Canadian small- and mid-cap stocks were roughed up this past spring as global demand for resources hit the skids and investors were concerned about the slowing Asian and European economies. But fund portfolio managers have become more bullish as valuations have come down, and some are confident that improving economic prospects will provide an extra boost.

“When there are a lot of gloom-and-doom media reports out of Europe and a lot of volatility, it’s very difficult to persuade inves-tors that stocks are on sale,” says Alex Sasso, CEO of Toronto-based Hesperian Capital Man-agement Ltd. and lead manager of Norrep II Fund (as well as Norrep Fund, which is closed to new investors). “But some of the more recent economic numbers are much stronger. These items tell us about the health of the consumer, who represents 70% of the North American economy.”

Sasso points to improving home construction, the pickup in retail sales and rising job creation south of the border. “All these things combined are important indicators that the U.S. economy is on the mend,” says Sasso, adding that the U.S. Federal Reserve Board’s Quantitative Easing III (QE III) policy will provide stimulus.

Meanwhile, Sasso argues that Europe is slowly bottoming out and that China will re-accelerate in the fourth quarter because China’s new leadership will introduce further stimulus measures.

Meanwhile, from a valuation perspective, Sasso maintains that investors will return to the small- and mid-cap sector once ultra-low bond yields rise again. “And when money moves from the bond market, which is many times bigger than the equities market, you will see a powerful move in earnings multiples in the broader market, but particularly Canadian small-caps,” says Sasso, adding that small-caps are trading at about 12 times earnings. “As soon as people feel comfortable about China, that Europe is getting its house in order and that the U.S. is on the mend, we’ll see quite a move.”

A bottom-up investor who runs a concentrated fund of 34 names, Sasso looks for companies that are growing faster than their industries, deliver high returns on equity and have positive earnings revisions, but whose shares are inexpensive. From a sectoral standpoint, energy is the largest weighting in Norrep II Fund, at 27.3% of assets under management (AUM), followed by 17.5% of AUM in information technology, 16.4% in industrials, 13.9% in consumer discretionary and smaller weightings in sectors such as materials.

One favourite holding is autoparts maker Linamar Corp., whose shares are trading at eight times earnings, largely because the sector has been beaten down. “Linamar has very good visibility of growth,” says Sasso. “And we’re starting to see re-acceleration of the Big Three automakers in North America.” Linamar is trading at about $22 a share, but Sasso believes the share price could reach $30 in 12 to 18 months.

 

it’s been a two-tier, small-cap market, argues Tyler Hewlett, vice president with Toronto-based BMO Asset Management Inc., and portfolio manager of BMO Special Equity Fund. This past September, Hewlett notes, resources stocks did rebound, mainly because of the impact of QE III. “Those resource stocks, which were beaten up so badly, bounced back to some degree.”

But the mid-term outlook is less certain. “Given the uncertainty we’ve been seeing, we expect to see these volatile swings in either direction,” Hewlett says. “While resource stocks have been sucking wind this year, more domestically-oriented sectors have provided strong returns, especially technology and financials.”

Hewlett is particularly cautious on resources companies because of their dependence on demand from China and emerging markets. “There are some good opportunities in that space, though,” says Hewlett, a bottom-up growth investor. “We’re focused on companies that are in production or the development stage, and we have a couple of exploration names that are very high-quality. We’re seeking firms that have the ability to generate cash flow internally or have quality assets [and] that have few problems accessing capital from the markets.”

Although valuations for the sector have dropped, Hewlett maintains they are at the mid-point of the range. “When we look at companies that we analyze, valuations are more neutral than anything else. Good growth stocks usually command a premium multiple to the market. But we are not seeing valuations that scare us away when we look at attractive growth names.”

Non-resources names are now more appealing, argues Hewlett, as they are leveraged to the economic rebound in North America and have better growth prospects. “Their balance sheets are in very good shape. And they are less exposed to some of the problem areas in Europe,” he says. “We’re excited because you’re likely to see multiple expansion for these growth companies.”

Running a fund with 60 to 70 names, Hewlett looks for companies that have strong management teams, competitive advantages, access to capital and sustainable growth. From a sectoral standpoint, about 35% of the BMO fund’s AUM is in energy and materials, 15% is in industrials, 15% is in financials, 10% is in consumer discretionary and smaller holdings are in sectors such as health care.

One of top names in the BMO fund is Element Financial Corp., which specializes in equipment leasing and financing. Headed by the former CEO of Newcourt Corp., Steve Hudson, Element Financial is filling the void in equipment financing created by the 2008-09 crisis. Element Financial stock is trading at about $6.15 a share, although Hewlett has a target of $8 in 12 to 18 months.

Another favourite is Descartes Systems Inc., a software and network solutions provider to the transportation and logistics industry. “This is a growing industry due to automated processes,” Hewlett says. Descartes’ share price is about $8.50 a share. Hewlett’s target is $10.50 within 12 to 18 months.

although some parts of the industrialized world look bleak, conditions are not so bad closer to home, says Michael Chan, vice president and senior portfolio manager with Toronto-based Fiera Capital Corp., who manages Fiera Sceptre Equity Growth Fund.

“Europe is problematic, with austerity and high unemployment. But North America has the potential to be the bright spot,” says Chan, noting that returns have been relatively strong in many markets in spite of negative sentiment and investors exiting equities in favour of bonds. Like Sasso, Chan points to improving new-home construction and auto manufacturing and unemployment falling below 8% in the U.S.

At current levels, small-cap valuations are perhaps the most attractive in several years, says Chan. Although the S&P/TSX small-cap index is trading at 12.2 times forward earnings, the stocks in the Fiera fund’s portfolio are trading at a 20% discount to the index. “This is typically a very good buying territory. Earnings growth is very good for the companies we own. We’re optimistic we could see double-digit returns for next year. But over three years, we see 50% upside for our core positions — although the path is difficult to predict accurately.”

A bottom-up growth manager, Chan looks for so-called “best of breed” companies that have proven track records and above-average prospects, and management teams that have a stake in the company. Non-resources stocks tend to differ from resources stocks as the former have higher returns on equity and free cash flow. Resources names that make it into the portfolio are chosen for their low-cost production and strong volume growth. “Over time, they will generate alpha for investors,” says Chan, who manages roughly 60 stocks in the Fiera fund.

On a sectoral basis, about 23% of the fund’s AUM is in materials, 20% is in financials, 17.2% is in energy, 17.3% is in industrials and smaller weightings are in sectors such as consumer discretionary.

One top energy name is Spartan Oil Corp., a junior producer active in the Cardium area, west of Edmonton. It is expected to produce 2,300 barrels of light oil a day, up from 1,000 barrels in 2011. “By 2015, it will be up to 6,800 barrels a day,” says Chan. “[Spartan is] among the most profitable producers.” Spartan shares are trading at about $4.75 a share, or around five times debt-adjusted cash flow. Over three years, Chan believes the stock may trade at $7.50 and has 60% upside.  IE