Canadian small-cap equities roundtable: Growth and value picks

Alliance Grain Traders looks appetizing; liftoff expected at COM DEV; takeover buzz on Le Chateau; and more.

Sonita Horvitch 12 February, 2010 | 7:00PM
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Editor's note: In today's final instalment of Morningstar's roundtable on Canadian small-cap equities, one growth manager and two value managers discuss the disciplines behind their stock picks, and name more of their favourite names.

Our panellists are Ted Whitehead, vice-president and senior portfolio manager at Toronto-based MFC Global Investment Management and manager ofManulife Growth Opportunities; Stephen Arpin, vice-president at Toronto-based Beutel, Goodman & Co. Ltd. and manager ofBeutel Goodman Small Cap; and Scott Carscallen, vice-president and portfolio manager at Toronto-based Mackenzie Financial Corp. and manager ofMackenzie Saxon Small Cap  andMackenzie Saxon Microcap. They spoke to columnist Sonita Horvitch, whose three-part series began on Feb. 8.

Q: Can we talk further about your styles and stock selections?

Whitehead: In Manulife Growth Opportunities we currently have 86 names. Our process is both quantitative and qualitative. The quantitative model looks at earnings-estimate revisions, earnings surprises and stock-price momentum. We are looking for positives in all three cases. We rank stocks on this basis and then follow up with fundamental analysis on the top-ranked stocks, and we look at the bottom-ranked as sell candidates, if they are in our portfolio. We have risk constraints in place.

We have been adding to our energy names. We added Bellatrix Exploration Ltd. BXE. We have also been adding to junior-exploration gold names such as Victoria Gold Corp. VIT.We own Rubicon Minerals Corp. RMX and San Gold Corp. SGR. We sold Goldcorp Inc. G, which was a source of cash to put into some of the more junior names.

A company that is well placed to take advantage of the investment by the United States and Canada in the smart grid is CVTech Group Inc. CVT. It builds transmission lines and services them. It's a big player in this niche. It's one of our smaller names. The company currently has an order backlog of $500 million or roughly two years of revenue.

 
Ted Whitehead: We have been adding to our energy names.

The largest lentil processor in the world that can consistently grow EBITDA (earnings before interest, dividends, depreciation and amortization) over the next few years is Alliance Grain Traders Inc. AGT. Demand for its products is being driven by developing countries. Near-term prospects are good in that it can source product from the strong recent harvest experienced in most lentil-growing regions and process this through its facilities worldwide.

The world's biggest producer and marketer of methanol is Methanex Corp. MX. Production is expected to double over the next three years. China surpassed the United States in 2009 to become the largest market for vehicles. We expect that gasoline blending in China will continue to accelerate.

Q: Time for our value managers. Steve

Arpin: In Beutel Goodman Small Cap, we can have 30 to 50 names. We currently own 40. Our holdings are typically 2.5% to 3% each. We screen for value. Our discipline is to look for a return of 100% from the stock over three to four years. Small caps can be unloved and underfollowed for significant periods of time. Also, you have to demand higher rates of return to invest in small caps versus large caps. The critical aspect of risk control is to buy stocks that are trading at a substantial discount to their intrinsic value, which we calculate by discounting free cash flow.

We check these intrinsic value calculations against actual transactions, sales of similar businesses that have been done for cash. We look for good balance sheets and cash flow coverage of interest expense.

 
Stephen Arpin: The critical aspect of risk control is to buy stocks that are trading at a substantial discount to their intrinsic value.

We have been adding to energy-services companies. Spending on drilling in North America is trending toward specialist directional or horizontal drilling. Cathedral Energy Services Ltd. CET has about 15% of this market in Canada. It has less than 3% in the United States and can grow this. We participated in a share issue at the bottom of the market. Cathedral's balance sheet is in good shape. The company will benefit from improved drilling-activity levels. A recent addition to the portfolio is COM DEV International Ltd. CDV a leading satellite sub-system designer and manufacturer.

Whitehead: We own it.

Arpin: Space spending has been trending upward. The company disappointed on earnings in the last few quarters and we were able to buy it at a substantial discount to its intrinsic value. COM DEV has a new initiative in micro-satellite-based ship monitoring to track ships around the world. If this is successful, the satellite business could be worth a multiple of what COM DEV is worth today. The company is in the best financial shape it has been in years.

Whitehead: This satellite business is the upside. We bought COM DEV during the depth of despair on the share issue.

Arpin: In the telecom sector, which has been generally out of favour, Quebecor Inc. QBR.B has an excellent franchise and is a strong cash flow generator. Its primary business is cable in Quebec, and this is a relatively under-served market so it is experiencing subscriber growth. The key here is valuation. We were buying the stock at the bottom of the market at $15 to $16 a share. It was cheap. The stock has almost doubled since, but we think that there is further upside. Quebecor is well placed to succeed with its wireless rollout.

We have sold gold producer Aurizon Mines Ltd. ARZ as the stock was fully valued. All its assets and costs are in Canada. The gold price is expressed in U.S. dollars. As it rose, the Canadian dollar versus the U.S. dollar was strengthening too, reducing the benefit of the rising gold price to Aurizon.

 
Scott Carscallen: I am finding more interesting value in energy-services companies than with some of the producers.

Q: Scott, your process and stock picks please.

Carscallen: As value investors, we screen for statistically inexpensive stocks trading at low multiples of price to book value and price to cash flow. When we uncover these stocks, we do the additional homework to find out why they are cheap. We are bottom-up focused. We look for good management, good balance sheets and revenue growth. The companies should generate capital internally. We are trying to lower the risk element of investing in small caps.

We are finding opportunities in the financial services sector. Brokerage firm Canaccord Financial Inc. CF has seen its stock improve dramatically over the past year. It still looks attractively valued. It trades at 1.4 times book value and it can trade as high as 2.5 to three times book value. It has a solid balance sheet. It introduced cost-cutting initiatives when its revenues dropped off last year, so it has a lower cost base. It is looking to expand in the United States and in the UK. It has the cash and the intent to make acquisitions.

Whitehead: Is Canaccord's asset-backed commercial paper (ABCP) problem behind it?

Carscallen: Yes. DundeeWealth also had challenges with ABCP. An attractively valued energy company that is in both Mackenzie Saxon Small Cap and Mackenzie Saxon Microcap is Total Energy Services Inc. TOT, which trades at 1.4 times book value per share. In the recent industry downturn, Total made an astute acquisition and it is now the largest oil-field rental-equipment company in Western Canada. I am finding more interesting value in energy-services companies than with some of the producers.

In the retailing sector, Le Chateau Inc. CTU.A has had a strong track record for almost the past 10 years. It has a steadily increasing dividend. You could have bought the stock last year with a dividend yield of about 10%. It is currently about 5%. It has a strong balance sheet.

Whitehead: Le Chateau is a takeover candidate.

Carscallen: It has a controlling shareholder. Le Chateau is trading at an enterprise value to EBITDA (earnings before interest, taxation, depreciation and amortization) of almost six times. La Senza was taken over at 12 times.

We sold seafood-products company High Liner Foods Inc. HLF, which turned out to be a value trap.

Photos: www.paullawrencephotography.com

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Sonita Horvitch

Sonita Horvitch  

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