Value manager Scott Carscallen, vice-president and portfolio manager at Toronto-based Mackenzie Financial Corp., says that although Canadian small caps have handily outperformed their bigger-cap counterparts in the year to date, they still trade at a significant discount to them.
The benchmark BMO Blended (Weighted) Small Cap Index produced a total return of 15.7% in the nine months ended in September, compared with 7.5% for the S&P/TSX Composite Index.
Yet, on a stock-price-to-book-value basis, the small-cap index trades at a 15% to 20% discount to the composite index, says Carscallen. "Price to book is our metric for valuation," he says.
Carscallen says there is room for this valuation gap to narrow, based on the experience of the last economic cycle. Also noteworthy, he says, is that there have been a number of takeovers of small-cap companies priced at considerable premiums to their stock prices. "This indicates that the private market is recognizing that there is value to be had in small-cap stocks."
For the whole small-cap universe to shine, there needs to be "an increased appetite for risk" among equity investors, says Carscallen. This will be fostered by the conviction that the recovery will be fairly robust, he adds.
In the year to date, the materials sector -- powered by gold -- has been the main driver of the small-cap index. Materials produced a total return of 26.4% and gold "was on fire" with a return of 29.2%." Most of the other sectors were relatively flat, Carscallen says. In September, there were signs of life in some cyclical sectors of the index, "which is a positive."
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| Index | YTD | 1yr | 3yr | 5yr | ||
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| BMO Small Cap Blended Weighted | 15.7 | 31.2 | 1.2 | 6.2 | ||
| S&P/TSX Composite | 7.5 | 11.6 | -1.4 | 5.2 | ||
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| For periods ended Sept. 30 Source: Morningstar |
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At Mackenzie Financial, Carscallen is responsible for managing some $500 million in small caps. This includes Mackenzie Saxon Small Cap, which has assets of $332 million. In selecting stocks, Carscallen uses the BMO small-cap threshold -- recently $1.6 billion -- as the definition for his 60-name portfolio.
A major underweight in the fund is materials at 20.7%, versus 32.9% of the benchmark index. Carscallen notes that in the materials sector, gold stocks constitute a "hefty" 22% of the BMO Blended (Weighted) Small Cap Index, whereas the fund has 5% in these stocks.
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"It is challenging to find value among the gold stocks," he says. "Also these companies tend to be fairly homogenous, and to have a weighting in the fund anywhere close to the benchmark would represent imprudent concentration."
A gold stock that Carscallen considers does offer value is Dundee Precious Metals Inc. DPM, which has a market capitalization of $774 million. Its core asset is a low-cost gold and copper mine in Bulgaria. The company has embarked on a "significant expansion" of the mine, which will result in production of 140,000 ounces a year. It is also expanding its gold and copper mine in Armenia.
Dundee Precious Metals stock trades at the net asset value per share of the company. "It is an inexpensive way to participate in the rising bullion price and in a good growth story," Carscallen concludes.
In the financial-services sector, Carscallen says there is value to be had in shares of the independent brokerage house GMP Capital Inc. GMP, which has a market capitalization of $822 million.
GMP's core business is investment banking and institutional trading, he says, "and it has been a powerhouse in both." The stock is a "play on any financial-market recovery." The weakness in Canadian investment banking over the past several years "has put a lid on GMP's revenue growth and caused investors to shy away from the stock."
At the beginning of October, Harris Fricker succeeded Kevin Sullivan as the brokerage's CEO. "Harris is a seasoned investment banker and will expand GMP's core business," Carscallen says. He views GMP stock as "cheap," trading at an enterprise value (equity plus debt) to EBITDA (earnings before interest, taxation, depreciation and amortization) of about five times forward estimates. It has a dividend yield of 2%. "The company recently raised its dividend and has the cash-flow generating capability to make further increases."
A producer of renewable energy that is trading below its book value per share and "has significant opportunity to grow its cash flow", says Carscallen, is Boralex Inc. BLX Boralex, which has a market capitalization of $300 million, owns wind power, hydroelectric power and biomass facilities in Canada, the United States and Europe.
The company is acquiring the units in Boralex Power Income Fund BPT.UN that it does not already own. This will increase the total power that it has under longer-term contract to more than 70% (versus the current 54%) by the end of 2011, says Carscallen.
In addition, it will reduce the company's exposure to the United States, where its biomass power facilities have been experiencing weak spot prices.Boralex's acquisition will also substantially increase the company's cash flow from operations, which will help to finance its new projects. "These projects will result in both a more stable cash-flow stream and substantial cash-flow growth."
Carscallen notes that two stocks held in the fund were the subject of takeover bids at significant premiums to the then going market price. The Quebec-based plastics manufacturer IPL Inc. is being bought by the private equity firm Novacap and the Quebec labour-sponsored investment fund Fonds de solidarité FTQ, for $94.2 million.
IPL shareholders will get $6.50 in cash for each multiple voting share held. "This represents a 28.5% premium to the stock's average trading price for 20 days to Sept. 3," Carscallen says.
Carscallen says Ontario-based Samuel Manu-Tech Inc., which formerly traded under the ticker SMT, was taken private by its controlling shareholder Samuel Son & Co. Ltd. in early September. In July, shareholders of Samuel Manu-Tech, an industrial products company, were offered $7.50 per SMT common share. This represented a premium of 81.6% to the volume-weighted average trading price of the stock for the 20 trading days to July 23.
