Canadian small-cap equity roundtable: Part 1

Michael Chan, vice-president and senior portfolio manager, Fiera Capital Corp. A growth manager, his responsibilities include Fiera Capital Equity Growth.

Scott Carscallen, vice-president and portfolio manager at Mackenzie Investments. A value manager, his responsibilities include Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class.

The roundtable was convened and led by Morningstar contributor Sonita Horvitch. This week's three-part series continues Wednesday and concludes on Friday.

Q: Canadian small-cap stocks handily outperformed the S&P/TSX Composite Index both in 2016 and in the 12 months to the end of March 2017. In the latter period, the small-cap index had a total return of 29.5% versus 18.6% for the Composite. Natural-resource stocks, which represented almost 50% of the S&P/TSX Small Cap Index at the end of March, performed exceptionally well in the 12 months to the end of March. Can Canadian small-caps continue to do well?

Arpin: Yes, this outperformance can continue. Bond yields are still very low, so there is not a lot of competition for stocks in general from fixed income. Also, small-caps tend to do well when the economy is better. The U.S. economy, which is important for both Canadian and global economic growth, continues to strengthen. Global economic growth, including most importantly China's growth, helps to determine key commodity prices. These, in turn, affect the performance of natural-resource stocks, which represent such a major weighting in the S&P/TSX Small Cap Index. Also, it must be noted that outside of the resource area, many of the successful Canadian small-caps have significant sales in the United States and, in some cases, internationally. The smaller-cap Canadian packaging companies and auto-parts makers are an example of this.

Chan: If you look at the average Canadian small-cap company, it's hard to know whether the stock will do better than the Composite this year. If you're focused on industry leaders, these companies are typically North American and global companies. Our portfolios focus more on them. They can outperform.

	Michael Chan

Arpin: It must be remembered that the United States is Canada's primary export market.

Chan: We look for companies that can grow revenue and earnings at a faster pace than the broader economy. We're finding excellent opportunities across all sectors.

Carscallen: There are quite a few companies in my portfolio that will benefit from global opportunities. Some of the names are slightly larger. I call them larger small-caps. These include global packaging, engineering and commercial real-estate brokerage companies.

Chan: From a global perspective, the emerging markets have been pretty quiet in the last six years, and there are signs that countries like Brazil, South Korea and Turkey are experiencing faster economic growth. If there is a turn in the emerging markets, this bodes well for the resource companies in Canada.

Q: The performance of the S&P/TSX Small Cap Index was stellar in 2016 with a total return of 38.5%. Coming back to the original question, are we going to see that kind of performance again in 2017?

Arpin: The reality is that few active managers outperformed this index last year. Most active managers are not comfortable having almost 50% of their portfolio in materials and energy.

Chan: One of the reasons why the total return for the small-cap index in the past year was so strong is because of the rebound in the commodity prices such as oil, natural gas, copper and gold. Some of the best performing names last year were companies that had had distressed balance sheets. The rise in commodity prices brought them back on side. That's not going to be repeated this year.

Stephen Arpin

Carscallen: For Canadian small-caps to do well in 2017, the energy sector must improve. It was the worst performing sector in the first quarter of this year, after its stellar performance in 2016. In 2016, the sector came off depressed levels. At the end of March 2017, energy represented 22.9% of the small-cap index. Energy faltered in the first quarter of 2017 and helped to stall the index, which produced a total return of 1.5% in the quarter. There are expectations that the oil price will improve. But, if the fundamentals for energy don't improve, it will challenge the Canadian small-cap universe.

Chan: The chances of energy doing better in the second and third quarters of this year are quite good. Over the past four to five years, the demand for oil in the middle quarters of the year has been higher than the first and last quarters. That the oil price pulled back in the first quarter was not surprising, but the surprise was how badly the stocks of some of the small and mid-cap energy companies performed.

Carscallen: From what I've heard, U.S. investors, who are sometimes holders of Canadian energy stocks, are concerned about the impact on the Canadian energy sector of a possible U.S. border-adjustment tax under the Trump administration. There are also concerns among investors about the cost pressures on Canadian energy producers.

Arpin: The U.S. investor is always important as an incremental buyer of Canadian stocks. The Canadian energy sector was, for a long time, attractive to the U.S. investor. But, more recently, U.S. investors have turned to the United States with the emergence of the importance of shale and the U.S. Permian Basin, which is attracting a lot of money. There has also been a considerable divestment by foreign companies of Canadian energy properties, particularly in the oilsands. This is affecting the Canadian energy sector in general.

There is concern about natural-gas prices in Canada due to the pipeline connection of the Marcellus shale play, which is in the northeastern United States, to Ontario. The Marcellus has changed the entire supply equation in North America.

Chan: The Marcellus has taken market share in the northeastern United States and it's taking additional market share in Ontario. Over time, it will also take market share in Chicago. These are big natural-gas consuming areas in North America. That's putting pressure on the pricing that Canadian producers are receiving for their natural gas.

	Scott Carscallen

Carscallen: We're starting to see merger and acquisition activity and IPOs in the Canadian energy sector. An example in M&A is Trican Well Service Ltd. (TCW), which is buying rival fraccing company Canyon Services Group Inc. (FRC). There are some IPOs. Another fraccing company, STEP Energy Services Ltd., is looking to do an initial public offering, and Source Energy Services Ltd. (SHLE) was recently listed. Also, BOS Solutions Holdings Inc., another energy-services company, recently announced it was seeking an IPO.

Chan: What's driving M&A in Western Canada is that the service companies are built with the expectation of higher levels of activity. This might not transpire and the companies are being forced to consolidate. Looking at the Canadian energy sector as a whole, there are good opportunities, but the focus is narrow in terms of the companies that will be successful. Within energy services, we focus on companies with North American or global operations such as Canadian Energy Services & Technology Corp. (CEU) and Enerflex Ltd. (EFX).

Arpin: I own Enerflex.

Carscallen: I also do.

Chan: I like Canadian Energy Services and Enerflex because even if there is a lower-price environment in the next three or four years, they can continue to grow their revenue and earnings. Enerflex has operations in the United States, South America, the Middle East and Asia. Canadian Energy Services has two-thirds of its business in the United States and its U.S. business is mostly in the Permian Basin.

	Canadian Energy Services & Technology Corp.	Enerflex Ltd.	Trican Well Service Ltd.
April 27 close	$6.28	$19.43	$3.80
52-week high/low	$8.65-$2.96	$20.57-$8.59	$5.59-$1.50
Market cap	$1.7 billion	$1.7 billion	$735.6 million
Total % return 1Y*	66.9	63.4	108.8
Total % return 3Y*	-13.8	5.6	-35.6
Total % return 5Y*	13.3	11.5	-19.8
*As of April 27 Source: Morningstar

Carscallen: Exposure to the Permian Basin is an important theme for services companies. I've tilted my energy holdings a little bit more toward the services companies.

Arpin: I have not done so.

Chan: Neither have I. The make-up of the producers that we own is now tilted more toward the international names such as Parex Resources Inc. (PXT).

Carscallen: I own it.

Chan: It's a growth-oriented oil exploration and production company. It is focused on South America, in particular Colombia.

Photos: Paul Lawrence Photography