Martin Ferguson, director and portfolio manager at Calgary-based Mawer Investment Management Ltd., says that Canadian small-cap stocks in a wide range of sectors put on a powerful performance in the first 10 months of this year, in contrast to that of the small-cap benchmark index.
"These stocks experienced a multiple expansion, bringing their valuations more into line with the cash-flow-generating capabilities of the companies and reflecting the current interest-rate and economic environment," says Ferguson, who is a veteran small-cap manager.
Following this strong performance, says Ferguson, there could be a period of consolidation in these stocks. For the first 10 months of this year, the BMO Blended (Weighted) Small-Cap Index produced a total return of 4.1% versus 10.3% for the S&P/TSE Composite Index.
This lacklustre performance of the benchmark small-cap index masks the fact that "most sectors in the index produced strong double-digit total returns over this period, with technology the top-performing sector with a total return of 37.4%."
A big drag on the index, says Ferguson, was its heavy weighting in the materials sector. This had a negative total return of 27.2% in the first 10 months of this year. "Gold stocks came under heavy selling pressure and base-metals stocks were also weak."
Ferguson notes that the materials sector began the year with a 31.1% weighting in the index, but this had shrunk to 22.8% by the end of October. "Materials still remain the largest sector in the index, but only just; energy, at 22.5% is close on its heels." The natural-resource sectors, he says, are now well below their previous 50%-plus weighting in the index. "Their influence has been reduced, but it's still significant."
At Mawer, Ferguson is responsible for managing $2.1 billion in assets. His mandates include Mawer New Canada 
and BMO Enterprise , both of which are closed to new investors. Both funds have five-star Morningstar Ratings for their historical risk-adjusted performance, and have produced sparkling year-to-date returns of 35% or more, as of Oct. 31.
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| Martin Ferguson picking up the 2011 Morningstar Domestic Equity Fund Manager of the Year award. | |
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Ferguson's discipline is to "systematically create a broadly diversified portfolio of wealth-creating companies that trade at a discount to their intrinsic value, as calculated using discounted-cash-flow analysis."
The definition of small caps used by these mandates is companies with market capitalizations up to 75% of the BMO Small Cap Index formula, at the time of initial purchase. This is currently $1.4 billion. The minimum market cap considered for these mandates is $50 million.
BMO Enterprise, with 51 names, has an overweight position in financials at 26.3% of the fund, industrials at 19.3% and technology at 14.6%. Within the natural-resources sectors, it has an underweight in energy at 17% and a big underweight in materials at 9.7%. The fund has no holdings in telecommunications services and utilities.
Ferguson reports that the strong performance of some of the larger holdings in the fund took their weighting in his portfolios above the 6% limit placed on any individual holding. As a result, he pared back holdings in Constellation Software Inc. CU, Home Capital Group Inc. HCG, Stantec Inc. STN and Paladin Labs Inc. PLB.
In early November, Paladin announced that it reached an agreement to be acquired by Endo Health Solutions Inc. ENDP in a transaction that is expected to close in the first quarter of 2014. "I have taken some profits in this stock, but I still have a holding in Paladin," Ferguson says.
Earlier this year, Ferguson eliminated his holding in Equity Financial Holdings Inc. EQI, a Canadian financial-services company that focuses on the sub-prime mortgage market. The company started life as a provider of stock-transfer services, foreign exchange and administrative and compliance services, says Ferguson. "It subsequently sold its transfer business so as to concentrate on its nascent sub-prime mortgage business."
This caused Ferguson to sell the stock. "I preferred to stick with two long-standing holdings in this area." They are Home Capital Group and Equitable Group Inc. EQB, both of which are leading sub-prime mortgage providers.
In the second quarter of 2013, a U.S. hedge fund shorted stock in Home Capital, says Ferguson, on its thesis that the Canadian housing market was poised for a major correction. Home Capital stock sold off and Ferguson used this opportunity to add to his holding. Thereafter, the stock rose sharply. Ferguson then trimmed it, but it remains a top-10 holding in both the BMO and Mawer funds.
Another holding in the financial-services sector is First National Financial Corp. FN, which operates in the prime mortgage market. It is Canada's largest non-bank originator and underwriter of prime single-family and commercial mortgages, says Ferguson. "It either places the mortgages it originates with institutions or it securitizes them, but retains the administrative role."
It currently has a portfolio of $74 billion in mortgages under administration, says Ferguson. "This role produces ongoing income and sustainable cash flow." The stock trades at a multiple of 10 times earnings-per-share estimates for 2014. It has a dividend yield of more than 6%.
| Equitable Group Inc. | First National Financial Corp. | Home Capital Group Inc. | ||
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| Nov. 18 close | $46.00 | $23.37 | $80.05 | |
| 52-week high/low | $49.73-$42.50 | $23.90-$15.15 | $83.78-$49.65 | |
| Market cap | $708.2 million | $1.4 billion | $2.8 billion | |
| Total % return 1Y* | 47.4 | 41.3 | 52.9 | |
| Total % return 3Y* | 27.9 | 15.4 | 20.8 | |
| Total % return 5Y* | 29.0 | 22.6 | 35.7 | |
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| *As of Nov. 18, 2013 Source: Morningstar |
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A tech addition, says Ferguson, is Solium Capital Inc. SUM. "This company is a leading global provider of administration software for equity incentive plans."
Its software platform serves both the companies and their employees. Solium, says Ferguson, dominates its niche in Canada, has expanded into the United States via acquisitions, and has a growing presence in the UK, which provides an entry to Europe. Early this month, the company raised an additional $20 million in equity and Ferguson participated in this issue.
Solium is "debt free and has a net cash position that will allow for further acquisitions and help accelerate its growth." The stock trades at 28 times 2014 earnings per share (EPS) estimates. Its enterprise value to earnings before interest, taxation, depreciation and amortization is 14.2 times based on 2014 estimates.
In the industrial sector, a long-standing holding that Ferguson continues to champion is Richelieu Hardware Ltd. RCH. "I have had a holding in this stock for two decades." Richelieu is a leading distributor and specialist in furniture, kitchen cabinets, and a wide range of hardware products. It sells to manufacturers and to retailers. "It is the largest company of its kind in what is a highly fragmented market in North America."
The company is a consolidator in this field, says Ferguson. "It has a strong balance sheet, a high and consistent return on equity and on invested capital, and good growth." The stock trades at 18.6 times 2014 EPS estimates.
