its near-twin, the $156.8-million GGOF Enterprise Mutual Fund, looks for small- and mid-cap companies that excel at creating wealth.

“Consultants like to divide investors into two major groups — growth and value,” says Ferguson, 48, a portfolio manager and director with Calgary-based Mawer Investment Management Ltd. “We divide the world differently. We focus on companies that create wealth.”

Ferguson lays out three other principles for managing the Mawer and GGOF funds, the latter of which is sponsored by Toronto-based Guardian Group of Funds Ltd. He seeks companies that are trading below their intrinsic value, he employs broad diversification by industry and economic sensitivity, and, most of all, he adheres to a systematic approach.

“We have a process that we follow and we stick to it, regardless of where we are in the economic cycle or market conditions,” he says. “We have a long-term view, and believe you can get better results than worrying about the noise in the market — or chasing hot stocks.”

Ferguson defines the first principle — wealth creation — as generating a return on capital that is greater than the cost of capital. In order to fulfil this requirement, companies must have several external competitive advantages, as outlined in Competitive Strategy, by Michael Porter, a Harvard Business School professor. A top holding, Russel Metals Inc., meets four of five external advantages. (Individual securities cited are held by both funds.)

First, Russel Metal is a leading steel distributor in Canada and has a 50% market share in certain niches. Second, because of its dominant position, the firm can buy steel more cheaply than its competitors. Third, it sells its steel mostly to small customers who lack bargaining power to negotiate better deals. Fourth, it is difficult for new entrants to get market share because of the high cost of setting up distribution systems. The fifth advantage concerns substitute products; in Russel Metals’ case, Ferguson says, it may be at a disadvantage as some larger customers may buy directly from steel mills.

Investee companies must also have internal competitive advantages, such as superior processes and highly competent management. “Russel Metals has both,” says Ferguson, adding that the company has made solid acquisitions and is less susceptible to being in the wrong place at the wrong time of the cycle. “It has a clean balance sheet, which is a sign of strong management.”

Russel Metals, whose shares have risen from around $5 each to $29.60 in the past five years, is representative of the wealth-creation process espoused by Ferguson.

“That’s what ties all of our stocks together,” he says. “If a company does not have these competitive advantages so that it can create wealth it doesn’t go into the portfolio. Because of that, there are both value and growth companies in our portfolio.”

This disciplined approach, combined with the flexibility to invest in value and growth stocks, accounts for Mawer New Canada’s strong returns. For the year ended May 31, the fund returned minus 3.3% vs minus 4.7% for the median fund in the Canadian small- and mid-cap equity category. Over three, five and 10 years, the fund has averaged 13.1%, 19% and 14.1%, respectively, vs 11.9%, 16.4% and 9.5% for the median fund in the group. The Mawer fund, which has a 1.5% management expense ratio, has been capped since 2004. It has a four-star rating from Morningstar Canada and a three-star rating from Globefund.

But investors still have access to the GGOF fund, which Ferguson has managed since September 2004. Sold on a deferred sales charge basis, the fund has averaged 7.1% return over two years, and 11.8% over three years. It has a 2.75% MER but is also available in a front-end version, GGOF Enterprise Classic, which has a 2.17% MER.

In picking stocks, Ferguson tends to be contrarian. One favourite value name is Supremex Income Fund. Canada’s largest manufacturer and distributor of envelopes, it has about a 60%-65% market share. “But envelopes are not a growth industry,” concedes Ferguson. “The direct-mail side is growing, although other parts are shrinking.”

Ferguson bought shares in Supremex at its initial public offering in the spring of 2006, paying $10 a share. Today, the price is $6.09 a share. Yet he’s standing firm, in spite of federal Finance Minister Jim Flaherty’s punishing new tax regime for income trusts and the strong Canadian dollar, which has hurt sales into the U.S.

@page_break@“Being long-term investors, we believe the thesis is there,” Ferguson says. “The company still has a competitive advantage and generates a lot of free cash flow. And its distribution yield is over 20%. There is a huge margin of safety.”

Like other managers, Ferguson measures a company’s value based on discounted cash-flow analysis. But he looks out 15 years rather than just five. He won’t say how cheap Supremex is, but concedes it’s trading at the “low end” of its fair value range. As a result of the new tax regime and the rise of the C$, the income trust has been punished by the stock market. “We would say it’s been overpenalized,” he says. “At $10, it was attractive. At $6.09, it’s very attractive.”

When it comes to growth stories, Ferguson cites companies such as ZCL Composites Inc. The Edmonton-based firm is a manufacturer of underground liquid storage tanks and is Canada’s leading supplier to gas stations.

