Encounter

Manager Scott Carscallen favours basket approach for illiquid stocks.
By Sonita Horvitch | 06/09/17

Scott Carscallen, vice-president and portfolio manager at Mackenzie Investments, says that some of the best opportunities in Canadian small-caps are to be found among the microcaps.

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.

A specialist in small-caps and a value manager, Carscallen defines microcaps as those companies with a market capitalization of less than $400 million. Investors, he says, appear to be favouring microcaps in the Canadian small-cap universe. "Stocks on the Canadian Venture Exchange, as represented by the S&P Venture Composite Index, have been doing better in the first seven months of 2017 than those in the S&P/TSX Small Cap Index."

A caveat, he says, is that these smaller smaller-cap companies tend to carry more business risk while they establish themselves. Also, their stocks are not that liquid. His strategy in tackling microcaps, he says, is to focus on those companies that are either profitable or "on the cusp of profitability." Furthermore, he says, he has only a modest weight in each stock. "It is more of a basket approach."

Canadian small-caps, as an asset class, have come under some pressure so far this year, says Carscallen. This is in the context of a Canadian equity market that has generally been suffering from a lack of investor enthusiasm, he says. "Investors have been shying away from the energy sector and are also wary of the potential fall-out from the pull-back in the Canadian housing market." He says the rise in Canadian interest rates, albeit modest and from low levels, has been a negative for investor sentiment, as well as for some sectors of the Canadian equity market.

For the first seven months of 2017, the S&P/TSX Small Cap Index produced a negative total return of minus 4.1%, Carscallen notes. "This is in sharp contrast to its stellar total return of 38.5% in 2016." Over five years, this small-cap index has registered an average annual total return of 4.6%. "This is substantially lower than the five-year average total return for the S&P/TSX Composite Index of 8.6%."

As a result of the weakness in the Canadian small-cap universe so far this year, valuations on these stocks have been coming down, says Carscallen.

The one valuation metric that he uses is the ratio of one-year forward enterprise value (EV) to earnings before interest, tax, depreciation and amortization (EBITDA). At the end of July, this EV/EBITDA ratio was 7.7 versus a ratio of 8.4 times at the end of March.

"The valuation on small-cap energy stocks has collapsed," says Carscallen. At the end of July, the ratio was 6.8 times versus 9.2 times at the end of March. Energy's weight in the S&P/TSX Small Cap Index at the end of July was 21.1%, he notes. "Given its importance, weakness in energy negatively impacts the Canadian small-cap universe, as well putting a drag on the Canadian equity market as a whole. It is 20.4% of the Composite."

Carscallen says that he has not made any changes to his energy holdings. "It is a challenge for small-cap managers to manage through the current storm in the Canadian energy sector," he says. But it is "imprudent" for a conservative portfolio manager to have zero weighting in this sector, he says. "Energy stocks can turn around quite quickly, as they did in 2016."

Mark Thomson
Scott Carscallen

At Mackenzie Investments, Carscallen's responsibilities include Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class.

At the end of July, the portfolio of 76 names had a 15.8% weighting in energy, an underweight position. Energy was the second largest sector weight in the portfolio after industrials, which were at 24.1% versus 12.9% in the index. The small-cap portfolio was also overweight in both consumer staples at 5.3% versus 2.9%, and in financials at 7.6% (5.8%).

In keeping with Carscallen's enthusiasm for microcaps, some 8% of the portfolio was invested in companies with a market capitalization of less than $400 million at the end of July.

A microcap in the industrial sector that he has invested in is Grande West Transportation Group Inc. (BUS), which designs and makes mid-sized buses for both transit authorities and commercial enterprises. The company focuses on its Vicinity brand of bus, he notes, and also has a robust parts and services division. "Grande West Transportation Group is making inroads south of the border." The U.S. market will be an important source of future growth, he says. The company is bordering on profitability, he says, "so it meets my threshold for investing in microcaps."

The largest holding among the industrials in Mackenzie Canadian Small Cap Value is Richelieu Hardware Ltd. (RCH). A long-standing holding, the company is a distributor and manufacturer of a wide range of decorative and functional hardware. "It is not a cheap stock, but is a consistent performer operationally, has excellent management and provides good earnings visibility."

A consumer-staples microcap in the portfolio that Carscallen considers has promising growth potential is GreenSpace Brands Inc. (JTR). "This company develops a wide range of natural food products, which it sells to grocery chains," says Carscallen. Its brands include Life Choices for its meat products, Rolling Meadow Dairy for dairy, Holistic Choice pet food, and Love Child for its organic baby-food products. "GreenSpace Brands is cash-flow positive."

Mackenzie Canadian Small Cap Value's largest holding in the consumer-staples sector is Clearwater Seafoods Inc. (CLR). This company harvests, processes and distributes a wide range of seafood to grocery stores and restaurants. "It is a seasonal business," says Carscallen. The company has had a weak first of half of the year, he says, as this is its harvesting time. "The second half of the year should show improvement, as this is when Clearwater sells its produce."

A microcap in the financial sector that Carscallen is highlighting from the portfolio is People Corp. (PEO). This company provides pension-fund consulting services and targets small- and mid-sized companies, he says. People Corp. is growing both internally and through acquisitions. "It is a consolidator in its field, buying up small rival companies." The company is "cash-flow positive."

Grande West Transportation Group Inc.GreenSpace Brands Inc.People Corp.
Aug. 31 close$2.62$1.35$6.85
52-week high/low$3.45-$0.50$1.80-$1.00$6.90-$3.45
Market cap$187.5 million$74.0 million$344.8 million
Total % return 1Y*424.013.598.6
Total % return 3Y*74.94.036.1
Total % return 5Y*n/an/a79.3
*As of Aug. 31
Source: Morningstar

The largest financial holding in the portfolio is Morneau Shepell Inc. (MSI). "This is a major pension-consulting and human-resources services company," says Carscallen. Besides its stronghold in Canada, the company has an international reach and is doing particularly well in the United States." The stock is not cheap, he cautions, "but the company is of high quality and growing steadily."

Carscallen reports that he has sold the portfolio's holding in Equitable Group Inc. (EQB), a sub-prime mortgage lender. "I sold the holding in two steps." The first sale, he says, was before the Ontario government's introduction in April of a 15% tax on foreign buyers of housing in the province. The rest of the holding, he says, was sold during the period of heightened concerns about the health of Equitable's rival, Home Capital Group Inc. (HCG).

"There has been a fundamental change in the environment surrounding the Canadian sub-prime mortgage market," says Carscallen, noting that Ottawa has been tightening up its rules on mortgages. Also, these sub-prime mortgage companies now need to pay more for their deposits, in the wake of all the concerns about this segment of the mortgage market, "so their cost structure has changed."

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