Canadian small- and mid-capitalization stocks have been on a tear, largely driven by rebounding commodities prices and increasing takeover activity. And although some market observers have warned that valuations could be getting rich, mutual fund managers operating in this space are optimistic that small- and mid-cap stocks still have room to run.

“Looking at the market in general, we don’t think valuations are stretched,” says Gary Baker, partner with Vancouver-based Connor Clark & Lunn Investment Management Ltd. and co-manager of TD Canadian Small Cap Equity Fund, which is sponsored by TD Asset Management Inc. “Assuming we are successful in navigating a global recovery — and we’re not in the camp that says there will be a double-dip [recession]. You could argue that valuations are cheap rather than expensive. When you look at the average earnings yield relative to bond yields, they are quite attractive. Risk premiums are above what we consider a normalized level.”

Yet the market appears to be uncertain about global growth, Baker says, and teetering between expectations of deflation or the return of inflation. “We are on a precipice right now,” he says. “Are we going to be successful in navigating out of a deflationary environment or will we see inflation move higher, and interest rates rise, too?”

He adds that it could take several months to determine the direction of world economies, but he’s “cautiously optimistic.”

Meanwhile, small- and mid-caps have rebounded to a greater extent than have large-caps, which is consistent with past economic recoveries. “They did the same thing in 2000, 1990, 1982, 1979 and 1974. Over the past 40 years, small-caps significantly outperform [at this stage],” says Baker, who shares fund-management duties with Gordon MacDougall, a CCL partner and director. “It makes sense. When fear is at its highest, there is a flight to quality and people sell small-caps. When people feel more positive, liquidity is not a concern because they’re buying for the next four years and not four minutes.”

However, the valuation discount that existed in 2008, when small-caps’ multiples were 20% lower than large-caps, is gone. Today, small-caps’ multiples are about the same as that of the S&P/TSX composite index. “Small-caps can continue to do well, but stock-picking is more relevant,” says Baker. “Some small-cap situations will outperform their large-cap peers.”

A fund manager who blends top-down and bottom-up styles, Baker is running a 100-name fund. From a sectoral standpoint, 35.5% of the TD fund’s assets under management are in materials (which includes 19% in precious metals), 20.5% in energy, 10.5% in financials and smaller weightings, such as 6.8% in industrials.

One top holding is Alamos Gold Inc., a mid-cap firm producing 170,000 ounces a year, but expected to ramp that up to 225,000 oz. in 2012. “It’s a well-run company and will benefit from the rising gold price,” says Baker, adding that he expects the price of bullion to keep going up. “And [Alamos] has an attractive valuation. It’s trading at 0.8 times net asset value, a 20% discount to its peers.”

The stock is trading at about $19.50 a share. Baker has a target of $26 within 12 months.

Another favourite is Calfrac Well Services Ltd., a specialized services firm benefiting from the boom in horizontal drilling used to extract natural gas from so-called “shale gas” zones. The stock is trading at about $29.50 a share; Baker’s 12-month target is $36.



Valuations For Small-caps are still attractive, agrees Martin Ferguson, director with Calgary-based Mawer Investment Management Ltd. and manager of Mawer New Canada Fund: “On an absolute basis, in this environment with slower expected economic growth and exceedingly accommodative interest rates, small-caps, as a sector, are reasonably valued. If you put money in a 10-year bond, you’ll get less than 3% returns. Based on our discounted cash-flow models, we’re getting internal rates of return for our stocks that are averaging close to 10%. This is a very large margin of safety, given the fixed-income alternative.”

On a relative basis, Ferguson shares Baker’s view that small-caps are trading in line with large-caps. “There is no huge valuation gap, as there has been in the past,” says Ferguson, who also manages BMO Guardian Enterprise Classic sponsored by Toronto-based BMO Investments Inc. and open to new investors, while the Mawer fund is closed.

