Canadian small-cap equities roundtable: Picks from the pros

Carscallen: It depends on how you define value versus growth. Using the BMO Small Cap group's definitions, value stocks were up 129% and growth stocks were up 64% in 2009. A lot of the value companies were the little companies that saw their valuations collapse and then rebound.

Arpin: I am often asked how you put value investing and small caps together. People associate growth investing with small caps. Value is successful in the small-cap universe as this discipline focuses on capital preservation. What investors don't talk about in small caps is the substantial level of attrition both in companies and in management.

Q: How do you define small caps?

Arpin: We use $100-- million to -- $1.5-billion in float for Beutel Goodman Small Cap, which I manage with William Otton. We manage a total of $1.1 billion.

Stephen Arpin: What investors don't talk about in small caps is the substantial level of attrition both in companies and in management.

Whitehead: We use the BMO definition, which is 0.1% of the total TSE market capitalization. It is currently about $1.45 billion. In Manulife Growth Opportunities, we can go up to 10% in large caps, but we must keep a minimum of 40% in small caps. This fund has a little over $1 billion in assets. In all, I manage $1.2 billion. In 2008, we maximized the large-cap holdings in the fund. Throughout 2009, we reduced our large-cap holdings and are currently down to 2%. This is probably going to zero.

Carscallen: We use the BMO definition as our upper market-capitalization limit in Mackenzie Saxon Small Cap, which had assets of $332 million at the end of December. The range here is a market cap of $200 million up to currently $1.45 billion. But we also have a microcap fund, Mackenzie Saxon Microcap, with assets of $14 million. This fund targets stocks with $10 million to $200 million in market capitalization. Not too many managers focus on microcaps, and this provides an opportunity. We are finding a large number of hidden gems among microcaps.

Q: The BMO Small Cap Blended Weighted Index has 23% in energy and 32% in materials for a total of 55%. What are your weightings?

Whitehead: We are overweight energy and underweight materials. The overweight in energy is mostly oil-producing companies. I have a lot of international names. An example is Pacific Rubiales Energy Corp. PRE Our biggest weighting in the portfolio is Baytex Energy Trust BTE.UN.

Arpin: We are modestly underweight materials and modestly overweight energy. We also own Pacific Rubiales in our small-cap portfolio. We own Baytex in our big-cap portfolio.

Whitehead: Most of our underweight in materials is as a result of an underweight in gold stocks. We are overweight base metals, particularly copper names such as Quadra Mining Ltd. QUA, Equinox Minerals Ltd. EQU and Taseko Mines Ltd. TKO. Being overweight oil and copper, we are 100% committed to global growth in 2010.

Scott Carscallen: We are finding a large number of hidden gems among microcaps.

Q: What about gold?

Whitehead: We were overweight gold in the fall of 2009.

Arpin: So were we.

Whitehead: Thereafter, we trimmed back our gold holdings and made a switch from the larger producers to the exploration and development companies.

Arpin: We had been overweight gold. We are now a little underweight. Similar to Ted's comments, we sold some of our larger, more mature names and added a few names at reasonable valuations, where we think there can be resource growth. We have added a few energy-services names. When the capital markets froze and materials stocks took a beating, we bought some base-metals companies. We are not seeing a lot of value opportunities among the base-metals stocks at present. We have been talking about copper here. Inventories are very high, and all of the demand is dependent primarily on China.

Carscallen: Relative to the BMO Index, Mackenzie Saxon Small Cap is market weight energy and underweight the materials sector. I agree with Steve that as a value investor, it is tough to find good value opportunities in the metal and mining space now. Early last year, it was easy. Some of the names we bought are now getting close to their upper limit of $1.45 billion.

Arpin: We don't have a hard sell rule at $1.45 billion.

Carscallen: We are under pressure to sell when the stock reaches the threshold market capitalization. We tend to have a smaller, small-cap focus than Steve and Ted.

Q: What about the financials?

Carscallen: We have 15% in financial services. We took our weighting up last year in small-cap names like DundeeWealth Inc. DW,which was one of our biggest winners last year. We still like the financials. In the small-cap universe, it is sometimes tough to find opportunities. You don't have big banks or insurance companies, but you do have brokers and investment managers.

Ted Whitehead: Financials pay dividends, and 2010 will be a year where dividends become more valuable.

Arpin: We are overweight financials at 17.9%. But we own some larger companies in this sector, such as Intact Financial Corp. IFC, which was the old ING Canada. It used to have a market float below $1.45 billion before the parent company ING Groep was forced to sell its stake into the market. We have kept our holding in the stock. There is a lot of value there. It is a premier property and casualty insurer and our largest holding.

We also own Industrial Alliance Insurance and Financial Services Inc. IAG. We have moved up the capitalization spectrum, for the reason that Scott identified.

Whitehead: We have 9.5% in financial services. We own Intact as well. It is one of our largest financial weightings. We are underweight financials, but we intend to increase our weighting. These companies pay dividends and 2010 will be a year where dividends become more valuable. In the last couple of months, a name we have added is Brookfield Properties Corp. BPO. Our largest financial holding is Home Capital Group Inc. HCG, which provides mortgage loans and other retail financial services.

Arpin: We own a similar company, Equitable Group Inc. ETC.

Carscallen: We own Equitable too. It has a much cheaper valuation than Home Capital.

Arpin: Yes.

Carscallen: It has a much lower return on equity than Home Capital.

Arpin: Equitable can grow its ROE.

Whitehead: It seems to disappoint from time to time, and this is something that I focus on as a quant.

Arpin: I also bought Genworth MI Canada Inc. MIC recently on the issue. I like the space because of the disappearance of some of these companies' competitors.

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