Stephen Arpin, vice-president and portfolio manager at Beutel Goodman, says the recent sharp pullback in the Canadian equity market resulted in some irrational pricing of high-quality small-cap businesses with strong fundamentals.
"Investors were selling stocks indiscriminately and we selectively took advantage of the weakness in the stock prices, to add to holdings," says Arpin, who is a small-cap specialist and value manager.
There has been much discussion about the potential for a material slowdown in China's economic growth, says Arpin. "If this comes to pass, this will likely put additional downward pressure on commodity prices."
While a further decline in oil and base-metal prices is a plus for overall global economic growth, they represent a significant problem for Canadian commodity producers. "The performance by smaller-cap energy producers has been poor so far this year," says Arpin, "as has that of base metals and gold producers, which are in the materials sector."
The problem, he says, is that energy and materials each represent substantial sector weights in the two Canadian small-cap benchmark indexes, the BMO Small Cap Index and the S&P/TSX SmallCap Index. As such, says Arpin, their weakness has contributed to the substantial underperformance of these two indexes relative to the S&P/TSX Composite Index, since the beginning of the year to recent close, as well as to the underperformance of the small-cap universe over the last number of years.
The financial-services sector, which is a significant weight in the two small-cap indexes, has also had some challenges of late, says Arpin. "Investors have become concerned about the outlook for specialist residential mortgage lenders, given the possibility of a correction in the Canadian housing market."
Arpin notes that the two Canadian small-cap indexes are currently trading at a substantial valuation discount to the composite index. "There have been times when small-caps trade at a premium to their larger-cap counterparts."
At Beutel Goodman, Arpin's responsibilities include Beutel Goodman Small Cap (assets $614 million), which he co-manages with William Otton. The team is responsible for managing a total of $1.7 billion in small-cap assets.
Beutel Goodman applies a value approach to stock selection. The small-cap managers target stocks that they consider can produce a 100% total return over a three-to-four-year period. When the stock reaches the target price, the team will automatically sell 25% of the holding, re-evaluate the company and, if appropriate, raise the target price.
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| Stephen Arpin | |
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The team follows MSCI guidelines for their definition of Canadian small-caps. This formula currently results in a market float of under $4 billion for new purchases.
Looking at sectors, Beutel Goodman Small Cap, which has 43 names, had significant weights in financials, 28%, materials, 21% and consumer- discretionary stocks 19%, at recent count.
The largest financial holding in the fund is Equitable Group Inc. (EQB), a sub-prime mortgage lender that has been expanding into the prime, insured mortgage market. In addition to investor worries about an overheated Canadian residential real-estate market, the July-end news release by rival Home Capital Group Inc. (HCG) caused further investor concern about smaller-cap mortgage lenders, says Arpin.
He notes that the two small-cap lenders use mortgage brokers to identify target borrowers. In a news release on July 29, Home Capital reported that it had ascertained that there was a falsification of income information accompanying loan applications submitted by certain mortgage brokers. The release went on to state that the brokers associated with the mortgage applications were identified and during the period of September 2014 to March 2015, the company suspended its relationship with a total of approximately 45 individual mortgage brokers. Home Capital's release added that the company concluded that it is unlikely that this matter will lead to credit losses.
"We do not own Home Capital; we continue to like Equitable Group, which has been a major holding in the fund for some time," says Arpin. He notes that the company generates a return on equity of 17%, yet the stock currently trades at around 1.2 times the company's book value per share. "Given Equitable's high ROE, this valuation metric should be higher." On a P/E multiple basis, the stock trades at 6.5 times forward estimates, which is also "inexpensive."
A new financial-services addition to the portfolio is Canadian Western Bank (CWB). The stock has come under selling pressure, says Arpin, because of the bank's exposure to Alberta and Saskatchewan. Yet, he says, this bank is a strong commercial lender. "We have stress-tested its earnings and the results are encouraging." The stock is trading at a P/E multiple that is "significantly lower than its historic average and carries a dividend yield of almost 4%."
| Canadian Western Bank | Equitable Group Inc. | |
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| August 31 close | $24.70 | $55.78 |
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| 52-week high/low | $40.96-$21.04 | $72.49-$46.62 |
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| Market cap | $2 billion | $862.9 million |
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| Total % return 1Y* | -37.2 | -13.3 |
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| Total % return 3Y* | -1.4 | 23.4 |
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| Total % return 5Y* | 2.9 | 22.8 |
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| *As of Aug. 31, 2015 Source: Morningstar |
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Real-estate companies also fall under the financial sector. FirstService Corp. (FSV) is a long-standing holding in Beutel Goodman Small Cap. At the beginning of June, the company spun off its commercial real-estate brokerage operation into a separate listed company, Colliers International Inc. (CIG). The result, says Arpin is that Colliers is a pure play on the real-estate brokerage business. "This brokerage has produced strong growth and has expanded into key markets around the globe," he says.
FirstService "remains one of the largest property managers in North America, with a specialty in the management of condominium developments," says Arpin. "We have kept both stocks; they continue to represent decent value and are good businesses."
Of the materials-sector weighting at 21% of the portfolio, Arpin points out that more than half of this weight is in packaging stocks, "which have benefitted from the lower commodity prices."
The team has reduced the fund's holdings in two long-standing names, Winpak Ltd. (WPK) and CCL Industries Inc. (CCL.B), based on valuations. "Though we trimmed our holdings, we continue to like these two stocks and they remain substantial weights in the portfolio."
Auto-parts stocks have been a mainstay of the fund's holding in the consumer-discretionary sector. Arpin is enthusiastic about the move by Uni-Select Inc. (UNS) to sell most of the assets of Uni-Select USA, Inc. and Beck/Arnley Worldparts, Inc. to affiliates of Icahn Enterprises, L.P. "This is a transformational move and one which has greatly improved the company's balance sheet," he says. The U.S. parts-distribution business has historically produced low rates of return, he adds.
The company retains its FinishMaster automotive paint and related products- distribution activities in the United States, he says, "as well as its legacy auto-parts distribution business in Canada." Uni-Select's new president and CEO, Henry Buckley, is "well positioned to grow the business both internally and through acquisitions."
The Beutel Goodman small-cap team trimmed the portfolio's holding in another Canadian auto-parts distributor, Linamar Corp. (LNR). "This was driven by the stock's valuation," says Arpin. The company has excellent growth prospects, he says. Linamar provides core engine components and transmission systems to automakers around the world and should continue to do well, "as long as the auto sales remain stable."
Also in the consumer-discretionary sector, the team has sold the portfolio's entire holding in BRP Inc. (DOO). The company, Bombardier Recreational Products, makes vehicles under such brands as Ski-Doo and Sea-Doo, for sale globally. "We bought the stock, when it came to market in May 2013 at $21.50 a share, as a play on the recovering U.S. consumer," says Arpin.
"We currently have concerns about its sales in Russia, as the ruble has collapsed," he says. The team also has concerns about the prospects for its Spyder vehicle, a three-wheel touring motorcycle. "This is an important product for the company and its success in the U.S. market matters."
