Canadian small-cap equity roundtable: Part 2

Scott Carscallen, vice-president and portfolio manager at Mackenzie Investments. A value manager, his responsibilities include Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class.

Stephen Arpin, vice-president and portfolio manager, Beutel Goodman & Co. A value manager, his responsibilities include Beutel Goodman Small Cap.

The roundtable was convened and led by Morningstar contributor Sonita Horvitch. Her three-part series began on Monday and concludes on Friday.

Q: It was suggested that for Canadian small-caps to do well in 2017, it was important for the energy sector to show some strength. What about another key driver of performance: valuations in the small-cap universe? After its huge run in 2016, is the S&P/TSX Small Cap Index now expensive?

Carscallen: The one valuation metric that I look at is the ratio of one-year forward enterprise value (EV) to earnings before interest, tax, depreciation and amortization (EBITDA). It's higher this year than last year. At the end of March 2017, it was 8.4 times versus 7.3 times at the end of March 2016. Energy and materials are two sectors where valuations have increased. The sectors where valuations have fallen are financials, technology, health care and real estate investment trusts. Health care, in particular, has fallen off quite a lot. This sector, which represented 4.1% of the small-cap index at the end of March, has gone from an EV/EBITDA of 11.7 times to 5.7 times.

Chan: To put the valuation of the small-cap index in context, we've had a good North American stock market for more than eight years. To use a baseball analogy, we're probably in the later innings. But it's reasonable to expect that we could go into extra innings. Valuations are still reasonable. Good companies are still trading at a good price.

Arpin: While valuations are not at an all-time low, you have to look at the alternative to stocks.

Q: We have talked about valuation metrics on small-cap stocks. What about dividends? Are there dividend-growth opportunities among the small-caps?

Chan: We don't make investments because the company pays a dividend. If a company is a leader in what it does and has a dividend and dividend growth, that's a plus. An example is power producer Boralex Inc. (BLX). It focuses on wind and solar power with operations in Canada and France. We've owned it for a long time and it has good dividend-growth prospects.

Carscallen: I've owned this stock for years. It's been traditionally cheap relative to its peers. It didn't always pay a dividend. It pays one now. It has a pipeline of growth projects that will allow it to continue to raise its dividend over time. I don't buy small-caps for the dividend yield. But, a lot of names in my small-cap portfolio do pay dividends.

Arpin: We don't explicitly look at dividend growth. But we do view that favourably, as we're looking for businesses that are free-cash-flow generative. In the small-cap universe, we are more focused on valuation. A note of caution: small-cap companies generally have less financial flexibility than larger-caps, so cash retention in the business is often important. But having said that, dividend payment by a company is an indication of quality.

Scott Carscallen

Chan: In summary, for investors seeking income, there are good opportunities for dividends and dividend growth among the small-caps.

Q: Briefly please, the number of names in your portfolios and your definition of small-caps.

Arpin: We have 38 names in Beutel Goodman Small Cap. Our current market-float range is about $200 million to below $3.5 billion.

Carscallen: There are 72 names in Mackenzie Canadian Small Cap Value. We tend to buy stocks with a market cap that ranges from $50 million to $2.5 billion. We can hold a stock with a market capitalization of up to $7.5 billion.

Chan: Fiera Capital Equity Growth has 60 names. The core of the portfolio has 40 names. We're slowly building a position in 10 names and there are 10 names that we are harvesting. The market-cap range is $150 million to $3.5 billion.

Q: Where are you finding opportunities in the Canadian small-cap universe?

Chan: There's a lot of excitement in the non-resource small-cap area.

Arpin: Real estate was recently separated out of financials in the small-cap index and allocated its own sector. At the end of March, this sector constituted 8.8% of the index. Beutel Goodman Small Cap had 9.4% in the sector at that date. The portfolio doesn't own any REITs right now, but it does have holdings in Colliers International Group Inc. (CIGI) and FirstService Corp. (FSV).

Chan: I own both stocks and have a total of 12.3% in real estate.

Carscallen: I also own Colliers and FirstService and have 9.2% in real estate.

Arpin: Toward the end of last year, we substantially increased our position in Colliers, an international real-estate broker. This real-estate segment had been selling off. In particular, Colliers' stock came under pressure because of concerns about Brexit and the valuation on the stock was attractive. The company has a significant exposure in the UK. Brexit has turned out not to be a serious issue, as of yet. This stock touches on a number of themes that we identified. It has international acquisition opportunities. It's a business that is well managed and one that generates significant free cash flow.

	Michael Chan

Q: What about technology? It was 4.9% of the small-cap index at the end of March.

Carscallen: I'm not finding a lot of opportunities in this sector. A lot of the names are very expensive. You have a mix of higher-growth companies and more troubled companies that may look cheap, but they're cheaper for a reason. Mackenzie Canadian Small Cap Value has 5.3% in technology.

Chan: It's important to find companies that offer revenue and profit growth in a modest economic growth environment. We do see opportunities in the technology sector, which is 7.7% of Fiera Capital Equity Growth. The portfolio has, for example, a holding in Enghouse Systems Ltd. (ENGH).

Carscallen: I also own Enghouse.

Chan: Enghouse is a software producer and it's a consolidator of mostly mature software companies. It has a high return on invested capital.

Arpin: Beutel Goodman Small Cap has only 0.6% in technology and only one name in this sector, Evertz Technologies Ltd. (ET). We've owned it for quite a while. The company makes electronic systems for the broadcast and film industry. The stock is reasonably priced in the context of the technology sector.

Chan: We should look at the health-care sector too.

Q: Health care represented 4.1% of the small-cap index at the end of March.

Arpin: Beutel Goodman Small Cap had 2.2% in this sector at the end of March. A stock that we own is CRH Medical Corp. (CRH). The stock has had a big run. The company operates in the United States and provides services and products for the treatment of gastrointestinal diseases.

	Colliers International Group Inc.	CRH Medical Corp.	Enghouse Systems Ltd.
May 1 close	$68.60	$8.23	$60.75
52-week high/low	$75.31-$42.80	$12.35-$3.66	$64.39-$48.40
Market cap	$2.9 billion	$586.9 million	$1.6 billion
Total % return 1Y*	32.4	102.7	16.9
Total % return 3Y*	22.2	117.5	25.6
Total % return 5Y*	29.7	66.7	34.5
*As of May 1 Source: Morningstar

Carscallen: It's been one of my biggest winners too. I have 2.6% in health care.

Chan: I have 2.7% in health care. I own CRH Medical too.

Arpin: It's a consolidator in its field. It has been able to do the acquisitions at reasonable multiples.

Stephen Arpin

Chan: Another health-care company that I've owned for a few years now is Knight Therapeutics Inc. (GUD), a specialty pharmaceutical company.

Carscallen: I also own this stock.

Chan: Knight's CEO Jonathan Goodman was the co-founder of another successful specialty pharmaceutical company, which was subsequently sold.

Carscallen: Goodman is a good builder of pharmaceutical companies. I am finding more opportunities in the micro-cap space, companies with a market capitalization of $50 million to $200 million. Some of my biggest winners have been micro-caps. CRH Medical was a micro-cap when I bought it.

Photos: Paul Lawrence Photography