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Canadian Small Cap Equity spotlight

An opportunity to tap into the "next big thing" while diversifying your portfolio.

Morningstar Canada 31 January, 2003 | 2:00PM
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The Canadian Small Cap Equity category is one of the few where even the fund in the middle of the pack has managed to outperform its benchmark over the long term. Over the past 15 years, the median Canadian Small Cap fund has doubled the return of the BMO Nesbitt Burns Small Cap Index.

The reason behind this phenomenon is that fewer investors, both professional and individual, look closely at small companies. This lack of attention results in a greater likelihood that professional managers working in this area will discover a hidden gem—a company whose price doesn't match its potential.

Canadian Small Cap funds typically hold companies with less than $800 million in market capitalization—companies such as the frozen dessert distributor Coolbrands International ( COB.A/TSX) and sporting-goods retailer Forzani Group ( FGL/TSX). Today's corporate giants started off as small companies and investing in small caps provides an investor with the chance to tap into the "next big thing."

Meet the players

With 133 funds at the end of 2002, the Canadian Small Cap category boasts about $12 billion in assets. The largest fund isFidelity Canadian Growth Company Series A at $2.1 billion, which is more than two and a half times larger than the second-largest,AGF Canadian Growth Equity.

Five Largest Canadian Small Cap Equity Funds (as at Dec. 31, 2002)

Fund and Morningstar Rating Assets($Mil) Incpt MER % 1 Yr Ret 3 Yr Ret 5 Yr Ret 10 Yr Ret
Fidelity Can. Growth Company Sr A
 2,092.6 Jul 94 2.64 -12.6 -0.8 4.6 n/a
AGF Canadian Growth Equity 794.4 Apr 65 2.82 -9.4 -1.9 0.5 9.7
Royal Canadian Growth
 579.4 Jan 93 2.31 -17.0 1.0 0.7 n/a
Clarica Canadian Small/Mid Cap 538.5 Nov 92 2.69 -3.5 -3.7 -4.5 6.3
CIBC Capital Appreciation 377.3 Aug 91 2.58 -15.8 -5.8 2.5 5.9

But sometimes small can also be beautiful. Notable long-term benchmark outperformers in this category include the highly concentratedResolute Growth ($82 million), the growth-at-a-reasonable-price orientedBissett Small Capital Class F ($130 million) and top 15-year annualized performerNorthwest Specialty Equity ($70 million).

A unique sub-group within this category focuses on companies with very small market capitalizations—less than $250 million. Among them areBissett Microcap F andCIBC Canadian Emerging Companies.

How have they performed?

The median Canadian Small Cap fund's 212% gain for the 15-years leading to Dec. 31, 2002 far exceeded the 105% performance posted by the BMO Nesbitt Burns Small Cap Index. Relative to the broader S&P/TSX Composite Index, small-cap funds have held their own, as the performance difference between the two indices is comparatively small.

Over the recent two-year period of global economic weakness, the median Canadian Small Cap fund lost 1% while the BMO Nesbitt Burns Small Cap Index gained 2% and the S&P/TSX lost 23%.

Five Star Canadian Small Cap Equity Funds (as at Dec. 31, 2002)


Funds		 Assets
($Mil)		 Incpt MER % 1 Yr Ret 3 Yr Ret 5 Yr Ret 10 Yr Ret Min Invest. $
IG Beutel Goodman Canadian Small Cap 269.9 Jul 96 3.28 -5.2 11.2 9.4 n/a 1,000*
Trimark Canadian Small Companies 268.4 May 98 2.68 7.2 19.8 n/a n/a 500*
Resolute Growth 82.3 Dec 93 2.1 40.2 45.4 28.5 n/a 25,000
Mawer New Canada 75.8 Jan 88 1.59 23.5 19.9 9.1 15.9 5,000
Beutel Goodman Small Cap 64.4 Jan 95 1.52 -3.2 12.6 10.5 n/a 10,000
Bissett Microcap Class F 53.5 Aug 97 2.54 36.2 21.1 21.7 n/a 500*
Elliott & Page Growth Opportunities 38.7 Nov 98 2.93 9.5 16.1 n/a n/a 500
Norrep 37.5 Jun 97 2.8 20.7 29.2 17.5 n/a 20,000
* fund was closed to new investment at Dec. 31, 2002.

Unlike categories such as Science & Technology and Financial Services, small-caps do not have a unique set of factors that drive their performance. Much like the broader market, the asset class is divided among various sectors, which individually have their own set of catalysts. Some managers feel small caps typically do well going in and out of a recession.

Worth noting
  • Securities regulations limit how much of a company a mutual fund can hold. When the companies are small, funds can reach these limits without investing large amounts of money. Therefore it's harder for larger funds to find enough small companies to invest all their money in. This is why some small-cap managers close their funds to new investment when they feel they are approaching this threshold. Funds are also able to invest a proportion of assets in larger capitalization companies and still be classified as small-cap funds.

  • Relative to the broader market, there are more companies in the information technology, healthcare and other consumer-related sectors in the small-cap arena. Consequently, there is a greater likelihood for a small-cap fund to be overweighted in these areas. There are fewer firms from the financial services, utilities and telecommunications sectors at the small-cap level.

  • Over the last five years, the median Canadian Small Cap fund has had a lower performance correlation to the median Large Cap U.S. and Global Equity funds relative to the median fund in the broader Canadian Equity category. That means that it offers a greater diversifying benefit to portfolios with holdings in foreign markets.

  • Funds in the Canadian Small Cap category tend to be more volatile (and hence more "risky") than more diversified types of equity funds, though less so than sector-based or specialty equity funds.

  • The median management fee for these funds is 2.76%, however over a quarter of these offerings charge MERs of at least 3%.

Suitability

The potential for explosive growth in small-cap companies, as well as the ability of fund managers to add value, makes this category attractive to long-term investors. Although the performance of many of the funds in the category has typically been more volatile than for other more diversified equity funds, these funds also offer an opportunity for better diversification within a portfolio.

See all the funds in the Canadian Small Cap Equity category and Morningstar Canadian Small Cap Equity Index returns.
No statement in this article should be construed as a recommendation to buy or sell securities or to provide investment advice or individual financial planning. Morningstar Canada does not provide specific portfolio advice and recommends the use of a qualified financial planner when appropriate.

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