Investing in a material world

This outperformance by small caps was in part, he says, due to the stellar run of materials companies, which were up 86.4% year to the end of September. Materials represent a hefty 29.5% of the BMO index, compared with 18.4% for the S&P/TSX Composite.

At the end of September, the small-cap index traded at a "significant" discount to the S&P/TSX Composite, using both price-to-book and price-to-sales valuation metrics, says Arpin. In absolute terms, the small-cap index traded at a price-to-book value of 1.4 times and a price-to-sales of 0.95 times, "which is fairly low by historic standards."

Materials sector shines this year, especially in small caps

Index	YTD Ret
BMO Small Cap Blended (Weighted) materials sub-index	86.4%
BMO Small Cap Blended (Weighted)	54.3%
S&P/TSX materials sub-index	26.4%
S&P/TSX Composite Index	30.0%
Data as of Sept. 30, 2009 Source: Beutel Goodman & Co. Ltd.; Morningstar Direct

Essentially bottom-up stock pickers, 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. Their target universe consists of companies and income trusts with a $100-million to $1.5-billion market cap float. (The float is the number of shares publicly owned and available for trading, multiplied by the share price.)

At the end of September, the portfolio held 38 names. "This is fairly concentrated. We do our homework carefully and want each stock that we put in the portfolio to have an impact," says Arpin.

A smaller-cap energy-services company that he considers offers good value at this juncture is Cathedral Energy Services Income Trust ( CET.UN). In August, the trust announced its intention to convert to a corporation by year-end.

Stephen Arpin

Cathedral Energy Services, which has a market capitalization of $150 million, provides horizontal, directional and other drilling services to the oil and gas industry in Canada and the United States. "Drilling activity has fallen sharply, but should revive as the commodity prices improve; oil has already rebounded off the bottom," Arpin says.

This energy services company, says Arpin, has a sizeable share of the market for specialized drilling in Canada and a small stake in the U.S. market. "The growth in North American demand for these advanced services is more robust than that for traditional drilling."

The trust unit currently trades at a price-to-book value of 1.5 times and a price-to-sales multiple of one. Looking at price to estimated earnings per unit/share for 2010, the multiple is 11 times.

In the materials sector, Otton notes that he and Arpin prefer mining companies that are close to or already in production rather than pure exploration plays. A precious-metals miner that meets the duo's criteria is Minefinders Corp. Ltd. ( MFL), which represented 5.3% of the fund at the end of September and was in its top 10 holdings. Its market capitalization is $800 million.

Minefinders' flagship mine is the Dolores mine in Mexico. The mine has commenced production of gold and silver and is "in the process of ramping this up," says Otton, who has a background in mining engineering. The Dolores mine has proven and probable gold reserves of around 2.4 million ounces.

Minefinders' stock, he says, trades at a "small premium" to his estimated net asset value per share of $7.50, "a valuation which is cheap by both Minefinders' historic standards and relative to its peers."

A Quebec-based telecom/media company that Arpin says is a "consistent cash flow generator and has a commanding presence in the market it serves," and which he considers cheap, is Quebecor Inc. ( QBR.B). This company has a market capitalization of $1.5 billion and was also in the fund's top 10 holdings at the end of September.

Quebecor is the largest cable operator in the province as well as a major internet service provider and provider of other telecom services. "More than 80% of its earnings before interest, taxes, depreciation and amortization (EBITDA) come from its cable operator Videotron Ltd," Arpin says

Quebecor is "successfully growing EBITDA at 10% per annum," he adds. Based on 2009 estimates, he says the stock trades at an enterprise value (equity plus debt of the company) to EBITDA of 5.8 times and a price-earnings multiple of 7.3 times.

In general, says Arpin, telecom stocks are out of favour and, in particular, "there is some concern about Quebecor's investment in a wireless network, through Videotron Ltd." Quebecor's objective is to offer advanced wireless telecom services in the province.

Arpin says that the cost of this move into wireless is not that onerous to the company. "A big percentage of the investment has already been made and this business has good growth prospects."

Arpin and Otton have sold their long-time holding in Stantec Inc. ( STN) a planning, engineering and architectural firm. "We bought the stock at $9 years ago, when it was undiscovered by investors and recently sold our remaining holding at $28 a share," Arpin says. The stock was trading at "fairly full value." (Its current valuation is 2.5 times book value per share and 16 times earnings-per-share estimates for 2009.)

Also, Arpin notes, Stantec's growth by acquisition strategy "will require it to make increasingly larger acquisitions, which it might find increasingly tougher to do at a reasonable valuation."