Canadian small-cap roundtable: Part 1

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.

 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. Ferguson's discipline is to buy wealth-creating companies at discounts to their intrinsic value.

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

The roundtable was convened and moderated by Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday and concludes on Friday.

Q: The BMO Blended (Weighted) Small Cap Index, which was introduced in 1988, is close to an all-time high. There has not been a major correction in this index going on two years. Are we due for one?

Ferguson: We don't see anything of immediate concern that would cause a sizeable correction. There could be a normal correction of, say, 5% to 10%. Stock-price performance should be positive this year, a reflection of both earnings and cash-flow growth. Your base case is that there should be decent positive returns from small-caps this year.

Whitehead: The underlying conditions driving the small-cap market remain intact. Interest rates still remain low. We're coming out of an economic slowdown and we're more on the upswing than on the downswing. It's a gentle upward slope. We're still not facing inflation, which would be a headwind and drive interest rates higher. This year looks like it should be another up year for small-caps.

Carscallen: The gold and the mining stocks have already gone through a correction. They've had a pretty messy time over the past two or three years. If you take them out of the small-cap index, the index has done pretty well. Gold and base-metal mining stocks have been coming back a little this year. It would take a macroeconomic shock to cause a major problem for stocks. But many stocks have had such a strong move that there are high expectations built into them. If there are any earnings-growth disappointments, you could see a price-earnings-multiple contraction.

Stephen Arpin and Martin Ferguson

Arpin: I agree that the economic backdrop for small-caps remains fairly favourable with low interest rates, subdued growth and low inflation. We-re not seeing central-bank actions that would be substantially negative and curtail the possibility for continued absolute returns from small-caps. My caveat is that valuations of the small-caps, excluding the mining space, have gone higher. There has been a huge move in small-caps and in the equity market in general over the past five years. Valuation is a risk factor.

Q: What was the total return on the BMO Small Cap Blended (Weighted) Index in 2013?

Ferguson: It was 7.8%.

Arpin: The S&P/TSX Small Cap Index, which is increasingly overtaking the BMO Index as a benchmark for Canadian small-cap performance, produced a total return of 7.6% in 2013. By contrast, the S&P/TSX Composite Index produced a total return of 13% last year.

	Index	2013	2012	2011	2010	2009	2008
	S&P/TSX Composite	13.0	7.2	-8.7	17.6	35.1	-33.0
	BMO Small Cap Blended (Weighted)	7.8	2.5	-14.2	38.5	75.1	-46.6
	S&P/TSX Small Cap	7.6	-2.2	-16.4	35.1	62.4	-45.5
	Source: Morningstar

Q: It is the third year in a row of relative underperformance for Canadian small-caps. Why?

Arpin: Scott mentioned the weakness in materials. Small-cap underperformance relative to the Composite reflects, in part, the different sector weightings in the two indexes. The small-cap index has a much heavier weighting in the materials sector than the Composite and a far lower weighting in financials. The mining stocks have been under pressure, whereas the financials have done well over that period. At the end of 2013, gold stocks represented 10.9% of the BMO Small Cap Index or almost half of the materials weighting at 21.1%. Gold stocks were the biggest factor in the poor performance of materials.

Carscallen: The Morningstar median fund-manager return for 2013 for the small-to-mid-cap space was over 21.3%. The performance of a lot of small-cap managers was superior to that of the BMO Small Cap Index of 7.8%. Many active managers were significantly underweight gold and base metals. I'm not a fan of gold stocks. They're too volatile. Also, the companies tend to have a low return on capital. But there could be some bargain-hunting here.

Ferguson: We haven't invested in gold stocks for a long time, because we haven't found any that have met our investment criteria.

Ted Whitehead

Whitehead: It's a difficult environment for gold, despite the fact that we've seen a rally in the stocks short-term. For the last eight or nine months, we've kept our weighting down dramatically. As the global economy recovers, there are other materials that are better, such as forest products and chemicals.

Arpin: We have a relatively low weighting in gold stocks. But there are few instances where gold stocks do meet normal investment criteria.

Carscallen: Looking at small-cap sectors in the BMO Small Cap Index that did well in 2013, health care, with a total return of 65%, was the best performer, technology, with a total return of 55%, was a huge winner and many consumer-related stocks did very well. Industrials were strong. Financials did OK. Companies with growth that paid dividends did well. Even better were those companies that are continuing to grow their dividends. This was a big theme in 2013.

Ferguson: In the last couple of years, companies have cottoned on to the idea that if they do increase their dividends, they will get more investor interest. In 2012, 29 of the approximately 55 companies in my portfolio increased their dividends, including six companies that did it multiple times. In 2013, 26 of my approximately 55 companies increased their dividends. So far this year, 14 companies have increased their dividends and one paid a special dividend, for a total of 15 companies.

Arpin: As was the case in 2012, the equity market penalized small-cap non-dividend payers in 2013. The market also continued to differentiate between those companies where dividends where perceived to be sustainable and those where they were not. Companies with sustainable dividends, i.e. payout ratios of up to 70%, were up 27%. Those with payout ratios above 70%, deemed to be less sustainable, were up 6%. Those companies that didn't pay dividends saw their stocks decline by 9.9%.

Scott Carscallen

Carscallen: In 2012, it was a risk-off environment with investors seeking safety. Real estate investment trusts and utilities that paid good dividends did well. In 2013, the companies had to actually grow their dividends to be favoured.

Ferguson: In 2013, REITs and utilities faced the headwind of the end of quantitative easing south of the border. Investors were looking at a future of rising interest rates.

Whitehead: Investors were willing to take on more risk in 2013. The REITs did not really grow their earnings from 2008 to 2013. The price increases on these securities reflected the expansion of their price-earnings multiples. The REITs got expensive.

Ferguson: I would not single them out. This was part of a greater theme. A lot of the higher-quality stocks continued to get more expensive.

Q: Will 2014 turn out to be yet another year of small-cap underperformance?

Whitehead: You have to believe that there will be a stronger global economic recovery so that base materials can get going, i.e. copper and iron ore. But there is a bull market starting in energy. This will likely continue for three to five years. The demand for oil is going up. Energy is a fairly big weight in the small-cap index at 21.6% at the end of February. It is a slightly lower weighting than in the composite, but the smaller-caps are likely to outperform dramatically. In general, small-caps could outperform in 2014.

Ferguson: The valuations of large-caps and of small-caps are pretty well equal right now. From a valuation perspective, either index could outperform. We are in a slow-growth economy and earnings growth is harder to come so this growth is valued at a premium. This means that small-caps are at an advantage. Because of their size, they will be able to grow faster than big-caps. I would give the edge to small-caps, but it is a horse race.

Arpin: Merger and acquisition activity was an important contributor to small-cap performance in 2013. Looking at the numbers, this activity was surprisingly down in 2013 versus 2012. This might reflect the cut in the M&A activity in materials and energy space in the last couple of years. The question is whether overall M&A activity will pick up this year?

Carscallen: In the first two months of this year, the BMO Small Cap Index outperformed with a total return of 8.9% versus 4.7% for the composite. This reflects, in part, a revival in gold stocks.

Photos: paullawrencephotography.com