Canadian small-cap equities roundtable: Part 2

Energy-services companies find favour.

Sonita Horvitch 6 March, 2013 | 7:00PM
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Morningstar's exclusive roundtable series on Canadian small-cap stocks continues today with the managers discussing their portfolio strategies and examples of their current holdings. As moderator and Morningstar columnist Sonita Horvitch learned, energy-services companies are getting positive reviews.

Our panellists:

 Martin Ferguson, director and portfolio manager at Calgary-based Mawer Investment Management Ltd. His mandates include Mawer New Canada, which is closed to new investors, and BMO Guardian Enterprise. His discipline is to buy wealth-creating companies at a discount to their intrinsic value.

 Stephen Arpin, vice-president at Beutel, Goodman & Co. Ltd. A value manager, Arpin is the lead manager of Beutel Goodman Small Cap.

 Ted Whitehead, senior managing director and senior portfolio manager at Manulife Asset Management. A growth manager, Whitehead uses both quantitative and fundamental analysis. His responsibilities include Manulife Canadian Opportunities and Manulife Growth Opportunities.

Horvitch's three-part series began on Monday and concludes on Friday.

Q: What of merger and acquisition activity in 2012, after the rash of small-cap takeovers in 2011? These takeovers tend to boost stock performance.

Ferguson: In 2011, we had eight companies come out of the portfolio due to takeovers. In 2012, there were two. One was Neo Material Technologies Inc. and the other was Distinction Group Inc.

"We have been reducing our holding in AltaGas, because we view the stock as being quite expensive. We have 23% of the portfolio in energy", says Arpin.

Whitehead: Two that come to mind are Neo Material Technologies and Progress Energy Resources Corp.

Arpin: It's pretty standard that these stocks are taken out at a premium. Our Gennum Corp. holding was taken out in early 2012, at a massive premium. At the end of the year, C&C Energia Ltd. was taken over by Pacific Rubiales Energy Corp. PRE, also at a premium. There is one takeover under way now. It's Uranium One Inc. UUU. Russia's state uranium firm ARMZ has offered to take Uranium One private at $2.86 a share.

Q: What is the outlook for the pace of mergers and acquisitions this year?

Arpin: There is debt financing available at attractive rates and this, coupled with a slow-growth economy, means that companies will look for acquisitions. But we are seeing that private-equity buyers are not as active as they were before, even though the financing is there. They seem unwilling to leverage their targets as aggressively as they did in the past.

Ferguson: You're still getting strategic buyers, with companies buying like companies. But you're getting fewer financial buyers.

Whitehead: There are a number of clear takeover candidates in the small-cap universe and some bigger-caps looking for acquisitions. The pace could pick up in 2013.

Q: Time to talk portfolios. What are your definitions of small-caps? How many names do you have?

Arpin: We define small-caps as companies with a market float of $1.5 billion or less at the time of purchase of the stock. We have 44 names.

Whitehead: We use the BMO formula, which currently arrives at a market-capitalization of less than $1.7 billion. We currently have around 75 names. Our range is 60 to 100. Of the 75 names, 19 are in the United States.

Ferguson: Our definition is three-quarters of the BMO threshold, or currently $1.3 billion, at the time of purchase of the stock. There are currently 57 securities in the portfolio. We keep it between 40 and 60.

Q: Let's talk sectors and strategies. Let's start with energy, which represented 16.8% of the BMO Small Cap Index at the end of January.

Ferguson: Energy has had a couple of bad years for valid reasons. The price of natural gas and the price of oil in Western Canada have both come down substantially. Earnings and cash flow drive these production companies and they have been hit. On the energy-services side, the cash flows of the exploration and production companies are their lifeblood. There are spots in the service sector that look attractive.

Whitehead: We are overweight energy and do like energy-services companies. We have sector constraints. We have to be in those sectors that are more than 10% of the BMO Small Cap Index. In the case of those sectors, our weighting can be 10% above or below the sector weighting.

In energy, two large international holdings are Gran Tierra Energy Inc. GTE and Coastal Energy Co. CEN. We see them growing their production and reserves. Plus, they are getting the Brent price for their crude oil, which is roughly US$20 per barrel above the West Texas Intermediate (WTI) price.