But, from a short-term perspective, Ferguson is reluctant to make any market forecasts: “Over the past seven quarters to the end of September, small-caps are up [by] 102%. There might be some froth, but I don’t know which way [the market] may go on an absolute basis. Yet, from a top-down view, we could face a lot of problems, whether it’s European sovereign debt or the U.S. consumer. The U.S. Federal Reserve Board has injected another US$600 billion into [that] economy — and we don’t know if it will work.”@page_break@Although materials stocks — particularly gold companies — have been driving returns in the small-cap sector, Ferguson has avoided gold plays. “Gold companies have never screened well,” says Ferguson, who uses discounted cash-flow analysis to screen companies. “People value them too highly. If you look at the marginal cost [of production], over the long term, the commodities price should reflect the cost of getting it out of the ground. I would argue we are nowhere close to that.”

Running a 58-name fund, Ferguson likes companies with strong management and business models, and minimal risk. One top name in the Mawer fund is Constellation Software Inc. The firm provides so-called “critical mission” software to a wide variety of industries and sectors, ranging from municipal transit authorities to golf and country clubs. “[It has] about 10,000 customers and very stable cash flow,” says Ferguson, noting that the firm continues to grow by acquisition.

The stock is trading at about $46.50 a share. Adds Ferguson: “It’s still reasonably valued, and trades at 10 times forward earnings.”

Another favourite is Canadian Energy Services & Technology Corp., which produces the so-called “muds,” the drilling fluids used in extracting oil and natural gas. “Mud is very important, because it can increase the speed of the drilling, protect the well bore and protect the reservoir from contamination,” says Ferguson. “[This firm has] developed the best muds in the industry, not only in Canada but around the world.”

The shares are trading at about $25, or 12.8 times forward earnings.



The Market Environment is reminiscent of that in the 1970s, says Ted Whitehead, vice president of Toronto-based MFC Global Investment Management (Canada) and manager of Manulife Growth Opportunities Fund: “We’re back to the historical multiple, which is 1.7 times book value. Can that multiple go to 1.9 times? Maybe. It did before, at the tail end of the 1970s.”

Globally, adds Whitehead, basic materials and energy companies are doing well and central banks and governments are providing liquidity with rock-bottom interest rates. “Commodities prices will remain strong but not outrageous,” says Whitehead, adding that resources companies should continue to be very profitable.

At the same time, he notes, many state-owned companies or foreign-owned large-caps are buying smaller Canadian resources players to tap into their expertise and management skills. For example, China’s Wuhan Iron and Steel Group Corp. has bought a 25% stake in Consolidated Thomson Iron Mines Ltd. A Japanese consortium led by Sojitz Corp. has bought a 25% position in Taseko Mines Ltd.’s Gibralter copper mine. “We don’t really see this trend changing,” says Whitehead. “It is driving up valuations, and scarcity value as well.”

Running an 85-name fund, Whitehead stays relatively close to the sector weightings in the small-cap index. “The market oscillates, and sometimes resources work and sometimes utilities work,” says Whitehead, a quantitative-oriented investor who looks for stocks with positive earnings revisions and strong price momentum.

The Manulife fund has an underweighted 32% of AUM in materials, vs 37% in the index, and an overweighted 23% in energy (vs 17%). Other sectoral weightings include 8.6% in financials, 7% in consumer discretionary and 7% in industrials.

On the lookout for lesser-known firms, Whitehead recently acquired Baja Mining Corp. The company is building a copper mine in Baja, Calif., and is expected to produce 56,700 tonnes of copper annually, as well as 1,700 tonnes of cobalt by 2013. Meanwhile, copper prices have rebounded and are now US$3.90 a pound vs US$2 in March 2009. Says Whitehead: “For this year and next, demand will outpace supply. Commodities prices will be going up — and copper stocks will participate.”

The stock is trading at about $1.10. Whitehead’s 12-month target is $2.

Whitehead also likes Fortress Paper Ltd., which has been held by the fund for four years. Fortress, which has a plant in Switzerland that prints money for members of the European Union, has acquired a pulp mill in Quebec and converted it into a mill that makes rayon, a hot commodity. “By converting this mill and selling forward a lot of production, [Fortress has] locked in some gains. The stock price has really run,” says Whitehead, noting that earnings are expected to rise by 100% in 2011 and by 90% in 2012.

The shares are trading at about $42 each, or about 16 times 2011 earnings. The consensus calls for $60 within 12 months, although Whitehead is reluctant to give a specific price target. “With its strong growth rate,” he says, “the stock has further to move.” IE