Canadian stocks had a rough year in 2011 and, within the broad universe, small-caps fared even worse. In part one of this week's roundtable series by Morningstar columnist and roundtable moderator Sonita Horvitch, three small-cap managers review the money-losing year just past and explain why they believe the prospects for small-caps have improved. The series continues on Wednesday and concludes on Friday.
Our panellists:
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.
Martin Ferguson, director and portfolio manager at Calgary-based Mawer Investment Management Ltd. His mandates include Mawer New Canada 
, which is closed to new investors, and BMO Guardian Enterprise . His discipline is to buy wealth-creating companies at a discount to their intrinsic value. Ferguson was Morningstar Canada's Domestic Equity Fund Manager of the year in 2011.
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.
Q: Let's start with a discussion of the performance of the Canadian small-cap stocks in 2011.
Ferguson: The benchmark BMO Blended (Weighted) Small Cap Index had a negative 14.2% total return last year.
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| Ted Whitehead | |
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Whitehead: By contrast, the benchmark S&P/TSX Composite Index had a negative total return of 8.7%.
Ferguson: Resource stocks, particularly materials, were poor performers in 2011 and the BMO Small Cap Index has a heavy weighting in these stocks.
Arpin: This index has 30.4% in the materials sector, which was by far the worst performing of the index's sectors in 2011, with a negative total return of 27.3%. Energy, with its current weighting in the index of 20.1%, had a negative total return of 14.9% in 2011.
Financial-services stocks held up. They have a weighting of 15.4% in the BMO Small Cap Index and produced a positive total return of 3.6% last year. The S&P/TSX Composite Index has a lower weighting than the BMO Small Cap Index in materials, a higher weighting in energy and a substantially heavier weighting in financials.
Ferguson: In 2011, the small-cap index was therefore overweight the worst performing sector relative to its weighting in the composite, and underweight financials, a sector that held its own.
Whitehead: Some 13 percentage points of the 14.2% negative total return of the BMO Small Cap Index in 2011 was due to energy and materials. Therefore, 90% of the index's poor performance was due to the weakness in the resource stocks. The S&P/TSX Composite's negative total return in 2011 was also largely due to resource stocks. Investors were risk-averse in 2011. Resource stocks as cyclical stocks took a beating last year. They now represent good value and could rebound sharply in 2012. I am finding opportunities in this area.
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| Ted Whitehead, Martin Ferguson and Stephen Arpin | |
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Ferguson: Within the small-cap sector of the Toronto Stock Exchange, the largest small-caps did the best in 2011 followed by the medium-size small-caps and finally, the micro small-caps were the worst performers.
Arpin: This is due to the relative liquidity of these stocks. To Ted's point, when investors become risk-averse, it tends to hurt the micro names the most. Another factor affecting the underperformance of small-caps versus large-caps is the fact that small-caps were not really cheap relative to large-caps last year.
Whitehead: Currently the BMO Small Cap Index is trading at 1.1 times price to sales, a price/earnings ratio of less than 12 times and a price to book value of 1.5 times. By historic measures, small-caps are cheap, but not as cheap as they were in the spring of 2009.
Ferguson: In the small-cap sector, we look only at companies with positive earnings. On that basis, small-caps are trading at a price to book value of 1.44 times, a price/earnings ratio of less than 12 times, and they generate a return on equity of 12.3%. Compare that to the S&P/TSX Composite Index, which is trading at 1.77 times on a price-to-book basis, a price/earnings ratio of 13.7 times and the Composite has a return on equity of 12.9%.
Whitehead: The question is, is it a good time to buy small-caps? Over the long haul, you do get paid for the additional risk associated with small-caps such as greater volatility and lower liquidity. The BMO Small Cap Index produced a 10-year total annual compound return of 9.8% versus 7% for the Composite index. The 15-year number is 7.6% versus 7%.
| Index | 1Yr | 3Yr | 5Yr | 10Yr | ||
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| BMO Small Cap Blended (Weighted) Small Cap | -7.1 | 30.0 | 3.7 | 10.4 | ||
| S&P/TSX Small Cap | -8.4 | 25.9 | 1.6 | 6.3 | ||
| S&P/TSX Composite | -5.7 | 16.0 | 1.9 | 7.5 | ||
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| For periods ended Jan. 31 | ||||||
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Arpin: There is more scope for managers to generate outperformance in small caps than in large caps.
Ferguson: Right now, on valuation, small caps carry a slight advantage. There has been a huge range historically, with small caps trading at very large premiums relative to large caps and at very large discounts. We are currently more or less on even ground, which puts small caps in a good position.
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| Martin Ferguson | |
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Arpin: Small-caps are not extraordinarily cheap, but the relative valuations have improved. Clearly, the larger decline in the small-cap index versus the large-cap index has helped this.
Ferguson: Overall, equities look extremely attractive relative to fixed-income alternatives.
Whitehead: The dividend yield on the BMO Small Cap Index is a little over 2.69%, which is high historically.
Ferguson: The dividend yield on the S&P/TSX Composite Index is 2.85%.
Aprin: These yields are in excess of a 10-year Government of Canada Bond.
Ferguson: This tells us that we are in a risk-averse environment.
Whitehead: It is also important to note that the U.S. Federal Reserve Board has committed to keep its interest rates at these low levels until 2014. This is good for equities, including small-caps.
Arpin: It is also important to emphasize the level of mergers and acquisition activity and its impact on valuations in the small-cap universe.
Ferguson: It is generally a good financial environment for merger and acquisition activity. Also, economic growth is going to be slow and small-caps want to show growth. If they can't get it through internal growth, they'll turn to merger and acquisition activity.
Arpin: Large-cap U.S. companies are also in a strong position to go shopping for companies in Canada. There was significant M&A activity in 2011 and there will be more in 2012. We already had two takeovers of stocks in our portfolio announced this year. Minefinders Corp. MFL is being taken over by Pan American Silver Corp. PAA, and Gennum Corp. GND is being acquired by California-based Semtech Corp. SMTC. We had four takeovers last year. We have 41 names.
Ferguson: We had eight takeovers in 2011, one of which closed in early January 2012. We had 57 names at the beginning of 2011.
Whitehead: We are also experiencing takeovers in our portfolios. The low interest rates are a positive factor.
Arpin: They should help to drive M&A activity.
Q: These takeovers are usually priced at a premium to the then trading stock price of the target company.
Arpin: Yes. It is a source of investment return. A 35% premium is normal.
Ferguson: The average takeover premium historically is about 30%, but we have seen anything from 3% to more than 100%, as is the case with Gennum.
Q: We should return to the question: Will small caps outperform their larger-cap counterparts in 2012?
Whitehead: They will. Even a slower global GDP growth will spell better returns for small caps. The drivers will be M&A activity and the fact that we are starting the year with lower valuations relative to large caps. I want to emphasize that investors get paid to take the risks.
Photos: paullawrencephotography.com
