Canadian small-cap manager roundtable: Part 2

Merger activity will help drive stock prices, panellists say.

Sonita Horvitch 16 February, 2011 | 7:00PM
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Editor's note: Mergers and acquisitions are expected to help drive the prices of selected small-cap stocks in both the resources and non-resources sectors, according to managers who participated in Morningstar's Canadian small-cap manager roundtable.

Our panellists:

 Stephen Arpin, vice-president at Beutel, Goodman & Co. Ltd. and lead manager of Beutel Goodman Small Cap  .

 Ted Whitehead, senior managing director and senior portfolio manager at Manulife Asset Management, who manages Manulife Growth Opportunities  .

 Martin Ferguson, director and portfolio manager at Calgary-based Mawer Investment Management Ltd. He manages Mawer New Canada, which is closed to new investors, and BMO Guardian Enterprise  .

William Aldridge, associate portfolio manager at Mackenzie Financial Corp., who is co-manager of Mackenzie Saxon Small Cap and Mackenzie Saxon Mircocap.

The moderator was Morningstar columnist Sonita Horvitch, whose three-part series began on Monday and concludes on Friday.

Q: Can we discuss energy?

Whitehead: We are overweight energy in Manulife Growth Opportunities. We have 24%. When it comes to demand, the puck is being passed from North America to the high-growth emerging markets, though the United States remains the biggest consumer. Looking at the favourable fundamentals and looking for companies that are generating production growth of 20% to 25%, we have a focus on Canadian companies with Colombian plays. We own Gran Tierra Energy Inc. GTE, one of our biggest energy weightings, Pacific Rubiales Energy Corp. PRE and Petrominerales Ltd. PMG. They were first movers in Colombia and tended to get the best land. The companies can hit some monster oil wells down there. We are predominantly in oil. We are bullish on the commodity. There are few substitutes for oil.

 
Martin Ferguson

Arpin: We do own some Colombian energy producers such as Pacific Rubiales and C and C Energia Ltd. CZE. We are overweight energy and have been for the last few years. The rise of horizontal drilling and fraccing has significantly expanded the resource potential in North America. This change in technology has been more beneficial to smaller and mid-sized conventional exploration and production companies in Canada than for larger companies.

I am not concerned whether the company focuses on oil or gas, as long as the valuation is acceptable. We have owned Celtic Exploration Ltd. CLT for a long time. It produces natural gas. We also own a significant number of services companies, like Cathedral Energy Services Ltd. CET, which is a directional driller, and Canyon Services Group Inc. FRC, which is a fraccing company.

Canyon Services
Group Inc.
Cathedral Energy
Services Ltd.
Feb. 15 close $11.99 $10.45
52-week high/low $12.20-$3.50 $10.56-$4.52
Market cap $719 million $381 million
Total % return 1Y* 216.8 83.4
Total % return 3Y* 57.2 6.2
Total % return 5Y* NA 3.7

*As of Feb. 15, 2011
Source: Morningstar

Ferguson: As at the end of last year, we were slightly overweight energy. We are more weighted to energy-service companies than producers. In our holdings of producers, we are more tilted to natural gas than oil, because of the relative valuation of the stocks. Oil names have been bid up. As Stephen mentioned, there are some good natural-gas names with good economics even at these low natural-gas prices. We own Delphi Energy Corp. DEE.

Aldridge: We have been overweight energy for a couple of years now. We currently have 23% in energy. Our success has come more on the services side, with exposure to the fraccers and the directional drillers. Like Stephen, we own Cathedral and Canyon. Other services stocks that we own include Calfrac Well Services Ltd. CFW and PHX Energy Services Corp. PHX.

 
Stephen Arpin

Whitehead: We also own Canyon.

Aldridge: The services companies have outperformed the exploration and production companies. Our gas names have not performed as well. We have owned NuVista Energy Ltd. NVA for some time and like Martin, we own Delphi, which has not been a great performer. We also own Celtic. We have owned it for four or five years now, and we own Surge Energy Inc. SGY, which is more heavily weighted toward oil. When it comes to valuation, the energy sector is still an attractive space.

Arpin: It is getting tougher to find value in the energy sector.

Whitehead: We still see opportunities.

Q: Martin has identified natural resources as an important driver of small-cap performance in 2011. The panel has also highlighted merger and acquisition activity as a key driver. Let's discuss this.

Whitehead: Small-caps have always been the fodder for the large-cap names. We come across periods where it happens more dramatically and I think that 2011 will be such a year. Fronteer Gold Inc. FRG is being taken out at a premium. When small-caps are bought out, the average premium is about 30%. A reason why M&A will ramp up this year is that the financing costs are incredibly low and so it makes it worthwhile for larger companies to leverage up and make these acquisitions.

Arpin: This easy, low-cost access to the corporate-debt market is an extremely important factor.

Whitehead: Exactly. An area in Canada where we have seen some takeover activity and may see some more is in the iron-ore space. We have already seen this in the case of Baffinland Iron Ore Mines Ltd. BIM and Consolidated Thompson Iron Ore Mines Ltd. CLM.

Arpin: We were just taken out of Consolidated Thompson.

Ferguson: I will take a different tack. We are experiencing a situation where investors are pulling money out of all other sectors and putting it in the materials sector. We are seeing a lot of M&A activity in this sector, as Ted has mentioned. At some point this materials juggernaut will cease, and when it does, there will be a realization that there are good valuations to be had in the rest of the market.

I am expecting some takeovers outside of the materials sector. We had three such takeovers in our portfolio in the 12 months to the end of January. With slow economic growth, companies are looking for ways to increase their growth rates and M&A activity is a way of achieving this.

 
William Aldridge

Arpin: We have had three takeouts in the last couple of months, including technology company Dalsa Corp. DSA, at a big premium. We are value managers and M&A provides important validation of the fact that you do have value in your portfolio. If the market doesn't recognize value in a stock, another company will.

Aldridge: It's a perfect environment for M&A. The one thing that has not yet been mentioned is the role of private equity. The private-equity players were forced to back-pedal after they made a lot of acquisitions in 2006 and 2007 at the peak of the equity market. They had great access to capital. They have spent the last couple of years restructuring their portfolios and now they are taking companies out of portfolio and offering them back to the market.

Their next step is to raise money, which they are doing and to put this to work via takeouts. Small-caps will be the beneficiaries of this. Like the other managers, we have experienced a number of takeouts from the portfolio in recent months. We owned Dalsa. Another example of a takeout is Western Financial Group WES, which was taken over by the Desjardins Financial Group at a massive premium. Another is Realex Properties Corp. RP, which is being taken over by Dundee Real Estate Investment Trust. D.UN.

Ferguson: We also own Realex.

Aldridge: In closing on the M&A side, we own investment dealers Canaccord Financial Inc. CF, which is one of the biggest holdings in the portfolio and GMP Capital Inc. GMP, another major holding. They are well positioned to take advantage of an increase in M&A activity.

One of my picks for the roundtable is Canaccord. It has a market of about $1.3 billion. Canaccord bought Genuity Capital Markets last year for a little less than $300 million. Genuity was a specialized M&A shop. In the near term, this stock is an earnings story. Longer term, Canaccord could itself be a takeout candidate. In all, we have 21% in financial services.

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Sonita Horvitch

Sonita Horvitch  

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