Active management pays off in a lagging asset class.
By Sonita Horvitch | 16/03/15

Editor's note: For years, Canadian small-cap equities have been a disappointing asset class. Returns have lagged the broader Canadian stock market and volatility, as always, has been higher. In part one of this week's coverage of our Morningstar roundtable on Canadian small-cap equities, moderator Sonita Horvitch poses a provocative question to the managers: Why invest in small-caps?

About the Author
Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

Our panellists:

Martin Ferguson, director and portfolio manager at Calgary-based Mawer Investment Management Ltd. His mandates include Mawer New Canada and BMO Enterprise, both of which are closed to new investors. His discipline is to buy wealth-creating companies at a discount to their intrinsic value. Ferguson and Jeff Mo, co-manager of Mawer's small-cap Canadian mandates, were named Morningstar's Domestic Fund Manager of the Year for 2014.

Ted Whitehead, senior managing director and senior portfolio manager at Manulife Asset Management. A growth manager, Whitehead's responsibilities include Manulife Growth Opportunities.

Stephen Arpin, vice-president and portfolio manager at Beutel, Goodman & Co. Ltd. A value manager, Arpin's responsibilities include Beutel Goodman Small Cap, which he co-manages with William Otton.

Scott Carscallen, vice-president and portfolio manager at Mackenzie Investments. A value manager, Carscallen is responsible for Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class.

Our three-part series continues on Wednesday and concludes on Friday.



Q: Over the past decade to the end of February, the two indexes that represent Canadian small-caps, the BMO Blended (Weighted) Small Cap Index and the S&P/TSX Small-Cap Index, have substantially underperformed the S&P/TSX Composite Index. Why invest in small-caps?

Ferguson: Canadian small-caps, as an asset class, have produced substandard returns at above-standard risk. So, there appears to be no reason to include the small-cap asset class in an overall portfolio. However, the four of us, as active managers, don't buy the asset class. We invest in individual companies. The small-cap segment of the equity market is not an efficient one, so there are many opportunities to generate above-market returns at below-market levels of risk. With that, there is an opportunity to create a small-cap portfolio that is worthy of being in an overall portfolio.

Stephen Arpin

Carscallen: The small-cap indexes have had top-heavy weightings in resources. Also, these indexes tend to be oriented toward the smaller small-caps. They contain a lot of micro-caps. Active management, in part, involves being cognizant of your sector exposure. Materials stocks have been poor performers over the past number of years. More recently, this has been the case with energy stocks. So two sectors that comprise a fairly large weighting in the small-cap indexes have underperformed. If you made a decision to underweight these sectors, you would have probably done better than the indexes. Also, if you had a higher orientation to the larger small-caps, you probably would have done better too. Over the last several years, larger small-caps have been outperforming the smaller small-caps. Also, mid-caps have been outperforming small-caps and the large-caps have been one of the top-performing categories. There is still a lot of risk aversion among investors.

Arpin: You have to be careful about the time period that you choose for your sample. The last decade for energy and materials has been one of the worst periods of their underperformance. These are coming off the euphoria in their valuation that occurred due to the strong demand from China for the commodities and high commodity prices. Now, this enthusiasm is completely out of the market. You have had weaknesses in these sectors and there might be more to come. But a reasonable analogy is what happened to U.S. equities. They have been one of the best asset classes recently, but they came off a decade of very low returns. Sometimes a decade is not long enough for a sample.

Ferguson: In summary, part of the underperformance of Canadian small-caps over the past decade is due to end-point sensitivity. We are ending a period when resources were out of favour. We also have a period where there is a lot of risk and uncertainty in the market. It has affected small-caps too, because they tend to be a riskier asset class.

Whitehead: The BMO Small Cap Index goes back almost 30 years, and typically over that period you have been compensated for taking on the added risk. Markets change over shorter periods of time.

Ted Whitehead

Q: Why should investors demand a premium for small-cap stocks?

Whitehead: They are less liquid than large-caps.

