High-quality small-caps are "pricey"

Beutel Goodman's Stephen Arpin finds value in selected cyclical names.

Sonita Horvitch 15 October, 2014 | 6:00PM
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 Stephen Arpin, vice-president and portfolio manager at Beutel, Goodman & Co. Ltd., says the pullback in the Canadian small-cap universe in September has provided select opportunities in cyclical stocks.

"But it remains challenging to find high-quality companies that trade at reasonable valuations," says Arpin, a small-cap specialist and member of Beutel Goodman's Canadian equity team. The firm uses a value approach to equity investing.

Up until the beginning of September, the Canadian small-cap universe was outperforming its bigger-cap counterpart, says Arpin. "The Canadian market retreated during September, with a steeper decline in small-cap versus large-cap stocks."

The Canadian small-cap segment, he notes, has a heavy weight in energy and a substantial, though more modest, weight in materials. These were both under significant pressure in September, he says, because of concern about the pace of global economic growth in general and China's outlook in particular. "When the tide goes out, it tends to be more difficult for small-cap stocks."

The result, he says, is that for the first nine months of 2014, the total return on the S&P/TSX Small Cap Index was 7%, and it was 7.7% for the BMO Blended (Weighted) Small Cap Index. This compares with 12.2% for the S&P/TSX Composite Index and 12.7% for the S&P/TSX 60 Index.

Comparing the relative valuation of big-cap stocks versus small-cap stocks has its challenges, says Arpin. Looking at price-earnings ratios on a trailing 12-month basis to the end of September, both the S&P/TSX Small Cap Index and the BMO Small Cap Index ratios were trading at 20.6 times versus 16.8 times for the composite index.

 
Stephen Arpin

"While it appears that the small-cap universe is more expensive on this metric, it is misleading," he says. "The P/E multiple is distorted for the small-cap universe, because a number of the small-cap companies are not generating positive earnings, in contrast to the big-cap segment."

Another metric often used for this comparison is price-to-book value per share, he says. At the end of September, the ratio was 1.6 times for the S&P/TSX Small Cap Index and 1.7 times for the BMO Small Cap Index, versus 2.4 times for the composite. This result would imply, he says, that small-caps are cheaper, (using price-to-book value), than their big-cap counterparts. "But the return on equity for those small-cap companies that are earning money is lower than that for their big-cap counterparts."

Most importantly to his discipline, he says, is that "if you drill down in the small-cap universe, the higher-quality companies that have good earnings are pricey by historic standards."

Arpin's responsibilities at Beutel Goodman include Beutel Goodman Small Cap  , which he co-manages with William Otton. At the end of September, the fund held 42 names, with 23.2% of the portfolio in financials, 22.2% in materials and 19.4% in energy.

Beutel Goodman's small-cap universe consists of those stocks that make up the bottom 15% of the S&P/TSX Composite Index in terms of market float. This currently translates into market float of around $4 billion at the upper end.

In initiating a small-cap position, Beutel Goodman looks for a total return of 100% from the stock over a three-to-four-year period. Its discipline is to reduce a holding in a stock by 25%, if that stock reaches its target price. It then reassesses the company.

The fund has added a gold name -- Alamos Gold Inc. AGI -- in the materials sector. "It is tough to find gold-mining stocks that meet our criteria." Alamos Gold operates the Mulatos Mine in Sonora, Mexico. "It is one of the world's lowest-cost gold mines," Arpin says

Alamos has a strong balance sheet, says Arpin, with some $3 per share in cash. "The stock trades at a reasonable valuation and you are not paying for Alamos' resource that is currently under development in Turkey."

In general, says Arpin, the global mining industry is faced with weaker commodity prices and is under pressure to cut costs. This is dampening exploration activity and resulting in disappointing results at Major Drilling Group International Inc. MDI, a long-standing holding. "This drilling-service company, which primarily works for the mining industry, is a low-risk way to play a commodity-price rebound."

By contrast, he says, the packaging industry is benefitting from a relatively stable natural-gas price. "Energy is a key input cost for an industry that relies on plastics."

Two long-standing holdings that feature in the fund's top 10 are CCL Industries Inc. CCL.B and Winpak Ltd. WPK. "CCL specializes in areas such as global cosmetics and is following its clients into emerging economies," says Arpin. Winpak focuses on food packaging, he says, and "is benefiting from the increasing demand for portion-sized packaging."

Beutel Goodman reduced its holding in CCL by 25% earlier this year, "as the stock had reached our initial target." CCL currently trades at an enterprise value (EV) to earnings before interest, taxation, depreciation and amortization (EBITDA) of 9.7 times for the trailing 12 months. Winpak's EV/EBITDA is 11.2 times. "These stocks are no longer cheap; this illustrates the fact that the market is prepared to pay up for higher-quality companies," Arpin says.

A more recent packaging addition is Intertape Polymer Group Inc. ITP, which makes a variety of specialized plastic products for both industrial and retail use. "This is a turnaround story; CEO Greg Yull has been increasing the company's profit margins rather than chasing revenue growth and has been culling non-profitable items," says Arpin.

"The stock pulled back earlier this year on concerns about earnings growth, which is when we bought it." It has since rebounded sharply, he adds. The company currently trades at an EV/EBITDA of 9.9 times.

CCL Industries Inc. Intertape Polymer
Group Inc.
Winpak Ltd.
Oct. 10 close $108.57 $15.54 $27.50
52-week high/low $119.21-$68.00 $16.37-$11.12 $$30.24-$21.41
Market cap $3.4 billion $942.6 million $1.8 billion
Total % return 1Y* 59.4 7.0 25.2
Total % return 3Y* 57.2 104.2 37.1
Total % return 5Y* 38.7 47.7 27.3
*As of Oct. 10, 2014
Source: Morningstar

In the energy sector, Arpin sold the fund's holding in junior producer Twin Butte Energy Ltd. TBE. "Drilling results were disappointing and there were negative revisions to its reserves."

The core holdings in this sector are liquids-rich natural-gas producers such as Paramount Resources Ltd. POU -- a top-10 holding -- NuVista Energy Ltd. NVA and Crew Energy Inc. CR. The fundamentals for these liquids, in particular the condensate, are robust, he says, as they are used to dilute bitumen from the oil sands so it can flow through pipelines.

Paramount, NuVista and Crew, all low-cost producers, are drilling in Western Canada's Montney formation, says Arpin. "The stocks have done well and are expensive on a price-to-cash-flow basis, but the companies' prospects are excellent."

In financials, top-10 holdings are Intact Financial Corp. IFC, Equitable Group Inc. EQB and Industrial Alliance Insurance and Financial Services Inc. IAG. These three stocks have been in the portfolio for some time.

Also in this sector, Arpin reduced the fund's holding in FirstService Corp. FSV by 25% earlier this year. "The stock of this global property management and real-estate brokerage business reached our target price."

A relatively new name in this sector is InnVest Real Estate Investment Trust INN.UN. This REIT has one of the largest hotel portfolios in the country plus a 50% interest in Choice Hotels Canada Inc., a major franchisor of hotels in Canada. "We supported Orange Capital LLC, an activist shareholder, in effecting a change in both InnVest's management and board earlier in the year," says Arpin. "It was a turnaround story when we bought it at an attractive valuation."

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Sonita Horvitch

Sonita Horvitch  

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