Once powered by the commodities boom and easy access to capital, Canadian small- and mid-cap stocks have been hit hard by an abrupt decline in resources prices and the credit crunch. Yet, fund managers see some opportunities in the rubble.

“In the summer of 2007, the liquidity bubble burst and we went from a credit bubble to a credit crisis,” says Martin Ferguson, manager of Mawer New Canada Fund and director at Calgary-based Mawer Investment Management Ltd. “Resources were the driver for the market until that summer. But 2008 has not been a good year.”

The benchmark BMO Canadian small-cap index has tumbled by 44% year-to-date.

Still, with market sentiment switching from greed to fear, valuations have become more attractive, Ferguson argues: “By the end of the third quarter, we found them compelling. Markets are the most attractive since the tech bubble.”

Ferguson believes that credit conditions are improving, as evidenced by the decline in so-called “TED spreads” (the relationship between U.S. treasuries and Euro-currencies, an indicator of defaults on interbank loans) and the drop in the Chicago Board Options Exchange volatility index.

Risk premiums (a measure of reward for investing in small-caps) “are starting to evaporate,” says Ferguson. “As this happens, small-caps will perform well. We were starting to see this over the past few weeks. This will be a bounce, just to eliminate the risk premium due to fear. It’s a first step.”

Yet, markets still have to come to grips with a slower economy and lower growth. “We will be in a period of volatility and slowly rising markets,” says Ferguson. “This is an excellent entry point into markets. The direction is up. But you will need patience before you reap the rewards of these low share prices. There won’t be a big V-shaped bounce — just slow economic growth.”

Ferguson is continuing to focus on companies that have competitive advantages and a track record of creating wealth. “Our companies, because they generate significant cash flows, don’t require external financing to complete their business models,” he says. “Strategically, we’re fine; tactically, we’re taking the opportunity in these distressed markets to build up our positions in great companies and give up some of our weightings in some good or better companies. We’re moving from good to great.”

Running a 55-name fund, Ferguson has added to existing holdings in Stantec Inc. and FirstService Corp. FirstService is involved in commercial real estate, residential property management and property services.

“It has an excellent track record of creating wealth,” says Ferguson. “The CEO, Jay Hennick, has done a very good job of building a company full of service businesses that have recurring revenue. For the most part, they don’t require a lot of capital. It’s a company that throws off a lot of free cash flow.”

FirstService stock was recently trading at $16.50 a share, less than half of its 52-week high of $34.75 a share. That’s largely attributable to market concerns about the prospects for the commercial real estate division.

But the Mawer fund, which has owned the stock for almost a decade, is staying the course. “The company’s exposure to the U.S. commercial real estate market is less than the market expects,” Ferguson says. He has no stated target for the stock.

A new name in the Mawer fund is New Flyer Industries Inc. The Winnipeg-based firm is the leading maker of heavy-duty transit buses in North America. It operates two assembly plants in the U.S., which allow it to circumvent so-called “Buy America” rules.

“This keeps out offshore competitors,” says Ferguson. “[New Flyer has] also been gaining market share, has the broadest product line and is a leader in alternative fuels.” New Flyer was recently trading at $9.40 a share, down from September’s $11.25 average purchase price.



Jason Gibbs, portfolio manager with Toronto-based Goodman & Co. Investment Counsel and co-manager of Dynamic Focus + Small Business Fund, is also finding value in the market. Yet, he and lead manager and vice president Oscar Belaiche are no hurry to invest the fund’s 33.8% cash weighting.

“We took a defensive stance coming into this year,” says Gibbs, noting that a number of the Dynamic fund’s holdings were privatized and the managers had decided to stay in cash. “The critical issue is preserving capital. It’s not a case in which we may have 40% cash today and will move to 5% tomorrow. We are taking our time and letting the opportunities come to us. In this environment, it’s a tremendous position to be in.”

@page_break@Gibbs is looking to take advantage of the selling pressure on small-cap investors. “When the other party is desperate to get any bid, it’s a great deal when you’re on the other side,” he says. “We are in a significant deleveraging cycle now, and small-caps are going to get hurt in this environment. Hedge funds have to sell, people are panicking and small-caps tend to have poor liquidity. You are going to see some serious moves downward.”