Arpin: They have less access to different sources of credit. I have seen periods of up to nine months where it was difficult for small-caps to raise equity. This is why we stress the strength of the balance sheet and the quality of the companies that we invest in. The cost of their debt capital is higher too.

Carscallen: Some of them are early-stage in their product or service.

Ferguson: This means that they don't have complete business models.

Carscallen: Because they are early-stage, they might have a concentrated customer base, maybe one or two customers.

Whitehead: Another issue is the depth of management.

Ferguson: There are risks that small-cap managers have to consider that large-cap managers might not have to consider. In the case of small-caps, there has been this period of underperformance relative to large-caps. Who is to say that the small-cap indexes are not setting themselves up for a period of outperformance?

Arpin: From underperformance comes opportunity.

Carscallen: It's important to note that the Morningstar median small-cap manager in Canada has substantially outperformed the small-cap indexes over the decade to the end of 2014, though this median 10-year number is still below the performance for the composite.

Whitehead: This confirms the case for active management in the small-cap space.

Arpin: Yes. It should also be pointed out that while Canadian small-cap indexes have underperformed their Canadian large-cap counterparts over the past decade, small-caps have done better than large-caps both in the United States and globally. There are specific reasons for the Canadian small-cap underperformance during this past decade. It is not indicative of their future potential. Just to clarify, the last 12 to 18 months was tough for small-caps generally, not just in Canada. Small-caps underperformed in the United States and globally. This was likely due to a flow of investor funds into larger-cap stocks.

Q: What about the valuation of Canadian small-caps versus large-caps?

Carscallen: It depends on what valuation measures you use. I am using the multiple of EV to EBITDA (enterprise value to earnings before interest, taxation, depreciation and amortization) on one-year forward EBITDA.

Martin Ferguson and Scott Carscallen

Ferguson: This EV/EBITDA multiple is a metric that many people use.

Carscallen: If you apply this measure and focus on the S&P/TSX Small Cap Index, it is now trading at an almost 20% discount to the S&P/TSX Composite Index. Back in January 2006, this small-cap index was trading at about a 10% premium to the composite. This discount has therefore been increasing with the passage of time. As mentioned, a large part of this is due to the poor performance in the small-cap resource space. Looking at the current valuations of the sectors in the S&P/TSX Small Cap Index, natural resources, industrials and consumer-related stocks have the most attractive values. By contrast, health care, financials, real estate investment trusts, technology and utilities tend to be on the expensive side.

Q: Martin, relative valuation?

Ferguson: There are a number of different ways to look at valuations. We compare those companies in the BMO Small Cap Index that have earnings to those companies in the S&P/TSX Composite Index that have earnings. On that basis, there is very little difference in their respective valuations. What we are trying to do is to create an apples-to-apples comparison. In the small-cap index there are a lot of oranges, a lot of lower-quality, higher-risk stocks.

Using only companies with earnings, we look at three metrics. On a price-to-book basis, small-caps look more attractively valued. But if you look at the return on equity, the small-cap companies' ROE is slightly lower and the price-earnings multiple of small-caps and large-caps is about the same. In summary, the valuation differential is minimal. If you use EV/EBITDA and include the lower-quality companies in the small-cap index, they have a lower EV/EBITDA multiple, as they should.

Carscallen: We are differentiating between higher-quality names, many of which are dividend-paying, more stable businesses, and those that are of lesser quality. The higher-quality businesses have produced a lot of the individual stock outperformance. These stocks are not great bargains. They continue to be good, quality businesses and, in times of volatility, they are a good place to be investing in.

Whitehead: With the stocks of quality names going up in value, it has allowed these companies to make acquisitions. They can acquire companies that are not of the same quality, cheaply. These deals become accretive to the acquirer.

Arpin: Given where interest rates are and given the current access to capital by small-cap companies, acquisitions will continue to be extremely important in the small-cap universe.

Whitehead: In the small-cap space, mergers and acquisitions are paramount. That is where a lot of the returns come from. The names are taken out at a premium. The higher-valuation multiples of the acquirers are being maintained because they are going out and making these acquisitions.

Photos: paullawrencephotography.com

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