Manager Insight

Favouring proven track records, manager shuns marijuana producers.
By Michael Ryval | 01/02/18

Don Walker, lead manager of the 5-star Morningstar-rated Norrep Entrepreneurs Class , says finding attractive Canadian micro-cap stocks can be especially rewarding, particularly since few of them are closely followed.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"We launched the fund because we wanted to take advantage of structural inefficiencies in the micro-cap space, but we want to do it in a way that mitigates a lot of the risks typically associated with the asset class," says Walker, a portfolio manager at Calgary-based Norrep Capital Management Ltd. By definition, micro-cap equities have market capitalizations of less than $250 million.

Walker seeks quality companies with proven management teams. "There are no 'story' stocks or 'concept' stocks or junior resource companies," he says. "To me, those are more synonymous with risk. They may offer big returns but they also offer lots of volatility if the thesis goes wrong. Instead we look for companies with proven track records and real cash-generative businesses." For instance, Walker is shunning marijuana producers, despite their huge popularity.

A native of Edmonton, Walker earned a BA degree in finance and economics from the University of Western Ontario. Joining Norrep in 2004, he worked his way up the ranks. Walker, who shares duties with Norrep CEO Alex Sasso and portfolio manager Sarah Hughes, has been on the team since the fund's inception in May 2010. He became lead manager in 2013.

A bottom-up investor who runs a portfolio of about 25 names drawn from a shopping list of 100, Walker says that the asset class allows him to find stocks that do well in a particular niche. "You will find proven management teams that over time have proven their expertise."

Although much is made these days about the economic cycle being at the top, and that share-price valuations are expensive, Walker argues that a proven management team can weather the cycle. "It can enter a downturn with financial strength and exit in a better position than when it started. Bad management teams are often over-levered at the top and when they hit a downturn they are forced to restructure their balance sheets or shed assets. Good teams are better at navigating the cycle."

Take, for instance, Winnipeg-based Pollard Banknote Ltd. (PBL), a leading printer of "scratch 'n win" lottery tickets. "There are only three companies in the world in this space and the barriers to entry are very high," says Walker, noting that Pollard Banknote, which is tightly held by the Pollard family, has a 20% global market share. Walker bought Pollard shares at $2 in 2013 when no analysts covered the company. "The stock was relatively ignored until 18 months ago," he says, adding that shares are now around $20.

"This business is almost recession-resilient. When people go to the gas station they also buy cigarettes and lottery tickets," says Walker. "The business is growing and management is expanding its capacity. On the defensive side, it's a lot less impacted by a potential recession than some of the more cyclical type of businesses."

Today, even though Pollard stock has attracted the attention of several analysts, the valuation remains attractive. "There is room to grow," says Walker, who employs a blend of value and growth criteria. "It's still trading below its intrinsic value."

In a similar vein, Walker favours ZCL Composites Inc. (ZCL), an Edmonton-based manufacturer of resin-based underground gasoline-storage tanks. "Resin tanks have completely displaced steel tanks. Steel will give you a 10-year warranty, whereas resin tanks come with a 30-year warranty. There are very few steel tanks being installed anymore." ZCL has a 90% market share at home and 40% in the U.S.

Acquired about five years ago, the stock had a market cap of about $150 million. Since then, however, the share price has doubled to about $11.35. "This is another name that was underappreciated. Management is very astute and converts the EBITDA (earnings before interest taxes depreciation and amortization) into free cash flow at a very high level," says Walker. "There are very little capital expenditures required in this business."

The share price had a bump about two years ago when an activist shareholder succeeded in getting ZCL to pay out its excess cash. "That was the catalyst that got them more attention on the institutional side," recalls Walker. "But on the business side it's got an end-market that is growing at around 10% per year as gas stations replace existing steel tanks with resin tanks."

ZCL was recently trading at about 15 times forward earnings. "I don't have a target," says Walker, "but do know it's still trading below its intrinsic value."

Walker is patient and will generally have a time horizon of three to five years. "We will sell if the industry deteriorates, or we lose confidence in management or if the stock is not trading below its intrinsic value."

In the meantime, and sitting with about 25% in cash, Walker notes that more opportunities are emerging even as speculative names attract all the attention. "The good news is that there are more inefficiencies than we've seen for some years. The bad news is that there are no natural tailwinds. So it might take a little longer for these companies to realize their intrinsic value."

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