Running a 56-name fund, Gibbs looks for “best in class” companies that have dominant market shares, strong brands, barriers to entry and management with strong track records. “When you’re buying those businesses now,” he says, “you will look smart in a few years.”

The Dynamic fund is dominated by income trusts, with a 48.4% allocation (29.7% in business trusts, 11% in utilities, 3.5% in real estate investment trusts, 4.2% in resource trusts), 17% in stocks and about 2% in real estate private equities. The bias toward income trusts is largely because Gibbs and Belaiche believe the small-cap trust universe is inefficiently priced.

“You can buy a lot of these business trusts at extremely attractive valuations,” says Gibbs. “In this volatile environment, yield is incredibly important. If you can get a significant distribution yield, that helps a great deal.”

One of the Dynamic fund’s top holdings and a recent acquisition is North West Co. Fund. An operator of mini-department stores, the firm is based in northern Canada. “It’s a classic example of a focused business. There is not a great deal of competition,” says Gibbs. “It has a ‘best in class’ management team, strong balance sheet and attractive valuation.” The income trust was recently trading at 11 times fiscal 2009 earnings (based on a January 2009 yearend). At $16.80 a unit, it has a 7.6% distribution yield. Gibbs has no stated target.

“Consumer staples are a very good place to be in this environment,” he says. “You want to own companies that provide an essential service. Consumers will slow their spending on discretionary items.”

Another favourite is GENIVAR Income Fund. A Quebec-based engineering firm, it provides services related to the repair, maintenance and building of infrastructure.

“You will continue to see significant investment in infrastructure, such as roads, sewers and power lines,” says Gibbs, noting that governments are spending billions on repairing aging infrastructure. “Any company that is geared toward providing these services will do very well. GENIVAR is certainly well positioned in this area.”

Acquired about two-and-a-half years ago at about $11 a unit, GENIVAR was recently trading at $19.70 a unit. It has a 7.7% distribution yield.



Jennifer Law, lead manager of Renaissance Canadian Small Cap Fund and vice president of Toronto-based CIBC Global Asset Management Inc., is cautious about the market: “We are seeing opportunities, but are also being very picky and patient.”

About 17% of the fund’s assets are in cash, which will be deployed over the next six to 12 months. “Our focus is on leading companies in core businesses,” Law adds. “We take a two- to three-year view on companies and are disciplined about the price we pay.”

She expects market volatility to remain high, as more negative economic data comes in. “We’re keeping our powder dry. Capital preservation is key at this point,” she says. “We don’t want to make any bets on how shallow or deep this recession may be. But we want to position the portfolio for a recovery.”

The Renaissance fund became defensive earlier in the year and took profits in a number of economically sensitive names in the base-metals sector. “There was a lot of M&A activity in the previous year, commodity prices were very high and valuations were starting to get rich,” recalls Law. “We were cautious then. Now, we’re looking ahead to the next two or three years and considering some opportunities. But we are not there yet.”

A “growth at a reasonable price” investor running a 66-name fund, Law favours high-yielding stocks and income trusts that can weather the economic storm. In particular, her fund has added to its holdings in Cineplex Galaxy Income Fund, which has been in the Renaissance fund for more than two years. Cineplex is the largest movie exhibitor in Canada, with a 67% market share. “We like the business because its operations are less dependent on the economy and more tied to box-office quality,” Law says. “It has a 70% payout ratio, which acts as a very good cushion.” Cineplex was recently trading at $15 a unit, down from its 52-week high of $19.50. But it has an 8.5% distribution yield.

Another long-time favourite is Liquor Stores Income Fund. Through aggressive acquisitions, this firm has emerged as the largest liquor-store operator in Alberta and has expanded into Alaska.

Liquor Stores was trading at $13 a unit recently, almost half of its 52-week high of $24.80, a decline attributed to concerns about integration of the acquisitions. As its unit price has fallen, its yield has risen to 12.8%.

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