Deep value to be found in natural resource space

In the first six months of 2015, the small-cap index modestly outperformed the Composite, with a total return of 1.1% versus 0.9% for the Composite. But the small-cap index underperformed over a longer period. For the 12-months to the end of June, this index produced an annualized total return of -16.4% versus -1.2% for the Composite. Over three-years, the small-caps' total return was 4.1% versus 11.1% for the Composite. Over 10 years, it was 2.6% versus 6.9% for the Composite.

On current small-cap valuations, Carscallen reports that there is not a lot of value to be found among the companies that are steady earnings growers and strong cash-flow generators. "There is deep value in the natural resource space and in businesses perceived to be dependent on these sectors," he says. "But there is a need to be highly-selective."

At Mackenzie Investments, Carscallen is responsible for small-cap mandates including Mackenzie Canadian Small Cap Value and Mackenzie Canadian Small Cap Value Class. The benchmark is the S&P/TSX SmallCap Index. "These funds have handily outperformed their benchmark, making a strong case for active management in the small-cap universe," says Carscallen.

Scott Carscallen

Mackenzie Canadian Small Cap Value, which had 54 names at the end of June, had a median market capitalization of $914 million versus $473 million for the index. The portfolio's biggest sector overweight at the end of June was industrials at 20.5% versus the weighting in the benchmark at 12.2%. The portfolio's biggest underweight was in materials, which represented 14.7% versus 30.9% in the index.

Carscallen reports that he has been finding value among smaller-cap industrials. "A number of these stocks are perceived to be linked to the natural resource industry and have sold off sharply; yet many of these companies have a well-diversified customer base."

Badger Daylighting Ltd. (BAD) is a prime example of this, says Carscallen. The company provides excavating services to a wide range of industries including engineering, construction, transportation as well as the energy sector. Its key technology is hydrovac trucks. "The company operates in both Canada and the United States, with revenues about evenly split between the two markets." The bulk of its recent growth has been in the United States, he adds.

Although some 55% of Badger's business is energy-related, some half of that is with the major pipeline companies and another big slice of it is with refineries and energy plants. "No fall-off in this activity is expected," says Carscallen. "About 10% to 15% of its energy exposure is related to oil field service activity and this is at risk." But, he adds, Badger expects to "offset any weakness in its energy-related business with growth in Eastern Canada and the United States. In all, he says, Badger generates significant cash flow, has a good balance sheet and strong management. The stock trades at an EV (enterprise value) to EBITDA (earnings before interest, taxation, depreciation and amortization) of 7.2 times 2016 estimates, "which is reasonable."

Aecon Group Inc. (ARE) has also seen its stock come under pressure, because of its natural resource exposure, he says. This construction and infrastructure company does do business with the mining industry and in the oil patch, including the Canadian oil sands, says Carscallen. "But its activities are well diversified beyond natural resources." The stock, he says, trades at an EV/EBITDA of six times 2016 estimates. "This is a reasonable valuation; I recently added to portfolio's holding in this stock."

	Aecon Group Inc.	Badger Daylighting Ltd.
July 20 close	$11.88	$23.95
52-week high/low	$17.08-$9.51	$36.07-$20.32
Market cap	$668.3 million	$903.9 million
Total % return 1Y*	-26.5	-27.6
Total % return 3Y*	1.3	42.7
Total % return 5Y*	3.8	41.6
*As of July 20, 2015 Source: Morningstar

Carscallen says that "high-conviction names" in the portfolio that have no resource exposure and are strong cash flow generators include Winpak Ltd. (WPK) and CCL Industries Inc. (CCL.B). Both stocks, which are classified in the materials sector, were among the portfolio's top-10 holdings at the end of June.

Winpak, which represented 4.4% of the portfolio and was its largest holding at the end of June, is a specialty packaging company that operates in Canada, the United States and Mexico. "Its packaging is used for a wide range of food, beverage and healthcare products. Demand for its products is growing." Winpak has pricing power and can protect its margins from rising raw material costs, he notes. The company is currently undertaking "an extensive capital expansion project," which it can fund internally," he says. "It aims to grow its revenue to $1billion by 2016, a 27% growth rate," says Carscallen. "It also has its eye on acquisitions." The stock trades at an EV/EBITDA of 9.1 times 2016 estimates. "Winpak pays a dividend, but this could increase if its capital expansion plans are successful."

CCL is a "global provider of specialty labels and packaging." It operates 68 plants around the world in 26 countries. The company's products have a wide range of uses including in-home care items, personal care, health care and food and beverage products, says Carscallen. "The demand for CCL's products is expanding and the company expects to see growth opportunities in health care and in emerging markets." CCL has a strong track record of making good acquisitions, and it is anticipated that it will continue with this strategy, says Carscallen. The stock trades at an EV to EBITDA of 10.4 times 2016 estimates and has a modest dividend yield.

Carscallen cautions that the valuation on these two stocks is fairly high by their historical norms. "But there is a strong investor demand for these steady earnings growers and solid cash flow producers." There have been a lot of IPOs of consumer-related, conservative stocks, he says. "The new issues have successfully come to market with EV/EBITDA ratios of 13 to 15 times."

Turning to financial services, these stocks represented 17.5% of Mackenzie Canadian Small Cap Value at the end of June versus 14.5% in the S&P/TSX SmallCap Index. The fund's largest holding in the sector is Element Financial Corp. (EFN). This company does vehicle fleet leasing and provides financing for a range of industries including rail cars and aircrafts. "CEO Steven Hudson undertook to grow the company through acquisitions and he has delivered on this undertaking." The company, says Carscallen, has bought a number of major companies in its field. "What remains are smaller targets, so Element's high growth rate is likely to slow." Element has become a "larger and more mature company and there is the potential for it to become dividend-paying."

Carscallen has sold the portfolio's long-standing holdings in two investment bankers: Canaccord Genuity Group Inc. (CF) and GMP Capital Inc. (GMP). "These two independent Canadian investment houses do have significant exposure to the Canadian resource sector and have not been doing well given the dismal performance of many natural resource stocks."