Scott Carscallen, vice-president and portfolio manager at Mackenzie Investments, says that the stellar performance of Canadian small-cap stocks so far this year largely reflects the heavy weighting of natural resources in the small-cap universe.
A specialist in small-cap stocks and a value manager, Carscallen points to the performance of the S&P/TSX Small Cap Index to the end of August. This benchmark produced a total return of 30.2% in the first eight months of the year and 22.7% in the 12 months to Aug. 31.
"With these strong results, Canadian small-caps were able to handily outperform their larger-cap counterparts," Carscallen notes. For the first eight months of this year, the S&P/TSX Composite Index, by contrast, had a total return of 14.4%, and 8.7% for the 12 months to Aug. 31.
Carscallen says that the strength of small-cap gold stocks, which produced a total return of 86%, and energy, with a total return of 32.4%, was a key contributor to the small-cap index's absolute performance in the first eight months of 2016. These two areas were heavy weights in the benchmark during that period.
At the end of August, the materials sector, dominated by gold stocks, which represented 21.6% of the index, had an index weight of 35.7% while energy was 17.1%. This made for a total weighting of 52.8% in natural-resources stocks in the S&P/TSX Small Cap Index.
Carscallen notes that gold stocks surged in the first half of 2016. Since the end of June, they have pulled back slightly, he says, but are still up substantially since the beginning of the year. By contrast, energy stocks continued their ascent, he says.
The ongoing prominence of natural-resource stocks in the Canadian small-cap space represents a challenge to investors, says Carscallen. "It has worked both ways in the past."
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| Scott Carscallen | |
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This year, he says, resources sectors have been an important driver of performance, "but in recent years, the worst place to be in the small-cap space was the natural-resources sector." The heavy weightings in these sectors, he notes, contributed to the underperformance of Canadian small-caps versus their bigger-cap Canadian counterparts over a number of years.
Looking at the respective annualized total returns over five years to the end of August, Carscallen points out that the S&P/TSX Small Cap Index produced a total return of only 0.9% versus 5.9% for the Composite.
The starring role of gold stocks in the small-cap benchmark in the first eight months of this year is evidenced, says Carscallen, by the fact that they dominated the top-10 list by index weight at the end of August.
As a result of their success, a large number of gold stocks previously included in the S&P/TSX Small Cap Index were removed from the index effective Sept. 16, as part of Standard & Poor's annual index review. "These gold stocks had become too large to qualify for this small-cap index."
Some sectors of the small-cap index, says Carscallen, have changed substantially as a result of this review, which applies minimum and maximum market capitalization criteria to a stock to assess its eligibility for inclusion. The most significant change was in the gold sector, he says.
"Gold's weighting in the index has roughly halved," says Carscallen. He points to a release by Standard & Poor's on its rebalancing of this index which puts gold at 10.9% of the index, the materials sector at 26.5% and energy at 23%.
This makes for a total of 49.5% of the index in natural resources versus 52.8% at the end of August. "There has thus only been a modest reduction in the overall exposure of the index to this more volatile section of the Canadian equity market."
At Mackenzie Investments, Carscallen is responsible for small-cap mandates that include Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class.
Carscallen generally buys stocks with a market capitalization below that of the BMO Small Cap market capitalization threshold of around $2.1 billion, at recent count. He can hold stocks until they reach a market capitalization of $7.5 billion. At the smaller end of the market-cap spectrum, he can buy stocks with market capitalizations as low as $50 million. "But my emphasis continues to be on investing in the bigger small-caps."
Mackenzie Canadian Small Cap Value currently holds 55 names. The fund has a modest weighting in gold stocks held through two ETFs, rather than via holdings in individual stocks. The weighting, says Carscallen, consists of holdings in iShares S&P/TSX Global Gold Index (XGD) and BMO Junior Gold Index (ZJG).
The junior-gold ETF seeks to replicate the performance of the Dow Jones North America Select Junior Gold Index. "I prefer the index approach to gain exposure to this area," says Carscallen, "as it is difficult to assess the viability and prospects of individual gold-mining companies, particularly among the juniors."
| BMO Junior Gold Index | iShares S&P/TSX Global Gold Index |
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| Sept. 30 close | $9.97 | $14.84 |
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| 52-week high/low | $12.00-$4.36 | $17.72-$7.39 |
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| Total assets | $91.4 million | $767.8 million |
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| Total % return 1Y* | 93.1 | 91.7 |
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| Total % return 3Y* | 9.7 | 11.1 |
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| Total % return 5Y* | -11.6 | -9.0 |
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| *As of Sept. 30, 2016 Source: Morningstar |
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In energy, Carscallen continues to focus on the producers rather than on the service companies. He remains enthusiastic about two oil-producing companies that have properties in Saskatchewan. They are Raging River Exploration Inc. (RRX) and Spartan Energy Corp. (SPE). "These companies are in a strong financial position to acquire attractively valued assets at the bottom of the cycle." Acquisitions should do well when the oil price continues its ascent, says Carscallen. The two oil companies are also low-cost producers and continue to look for efficiencies in their operations, he adds.
Carscallen reports that he has modestly trimmed holdings in two energy producers: NuVista Energy Ltd. (NVA) and Crew Energy Inc. (CR). "The sector as a whole has had a good run and I took a little money off the table." The fund's energy weighting is currently 16% versus the previous 17%, he notes.
Troubles in the Canadian oil patch continue to affect a significant financial-services holding in the fund, Canadian Western Bank (CWB), says Carscallen. "There is concern that its loan losses could increase because of the bank's exposure to Alberta." But to Carscallen, "the worst is over as oil prices have stabilized and the bank is diversifying geographically by looking to increase its business in central Canada." Furthermore, he says, a rise in the oil price from these levels will improve investor sentiment toward the bank.
A real estate investment trust held in the fund that has a "significant exposure to Atlantic Canada" is Killam Apartment REIT (KMP.UN). Killam, which is headquartered in Halifax, "is reaping the benefit of a strong economy in Eastern Canada," Carscallen says.
Killam owns and manages apartments in the six largest cities in Atlantic Canada: Halifax, Saint John, Moncton, Fredericton, St. John's and Charlottetown. It has been active in Atlantic Canada since its first acquisition in early 2002. "Its apartment buildings have high occupancy rates and rising rental rates; in all, the fundamentals for this REIT are solid."
In other sectors, Carscallen says that he has been reducing the fund's holdings in the consumer-discretionary sector and adding to consumer staples.
A new name in the portfolio is Clearwater Seafoods Inc. (CLR), which harvests, processes and markets products that include shrimp, clams, scallops and lobster. Clearwater markets globally with a growing focus on emerging markets, particularly China, says Carscallen. The company, he says, has good short-term prospects reflecting the recent completion of a successful harvest. "It also has solid long-term fundamentals."
