Canadian small-cap manager roundtable: Part 1

 Ted Whitehead, senior managing director and senior portfolio manager at Manulife Asset Management. A growth manager, 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.

William Aldridge, associate portfolio manager at Mackenzie Financial Corp. A value manager, Aldridge is co-manager of Mackenzie Saxon Small Cap and Mackenzie Saxon Microcap.

Moderating the discussion was Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday and concludes on Friday.

Q: Canadian small-caps handily outperformed the S&P/TSX Composite Index in both 2009 and in 2010. Can this continue? The outperformance in 2009 followed five straight years of underperformance.

Arpin: The benchmark BMO Small Cap Blended (Weighted) Small Cap Index produced a total return 75.1% in 2009 and 38.5% in 2010. One factor that has driven this outperformance was the relative valuation of the two indexes. The other is the general economic growth, which helps small-caps disproportionately versus large-caps. Outperformance will be difficult in 2011.

Ted Whitehead

Ferguson: We are expecting small-caps to perform more in line with large-caps this year. For them to outperform, the economy has to grow in line with or greater than expectations. Also, investors have to be risk-tolerant.

Whitehead: Investors have to chase returns.

Ferguson: Another factor that will determine the outperformance is the huge resources weighting in the BMO Small Cap Index. You need continued growth in China, because China is driving the resource sectors. As Stephen mentioned, there is the issue of valuation. Small-caps and large-caps are trading at similar valuations.

Whitehead: The best valuation metric to use is price-to-book.

Aldridge: At the bottom of the trough in the equity market, small-caps were at about a 40% discount to large-caps. The valuations are about equal now.

Ferguson: At the end of 2010, the price-to-book value on the BMO Small Cap Index was 2.00 times and for the composite, it was 2.08 times. It is a rounding error.

Arpin: There have been periods in history when small-caps traded at a premium to large-caps, but these premiums are not sustained over the long run.

Whitehead: In the past two years, small-caps outperformed by more than double. In 2009, it was a return of 75% versus 35% for the S&P/TSX Composite Index, and last year it was 39% versus 18%. The difference this year will probably be within 5%. The drivers for small-caps are still there. There is a benign interest-rate environment and a recession is not in the cards. Historically, small-caps outperform in such an environment. Also, most importantly, there will be a flow of funds from bonds to equities.

Arpin: Equity flows have turned positive in the last couple of months.

Aldridge: Despite two incredible years of small-cap performance, investors have continued to chase income products and have missed this.

Q: William, are you finding it tough to find value?

Aldridge: Yes it is difficult. It was so easy in the past two years.

Stephen Arpin with Martin Ferguson and Ted Whitehead.

Ferguson: It is tougher to find value, but there are still lots of opportunities. I can still find small-cap companies that have internal rates of return in the double-digit range.

Q: Going around the table, will small-caps outperform in 2011?

Aldridge: Yes.

Arpin: The performance will be roughly in line. But we should talk about mergers and acquisitions in the small-cap universe.

Aldridge: M&A activity is one of the reasons why small-caps can outperform in 2011.

Arpin: I agree that if they do outperform, M&A will be a factor.

Ferguson. If small-caps outperform, besides M&A the other driver will be the resource sector, the continuation of the materials sector's dominance that we have seen in the last two years.

Whitehead: The skew of the BMO Small Cap index toward resources will certainly help small-caps outperform in 2011. I think 2011 will be the year for energy. If we get global economic growth between 3% and 4.5%, the demand for energy will be robust.

Arpin: Ted is talking about a leadership change in performance favouring energy. But you have to recognize that at the end of December, 39% of the BMO Small Cap Index was in materials. It is the only sector that has outperformed the index from the bottom in the market. You cannot overstate Martin's point about the role of the materials sector.

Whitehead: The outperformance of materials in the market's rebound must be seen in the context of the fact that they got destroyed in the market meltdown.

Arpin: True.

Whitehead: They came back the sharpest in the updraft.

Aldridge: The materials weighting in the index came down a little in January. There has been a migration into large-cap territory for some materials stocks. At the end of January, this weighting was 34.7% and energy was 19.5%. Energy came up a couple of points. The total resource weighting is 54.2%. Gold is interesting. The average gold weighting in the index over the last 10 years was about 11% and now it's about 24%.

	Can small-caps extend their winning streak?
	Index	2010	2009	2008	2007	2006	2005	2004	2003	2002	2001	2000
	BMO Small Cap Blended (Wght)	38.6	75.1	-46.6	2.0	16.6	19.7	14.1	42.7	-0.9	3.4	7.3
	S&P/TSX Composite	17.6	35.1	-33.0	9.8	17.3	24.1	14.5	26.7	-12.4	-12.6	7.4
Total returns for calendar years Source: Morningstar

Q: Ted, you have been quite a gold enthusiast?

Whitehead: We currently have about 16% in gold.

Arpin: We have a weighting in that range, 16% to 17%.

Aldridge: We have around 6% or 7%. A gold stock that we own is Dundee Precious Metals Inc. DPM. It is a good weighting in the portfolio and has been an excellent performer. We have 24% in materials. The holdings are well diversified. For example, we own Winpak Ltd. WPK, a packaging company.

Arpin: I also own it.

Ferguson: So do I.

William Aldridge

Whitehead: In Manulife Growth Opportunities we have scope to add bigger-cap names. We currently have some 51% in true small-caps and the balance would be in mid and large names. The latter is about 3% or 4%. We continue to hold larger-cap gold names such as IAMGOLD Corp. IMG and Eldorado Gold Corp. ELD. We also have exposure to exploration names such as Rainy River Resources Ltd. RR and San Gold Corp. SGR. We have a total of 36% in materials.

Ferguson: We have zero in gold and are extremely underweight materials. We look at all companies the same. We are trying to forecast their ability to create wealth. About half the gold companies in the BMO Small Cap Index have no production and ones that do have production, often have a single mine, often in a country other than Canada. Investing in gold stocks does not fit with how we invest. In all, I have 10.5% in materials. The closest we get to mining is Neo Material Technologies Inc. NEM, which is actually a processor.

Whitehead: We have owned it for a long time.

Aldridge: The enthusiasm for gold is not going away. Investors will want to have a portion of their portfolio in gold. There has been a change in investor attitude.

Arpin: A big driver of the bullion price and that of many commodities is the ability of investors to buy these commodities through exchange-traded funds. We own gold stocks like Allied Nevada Gold Corp. ANV, Minefinders Corp. Ltd. MFL and NovaGold Resources Inc. NG. We also own Fronteer Gold Inc. FRG, which is being taken over by Newmont Mining Corp. NMC. We control the risk of investing in these smaller mining companies, by requiring that there is third-party evaluation of the deposit.