Some investors like to allocate a portion of their portfolio to companies with smaller market capitalizations because they tend to grow at a faster pace than their larger peers. Superior earnings growth can lead to higher stock returns.
That's definitely been the case as of late. On a year-to-date basis (as of Nov. 15), the S&P/TSX Smallcap Index has jumped 24.9%, more than double the S&P/TSX Composite Index's 12.2% gain.
However, smaller-cap stocks tend to be riskier than the large-caps. They're less widely followed by equity analysts than large-cap companies, and bid-ask spreads on small-cap stocks are wider because their trading volumes are lower.
Active fund managers can exploit these market inefficiencies, so there are more opportunities to outperform the market indexes. This makes indexing a less attractive strategy, which explains why Morningstar's manager-research team doesn't favour any of the exchange-traded funds in the Canadian Small/Mid Cap Equity category. (ETF ratings were launched earlier this month.) Nor are there currently any mutual funds with Gold medallist ratings.
Morningstar's research team has given Silver medallist ratings to four funds in the category. Two of them -- BMO Enterprise and Mawer New Canada, both managed by Calgary-based Mawer Investment Management Ltd. -- are closed to new investors. The two highest rated medallist funds that remain open to new purchases are:
Beutel Goodman Small Cap Class D
Management expense ratio: 1.49%
Morningstar medallist rating: Silver
Portfolio managers Stephen Arpin and William Otton of Beutel, Goodman & Co. Ltd. follow a value strategy. They look for companies that are stable with positive cash flow and have defensive characteristics.
The managers screen 300 stocks and narrow them down to an active list of 80. From that list, they analyze the companies' financials and business fundamentals and build a portfolio of between 30 and 50 stocks.
Before making a purchase, they look for companies trading at a 50% discount to intrinsic value or that they believe will provide a 100% return over a three- to four-year period. When stocks hit their price targets, the fund automatically sells one quarter of the position. Another analyst then reassesses the position and if the intrinsic value estimate hasn't increased, the entire position is sold.
"This ensures the portfolio maintains its value characteristics and avoids holding pricier stocks, while also limiting behavioural issues such as anchoring and confirmation bias," notes Morningstar analyst Jeffrey Bunce.
By focusing on companies with positive cash flow, the managers hold more mature companies with relatively larger market capitalizations. As of Oct. 31, 59% of the portfolio was composed of mid-cap stocks. But the fund's weighted average market cap of $2.1 billion is below the category average of $2.8 billion.
The fund's largest sector weight was in consumer-cyclical stocks at 26.6%, about 11 percentage points above the category average. On the other hand, the fund holds fewer energy companies than its peers, which has been the case since early 2014.
There was a difference of more than five percentage points in February 2016, with the managers having reduced their holdings in lower-quality energy companies as oil prices fell. But as crude has rebounded, they have increased their sector weight to 12.8% compared with the category average of 15%. While doing so, the managers have also sold lesser-quality companies and replaced them with those that have stronger balance sheets.
Sionna Canadian Small Cap Equity Series A
Management expense ratio: 2.56%
Morningstar medallist rating: Silver
The fund's manager is Teresa Lee, who is co-chief investment officer of Sionna Investment Managers Inc., the Toronto-based firm headed by Kim Shannon. The Sionna team uses an intrinsic-value model to screen and rank stocks based on book value, historical return on equity, and relative price/earnings ratios. They then focus on stocks trading 30% below their intrinsic value.
The firm usually likes businesses that are going through operational or cyclical difficulties, and which the team believes are mispriced on the stock market. Their expectation is that the stock price will return to its intrinsic value. They assess a company's competitive position and its ability to produce reliable cash flows and profits. The team takes a disciplined approach as well by reducing or increasing stock positions as they move further from or closer to their intrinsic value.
The portfolio usually consists of between 30 and 55 stocks. As of July 31, there were 42 holdings. The fund's weighted average market capitalization was $680 million, well below the category average of $2.8 billion. The majority of stocks in the portfolio have a market cap of less than $2 billion, with nearly 55% being small-cap names. The rest of the portfolio is split almost evenly between mid-cap and micro-cap stocks.
Lee avoids junior gold and oil companies with little to no revenue. Instead, she prefers companies with long-term track records. The fund is overweight in consumer cyclicals and underweight in basic materials. Notably, it has no exposure to telecommunications, health care or utilities. "The fund can lag its more aggressive peers in up markets but should protect value in falling markets," says Bunce.
