Canadian small-cap roundtable: Part 2

 Stephen Arpin, vice-president at Beutel, Goodman & Co. Ltd. A value manager, Arpin is the lead manager of Beutel Goodman Small Cap  . This fund was selected as the best Canadian Small/Mid Cap Equity Fund at the Morningstar Canadian Investment Awards in 2011.

 Ted Whitehead, senior managing director and senior portfolio manager at Manulife Asset Management. A growth manager using both quantitative and fundamental analysis, Whitehead's responsibilities include managing Manulife Growth Opportunities.

The roundtable was moderated by Morningstar columnist Sonita Horvitch, whose three-part series began on Monday and concludes on Friday.

Q: Let's have a further discussion on the case for small caps.

Ferguson: I consider them to be a separate asset class, distinct from big caps, although they both trade on a public stock exchange. The historical correlation between the BMO Small Cap Index and the S&P/TSX Composite Index is fairly high at more than 0.80. But correlation is more a measure of the direction of the indexes, rather than of the amplitude of their movements. There is a different set of investors for small caps versus large caps with different approaches and different risk/return parameters. The small-cap market is less efficient.

Stephen Arpin

Arpin: Therein lies the opportunity for small-cap managers to add value. It must be remembered that there is no exchange-traded fund on the BMO Small Cap Blended (Weighted) Index. It is not an investable index. But it has a lot of good historical data.

Ferguson: It is a broad index with 400 companies. There are fewer companies in the S&P/TSX Small Cap Index, which is investable.

Q: Ted, in Manulife Growth Opportunities, you have the ability to invest in the spectrum of market caps, including large caps. How much do you have in small caps at present?

Whitehead: I currently have 57.9%. I can go as low as 40%. This is a small/mid-cap fund. My large-cap limit is 10%.

Q: How much exposure should investors have to small caps?

Ferguson: At Mawer Investment Management, the balanced fund targets a strategic weight of 15% in small caps in the overall fund. Of this 15%, half or 7.5% of the fund is in Canadian small caps and the other half is in global small caps. Currently, we have a slightly higher weighting in global small caps than we do in Canadian, on a tactical basis.

Whitehead: Generally, an individual investor's exposure to small caps should be shaped by risk tolerance and life stage. It must be remembered that the S&P/TSX Composite Index already has roughly 12% in small caps, using the BMO Small Cap Index definition. We use this as our definition. The formula currently produces a market capitalization of under $1.6 billion.

Arpin: At Beutel Goodman, our small-cap range of allocation for institutional clients is between 5% and 20% in the Canadian equity portfolios we manage.

Ted Whitehead, Martin Ferguson and Stephen Arpin

Ferguson: As small-cap stocks are volatile, it is tempting for individual investors to trade them. It is hard to time the market.

Q: Steve and Martin, what are your definitions of small caps?

Arpin: Beutel Goodman's definition is under $1.5 billion in market float. We can continue to hold stocks if their market cap goes above that. Using our definition of small caps, they represent some 7% or 8% of the S&P/TSX Composite Index.

Ferguson: Mawer has been managing small caps since 1988. From then until Sept. 30, 2011, we used a market cap of $500 million or less at the time of initial purchase as our definition. As of last September, we increased that because of the changing dynamics in the market. We have gone up to 75% of the BMO Small Cap Index formula, which today works out to $1.2 billion.

Q: Time to talk about your portfolios. Let's start with the financial-services sector.

Ferguson: The portfolio, which currently has 55 names, has 22.7% in financials. A long-term holding that is now in our top 10 is Equitable Group Inc. ETC.

Arpin: I have owned it for some time. Beutel Goodman Small Cap has 41 names. Last year, we would have had more in financials, but we took some money off the table in Intact Financial Corp. ITC, though it remains a major holding. The stock hit our initial sell target, and our discipline is to sell a quarter of the holding. We bought it when the float was less than $1.5 billion.

Whitehead: Intact Financial is a significant holding in Manulife Growth Opportunities, which has 92 names and some 12% in financials. I have been managing this portfolio since March 2000. We talked about relative valuations versus big caps and this was the premier time to get into small caps.

We recently added to our holding in Intact. It is one of Canada's largest property and casualty companies. The company has 17% of the Canadian P&C market. The price/earnings ratio on the stock is 10.4 times and the dividend yield is 2.7%. Its return on equity is much higher than its peers. Its acquisition of AXA Canada from Paris-based AXA Group is expected to be accretive to Intact's earnings. Earnings estimates are going up, which I like to see as a quant.

Martin Ferguson

Arpin: It has a good track record of making successful acquisitions. Another major holding is Industrial Alliance Insurance and Financial Services Inc. IAG. We have owned it since it came public. It has been challenging for life companies lately, but the company has generated significant value since its IPO. The valuation on the stock is attractive.

Whitehead: The financial sector generally is one where we have been able to buy names and hold on to them for a good length of time. An example is Home Capital Group Inc. HCG, which I have held for 10 or 11 years.

Ferguson: I bought this stock in 2001.

Whitehead: Home Capital's return on equity is high.

Ferguson: We have been overweight financials relative to the BMO Small Cap Index for many years. These companies focus on return on invested capital, return on equity, which is one of my focuses. I own Canadian Western Bank CWB, which has grown its per-share earnings by double-digit amounts in 21 of the last 23 years. We are also heavily weighted toward mortgage lenders. I own Home Capital, Equitable Group and First National Financial Services Ltd. FN.

Whitehead: I also own First National. We got in on the IPO at $10. It offers a high yield and it has not had any big misses. Chairman Stephen Smith and Moray Tawse own a total of 80% of the company and may sell at some stage.

		First National Financial Services Ltd.	Intact Financial Corp.
	Feb.7 close	$18.00	$60.85
	52-week high/low	$19.25-$13.77	$61.69-$46.49
	Market cap	$1.1 billion	$7.9 billion
	Total % return 1Y*	2.5%	22.1%
	Total % return 3Y*	31.3%	29.2%
	Total % return 5Y*	10.6%	4.9%
	*As of Feb. 7, 2012 Source: Morningstar

Arpin: We sold our holding in First National last year.

Ferguson: First National's dividend yield at year-end was 7.16%. Mortgage lenders have done well historically. They are lending against good collateral, an individual's home. Two of the companies, Home Capital and Equitable Capital, do non-prime mortgages. Another niche company that we own is DirectCash Payments Inc. DCI, a leading independent owner/operator of automated-teller machines in Canada. It also operates in Mexico and Australia. In all, the financial-services sector offers good-quality companies and management, stability of earnings and growth.

Photos: paullawrencephotography.com