"We have reduced our gold-stock weighting in Manulife Growth Opportunities to less than 5%. Over the years, we've been typically north of 10%," says Whitehead.

We have been buying more of the services stocks such as Calfrac Well Services Ltd. CFW, Western Energy Services Corp. WRG and Canyon Services Group Inc. FRC. All these companies pay a decent dividend, in the 4% range. We have roughly 4.5% in service companies.

I also own (energy-services provider) ShawCor Ltd. SCL.A. Coming back to how we manage money, the company has been producing positive earnings surprises. ShawCor is close to eliminating its dual class of shares.

Ferguson: I own ShawCor. It's the leader globally. It's a well run company with a strong balance sheet. At the end of January, our energy weight at 17.2% was approximately the same of that of the benchmark at 16.8%. The composition of our energy holdings is significantly different from that of the BMO Small Cap Index. Of the 17.2%, we only have a small weighting in energy producers. The rest is in service companies.

This is where we find companies with competitive advantages. Our two largest holdings in this sector are Canadian Energy Services & Technology Corp. CEU and AltaGas Ltd. ALA. Canadian Energy Services is a leader in its industry. We have held AltaGas for many years. The chairman and CEO, David Cornhill, focuses on return on invested capital. Both these companies pay sizeable dividends and generate huge free cash flows.

AltaGas Ltd. Calfrac Well
Services Ltd.
ShawCor Ltd.
March 4 close $35.16 $24.58 $39.19
52-week high/low $36.66-$27.46 $33.81-$20.22 $46.75-$29.79
Market cap $3.7 billion $1.1 billion $2.8 billion
Total % return 1Y* 18.4 -21.2 20.6
Total % return 3Y* 29.3 -0.1 13.8
Total % return 5Y* 12.5 9.6 6.7
*As of March 4, 2012
Source: Morningstar

Arpin: We have been reducing our holding in AltaGas, because we view the stock as being quite expensive. We have 23% of the portfolio in energy. We have 2.5% in Uranium One, which is the subject of a takeover offer. We recently bought uranium producer Denison Mines Corp. DML. It's trading at a significant discount to its intrinsic value. We consider that the current low price for uranium is unsustainable and the commodity will have to trade higher.

Our biggest energy weighting is Paramount Resources Ltd. POU. It's in a sweet spot in the Deep Basin in Alberta. It has attractive assets, with high liquids yields, specifically condensate. It will ultimately be a low-cost producer of natural gas on a go-forward basis, with an ability to grow this business. Condensate prices will stay at a premium to WTI prices in Canada.

"I own ShawCor. It's the leader globally. It's a well run company with a strong balance sheet," says Ferguson.

Ferguson: I own Paramount. It's run by the Riddell family, which has a significant stake in the company, and runs it with a long-term vision.

Q: Materials? This represented 30.7% of the BMO Small Cap Index at the end of January.

Whitehead: Manulife Growth Opportunities has 25% in materials. The holdings are widely diversified across a number of sub-groups such as paper and forest products and packaging.

Arpin: Beutel Goodman Small Cap has 21% in materials.

Ferguson: I have approximately 9%. The problem is that a big part of the sector is gold. I have no gold holdings and no metals and mining stocks. The bloom is coming off the gold-bullion rose.

Whitehead: Yes. A number of resource funds have closed and a big portion of their holdings was in gold, which they are selling.

Arpin: A key factor in this is that the U.S. economy is improving. A big issue for the United States historically is its energy deficit and this deficit is set to shrink.

Whitehead: We have reduced our gold-stock weighting in Manulife Growth Opportunities to less than 5%. Over the years, we've been typically north of 10%. A recent sell from the portfolio was Sunward Resources Ltd. SWD, which explores for gold in Colombia.

Arpin: We've cut our weighting in gold stocks dramatically. We were more than 10%, at one point. We reduced our position in Allied Nevada Gold Corp. AANV, after it hit our target price in the fall. It remains a significant weighting in the portfolio.


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Sonita Horvitch

Sonita Horvitch  

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