Materials slump weighs heavily on small-caps

Beutel's Stephen Arpin finds value in select resources stocks.

Sonita Horvitch 27 July, 2011 | 6:00PM
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 Stephen Arpin, vice-president at Beutel, Goodman & Co. Ltd., says that valuations of the Canadian small-cap universe are far less attractive, relative to their big-cap counterparts, than they were at the market trough in early 2009. This is one reason why small-caps underperformed in the first half of this year.

"By some metrics, Canadian small-caps now trade at a premium to large-cap stocks. By other valuation metrics, their discount relative to big caps has narrowed significantly since the market rebounded in early March 2009."

Another factor in the first-half underperformance of the small-cap universe, Arpin says, was the substantial weakness of small-cap materials stocks in the first half of the year. "This sector accounts for more than one third of the benchmark small-cap index."

In general, says Arpin, small-caps tend to outperform when there is optimism about the outlook for global economic growth. "Increasing concerns about sovereign-debt problems in Europe and the United States have put a damper on growth expectations."

After their stellar performance on both an absolute basis and relative to their big-cap counterparts in 2009 and 2010, small-caps have certainly stumbled in the first six months of this year, says Arpin.

The benchmark BMO Small Cap Blended (Weighted) Total Return Index produced a loss of 4.2% in the first six months of this year versus a positive 0.2% return for the S&P/TSX Composite Index.

"The role of the materials sector in this underperformance is telling," says Arpin. This sector was a significant contributor to the stellar performance of small caps after the market bottomed in March 2009, he says. "More recently, the dominance of this sector in the index worked in reverse."

 
Stephen Arpin

At the end of June, the materials sector represented 34.6% of the benchmark small-cap index, and the sector had a negative total return of 12.2% for the first six months of 2011.

By contrast, Arpin notes that materials represent 21.6% of the S&P/TSX Composite Index as of the end of June, and this sector's total return for the first half of the year was a negative 9.7%.

At the firm, Arpin's small-cap mandates total $1.5 billion and include the $600-million Beutel Goodman Small Cap  , of which he is the lead manager. The fund is co-managed with Bill Otton, who is also a Beutel Goodman veteran.

Arpin and Otton look to invest in businesses that they consider can produce a total return of 100% over a three- to four-year period. They target companies with a $100-million to $1.5-billion market-cap float. (This is the number of shares publicly owned and available for trading, multiplied by the share price.)

In mid-July, Beutel Goodman Small Cap, with 43 names, was underweight in the materials sector at 28.4% (19% in gold stocks), and had overweight positions in the energy (26.9%), financial services (16.7%) and consumer-discretionary (12.6%) sectors.

In the materials sector, the small-cap team added to a holding in a junior gold-mining company, Sulliden Gold Corp Ltd. SUE. This exploration and development company is currently focused on its Shahuindo Gold Project in the gold-rich area of northern Peru. "It is a low-cost operator and has low capital requirements," says Arpin, "and the company is run by seasoned management."

The team has taken some profits in Allied Nevada Gold Corp. ANV, one of the biggest holdings in Beutel Goodman Small Cap. The company has a producing mine, its wholly owned Hycroft gold mine in Nevada.

Allied Nevada also owns exploration properties throughout the state. The stock, says Arpin, "has had a good run and while we remain optimistic about its prospects, it reached our target, and our discipline is to reduce our holding by 25%."

Sulliden Gold Corp Ltd.

Allied Nevada Gold Corp.
July 26 close $2.03 $37.41
52-week high/low $0.61-$2.78 $16.11-$41.28
Market cap $431.3 million $3.3 billion
Total % return 3Y* 22.7% 80.1%
Total % return 5Y* 17.2% n/a
Total % return 10Y* 13.2% n/a
*As of July 26, 2011
Source: Morningstar

Turning to other commodities, the duo has been adding to the fund's uranium exposure. "These stocks were crushed in the aftermath of the Japanese nuclear meltdown," says Arpin. "We think that the commodity price will go higher, given that there is likely to be a supply shortage, even if no new nuclear power plants are built."

The biggest uranium holding in the Beutel Goodman Small Cap is Uranium One Inc. UUU, which has interests in Kazakhstan, the United States and Australia.

Also in the materials sector, Arpin and Otton sold the remainder of their holding in Consolidated Thompson Iron Mines Ltd. before the completion of its acquisition by Cliffs Natural Resources Ltd. in May this year. "We did well in this stock," says Arpin.

In the energy sector, the small-cap team added a new name, Emerge Oil & Gas Inc. EME. This junior, says Arpin, specializes in heavy-oil production with properties in Western Canada.

The commodity price is favourable, and Emerge has good wells, but the company needs to reduce its operating costs, he says. "These are currently too high and are affecting the economics of its business." The stock is "cheap," he adds. "It trades at 4.5 times forward cash flow per share."

The two managers sold their holding in the oil and gas producer Celtic Exploration Ltd. CLT. "The stock did well and met our target price; at the time of our sale it was trading at 11 times forward cash flow, which is expensive," says Arpin.

Turning to the financial-services sector, Intact Financial Corp. IFC, a major Canadian property and casualty insurer, is one of the largest holdings in the fund. Arpin says he is enthusiastic about Intact's acquisition of the Canadian insurance operations of Paris-based AXA Group.

This acquisition will be significantly accretive to Intact's earnings, says Arpin. "It will also diversify Intact's business mix in that AXA has a strong presence in the commercial insurance market versus Intact's concentration on personal insurance."

Another long-standing favourite in the fund is the Montreal-based telecom/media company, Quebecor Inc. QBR.B, "which is the largest cable operator in the province, says Arpin. "We recently added to our holding in the stock," he says, "as it was cheap relative to its peers and the company has the potential to grow its wireless business using its strong cable customer base."

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Sonita Horvitch

Sonita Horvitch  

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