Martin Ferguson, director and portfolio manager at Mawer Investment Management Ltd., says that the Canadian small-cap universe could be volatile over the short term, after its huge run-up from its November 2008 lows. "But we see a good margin of safety in the valuation of our small-cap stocks, given the historically low interest rates and considering the present uncertain economic backdrop."
Ferguson notes that the benchmark BMO Blended Weighted Small Cap Index currently trades at a similar valuation to the S&P/TSX Composite Index, if only those companies with positive earnings are included. Ferguson focuses only on small caps with positive earnings.
"Over the last decade, this category has traded at a slight discount to the composite, with the discount widening substantially during the recent recession." The gap has since closed, he adds.
The BMO Small Cap Index has produced a total return of some 127% since its low in early November 2008, versus 45% for the Composite index, says Ferguson. In the small- cap index, the materials sector was by far the strongest performer with a total return of 253%.
"This sector was the hardest hit in the market crash." True to form, "small caps over-reacted on the downside, but subsequently staged a sharp rebound in the early stages of the economic recovery."
At Calgary-based Mawer (assets under management $8 billion), Ferguson's mandates include Mawer New Canada, which is closed to new investors, and BMO Guardian Enterprise, which is managed along similar lines. In all, he is responsible for $1.2 billion in assets.
Ferguson targets companies that have a market capitalization of $500 million or less at the time of first purchase. His 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."
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With 55 names, the portfolio currently has an average market capitalization of $655 million. It has a substantial underweight to materials at 9.1% of the portfolio versus 36.8% of the BMO Small Cap Index.
"Gold stocks have a 22.5% weighting in the index, and we have no gold stocks in the portfolio," he says. "They do not fit our investment process. We look for companies that have a good return on capital over the long haul and trade at reasonable valuations."
The portfolio has overweight positions in energy (18.2%), financial services (25.5%), industrials (23.4%) and technology (10.2%).
An important source of wealth creation for many small-cap companies, says Ferguson, is a long-term, well executed acquisition strategy. "Acquisitions carry risks and not all companies are disciplined in their timing and pricing of their purchases."
In the technology sector, a software company that has successfully added value for shareholders through its acquisitions, says Ferguson, is Constellation Software Inc. CSU, which is in the top 10 holdings in the portfolio. "Its president and chairman, Mark Leonard, is adroit at making acquisitions and growing the company internally."
The company has been a holding in the portfolio since Constellation's initial public offering in 2006, says Ferguson.
Constellation provides "mission-critical software solutions to more than 20,000 customers around the world." It targets both the public sector, which accounts for two-thirds of its revenue, and the private sector, which is responsible for the remainder, Ferguson says.
Constellation's software addresses the needs of a wide range of businesses and government departments, says Ferguson. The company has a "leading market share in most of the industries or verticals it sells to." In all, he says, the company "has a solid business model, a growing cash flow, and the stock is reasonably valued."
A company that franchises and operates quick-service restaurants under 27 different banners, and that is also an astute acquirer, says Ferguson, is MTY Food Group Inc. MTY. Ferguson originally bought the stock in the third quarter of 2007.
MTY's banners include Cultures, Tiki-Ming, Thai Express and Country Style, a recent acquisition. It has more than 1,700 restaurant outlets, roughly half of which are in shopping centres, says Ferguson.
Stanley Ma, the CEO, has developed a successful business model "which generates great profit margins and requires little of the firm's own capital." MTY has "excess cash on the balance sheet," and it recently initiated a "small dividend." The dividend yield on the stock is 1.4%.
The consulting-services provider Stantec Inc. STN another consolidator in its field, is one of the longest standing holdings in the portfolio, says Ferguson. "Over time, we have trimmed it and added to it."
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MTY Group Inc. | Stantec Inc. | ||
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| Nov. 30 close | $47.64 | $13.11 | $26.81 | |
| 52-week high/low | $34.85-$48.00 | $8.06-$13.60 | $22.79-$30.85 | |
| Market cap | $1 billion | $248 million | US$1.2 billion | |
| Total % return 1Y* | 36.7 | 46.2 | 0.2 | |
| Total % return 3Y* | 26.3 | 0.9 | -7.4 | |
| Total % return 5Y* | NA | 28.9 | 6.2 | |
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*As of Nov. 30, 2010 |
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Stantec, which has more than 150 offices in North America, provides services in a wide range of disciplines including planning, engineering, architecture and environment sciences to both the public and the private sector. The company has been "resilient" in the economic downturns. It is also "perennially profitable, with 45 years of straight profitability."
Stantec has "strong gross margins, a double-digit return on equity and is self-sustaining when it comes to its capital requirements," says Ferguson. "The stock trades at a reasonable valuation." Investors, he says, have been concerned about the impact of the U.S. economic slowdown on its business and the stock has been flat over the last two years. "We have used stock pullbacks over this period, as opportunities to add to our holding in Stantec."
A major holding in the portfolio, Parkbridge Lifestyle Communities Inc. PRK, was the subject of a recent takeover offer by British Columbia Investment Management Corp., says Ferguson. Parkbridge operates gated communities, marinas and recreational-vehicle parks across Canada.
Ferguson notes that BCIMC's offer price of $7.30 per share in cash represents a 35% premium to the volume-weighted average price on the stock for the 30 trading days ended Oct. 1, and a premium of around 30% over the closing price of the stock on Oct. 1. The transaction is scheduled to close early next year.
