In scanning the global universe of stocks, small-cap specialist Greg Dean argues that smaller companies that outperform the market are less reliant on macro events and tend to control their own fortunes.
"Typically, it's not so much that they do well in great times, but those businesses that are in control of their destinies suffer less in bad times," says Dean, a 10-year industry veteran and principal at Cambridge Global Asset Management who manages the $375-million CI Cambridge Growth Companies Corporate Class. "There are a few reasons for that. Because they operate in industries with less regulation, they are less susceptible to things like interest-rate pressures or political intervention. Call them left-field risks that can come out of nowhere."
A bottom-up stock picker, Dean looks for firms that do not rely on exogenous factors to succeed. "They are small, but through organic growth and acquisitions they can execute well." He points, for example, to TransForce Inc. (TFII), which has 5% market share of the North American truckload-shipping market yet has been able to grow through acquisition and internal growth. "They could double in size and would still not be very big."
In a similar vein, convenience-store operator Alimentation Couche-Tard Inc. (ATD.B) has demonstrated its ability to grow its market-cap 15-fold in the past decade through growth in the U.S. and expansion into other offshore markets, and by cost-cutting. "It comes down to the management teams acting like owners and to the industries they operate in," says Dean, who joined Cambridge Global Asset Management, a unit of Toronto-based CI Investments, in 2011. "You would not look in real estate or mining or oil and gas to find a business that controls its own destiny. The starting point is in industrials, technology and consumer staples."
Attributes common to small companies that Dean favours include the ability to generate significant cash flow and convert a high percentage into free cash flow, after accounting for capital expenditures, working capital and interest costs. The challenge is that few companies make the cut as far as Dean is concerned. "I own only a little more than 1% of the universe of 4,000 stocks," says Dean. The fund currently holds 44 companies, although he monitors about 250-300 at any one time.
While many of the stocks he owns have relatively high price-earnings ratios, he prefers to look at another measure, price to free cash flow.
"Earnings and cash flow are not interchangeable for these companies. That's because for every dollar of net income, some generate anywhere from $1.10 to $1.40 of free cash flow," says Dean. This is because the firm's capital expenditures are lower than its depreciation costs and because it has very low working-capital requirements.
"My two largest holdings would be defined as expensive on a price-earnings basis, but if you dug deeper to see how much free cash flow they generate, they would look about 25% cheaper than if based on earnings," says Dean. "This free cash conversion is the most important metric for me. I want it to be high and sustainable and I need to understand why that is the case."
As someone who relishes touring the globe for interesting companies, Dean visited Japan a year ago and met with management of more than 20 companies. In the end he added three Japanese companies to the portfolio.
One representative holding is Seria Co. Ltd., owners of so-called 100-Yen shops and considered the Dollarama of Japan. "They are managed by a very smart CEO, Eiji Kawai, who has built a proprietary IT system that allows him to better understand what's being purchased and what is selling best'" says Dean. "And he can customize stores in different regions of Japan."
Another favourite is Auto Trader Group PLC, which has transitioned from a print advertising medium to the dominant web portal for vehicle sales in the UK. "They are a data-driven company that tries to help dealers turn over their inventory more often and help determine which vehicles to stock," says Dean.
"Our thesis was that in making the transition to the web they were going to grow cash flow much than faster than revenue. And that's exactly what's happened," says Dean. "Revenue is only growing about 10% a year, but free cash flow is growing 20-25%."
Dean says Auto Trader doesn't look that attractive in terms of the big picture. "But if you dig deeper, you can see that you're getting about 20% free cash flow per share growth for 15 times free cash flow," he says, adding that the company plans to use some of its free cash flow to pay down debt and buy back stock.
The 5-star Morningstar rated fund returned 15% for the 12 months ended Aug. 31, versus 8.9% for the median fund in the Global Small-Mid Cap Equity category. On a three-year basis, the fund returned an annualized 12.2%, versus 7.2% for the median.
Dean, who is currently holding about 14.5% in cash, makes no promises about future performance. "We're not finding as many good ideas today as we did 12 or 24 months ago."
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