“Its tanks are the best in the market, and are not made of steel but of dual-walled, fibreglass-reinforced plastic,” says Ferguson, adding that the company has a patented three-dimensional fabric (called Parabeam) that has a built-in saline solution that alerts operators if there are breaks in the fabric. ZCL has been limited to the Canadian market because of a patent-sharing agreement with Minneapolis-based Xerxes Corp.

But ZCL’s purchase of Xerxes Corp. in early 2007 has changed all that. “Xerxes was one of the two largest players in the U.S.,” says Ferguson. “This acquisition gave [ZCL] the ability to go into the U.S. and around the world.”

Given the huge market potential, ZCL’s stock has performed well. Ferguson bought shares at around $1.80 a share in 2004; it is now $8.23 a share, although the stock hit a high of $15 in mid-2007 and then dropped because management’s forecasts did not materialize. “For the past year, it has been integrating operations and getting a better handle on what Xerxes has,” says Ferguson, who believes that ZCL could get back to the $15-a-share level but can’t say when.

A native of Prince Albert, Sask., Ferguson is a 26-year industry veteran. He earned a bachelor of business administration and commerce from the University of Alberta in 1982. Ferguson got his foot in the money-management industry door when he landed a summer job as a U.S. equity analyst in the investment-management division of Alberta Treasury Branches. He enjoyed the work and was taken on full-time. Ferguson stayed until 1985, when he was hired as an analyst at Principal Securities Management Ltd., a unit of the Principal Group. In 1987, a month before Principal Group collapsed, Ferguson returned to his previous job at ATB.

In 1993, he moved from the U.S. side to the Canadian side as an analyst and assistant portfolio manager. Ferguson credits some of his investment style to his superior and mentor at ATB, John Campbell, who emphasized a common-sense approach to investing. When Ferguson joined Mawer in late 1996, he was instrumental in refining the house style.

Ferguson works closely with Jim Hall, director of research at Mawer, and a 12-person research team. Ferguson limits individual holdings to about 6% and is a buy-and-hold investor. Portfolio turnover has been low, at 27.2% for 2007 and 23.8% in 2006.

Although the majority of holdings work out, Ferguson is not afraid to admit that some have disappointed. These include names such as Coventree Capital Group Inc. and Menu Foods Income Fund.

The former is a niche investment-banking firm that once had a strong return on capital from its involvement in asset-backed commercial paper. When that market seized up last summer, its shares plummeted. “We followed our discipline, but we couldn’t predict that the ABCP market could collapse,” Ferguson says, adding that he exited the stock in late 2007.

Menu Foods ran into trouble in 2006, when it took on too much debt and was squeezed by competitors in the pet-food market. Ferguson exited in time, as the company was later hit by a tainted-food scandal.

Although the Mawer fund returned 16.6% in 2007, it has been a struggle year-to-date — it’s down around 5.5%. (The GGOF fund is down 5.6%.) Ferguson attributes that to weak stocks such as Transat A.T. Inc., a charter airline and tour operator that’s been hurt by market fears that its earnings could be threatened by new competitors. “It’s been there before, and will overcome this latest challenge,” he says, noting that he’s been adding to the position.

Ferguson believes the market is preoccupied with three fears: a slowing U.S. economy, the credit crisis and the re-emergence of inflation. “Money has been sucked out of various industries,” he says, “more so than in previous years, because of the move into materials.”

Yet he is sticking to his time-tested discipline and maintaining heavy weightings in industrials (32% of the Mawer fund), energy (25%) and financial services (21%). “There are many ways to make money. This is our way,” says Ferguson. “There could be periods, such as year-to-date, when it doesn’t work well. But over the long term, it does.”

Fund industry analyst Dan Hallett, head of Windsor, Ont.-based Dan Hallett & Associates Inc. gives the funds top marks. “I have a high opinion of [Mawer] overall, and Ferguson is no exception,” says Hallett, who has recommended the GGOF fund for several years. Ferguson, adds Hallett, has a track record of finding reasonably-priced companies that have a history of growing shareholder value: “It shows up in the returns. He’s a proven manager.”

Although Ferguson may have had his share of mistakes, Hallett argues that the winning stocks have far outnumbered the losers: “The upside has really outshone the downside, both in the frequency of getting it right and the magnitude.”

Ranga Chand, analyst and president of Ottawa-based Chand Carmichael & Co. Ltd. , also recommends the GGOF fund. “It’s a heavy hitter, and one of our top picks in its category,” says Chand. “It delivers above-average rates of return with below-average risks.” IE