The U.S. small/mid-cap universe encompasses about 2,500 companies, and because of their smaller size many have a limited analyst following and are ripe for the picking, argues David Slater, U.S. equity analyst at Vancouver-based Leith Wheeler Investment Counsel Ltd.
"All the U.S. indices, small-cap and large, are trading at around 21 times earnings," says Slater, co-manager of Leith Wheeler U.S. Small/Mid-Cap Equity. "Regardless of the price-to-earnings ratio for the indices, we believe, and have found with our Canadian work over the past 30-plus years, that there is often more fertile ground in finding attractively-priced stocks in smaller companies."
Established in 1982, Leith Wheeler offers 12 mutual funds and has $18 billion in assets under management. After developing its expertise in small and mid-cap stocks in its Canadian equity portfolios, the firm decided to launch the U.S. small/mid-cap equity fund last October.
"There is not as much capital chasing these smaller stocks since many managers can't invest in them because they run large pools of capital. So there is less competition on the buy side. That creates greater opportunities for mispricing. That's what we are trying to do: find mispriced securities," adds Slater, who joined Leith Wheeler in 2015 and has been in the industry since 1997 when he earned an MBA at the University of Toronto's Rotman School of Management.
The small and mid-cap universe spans a wide range of market-capitalizations, varying from about US$800 million to US$15 billion. As value investors, Slater and co-manager Raymond Lai conduct fundamental research on each company that comes up on their screens, and talk to management, suppliers, customers and competitors. "We uncover information for ourselves and develop our own point of view of a company. And we like it if it isn't well-followed. If we know more than a lot of people, then we have an edge that we can exploit."
Leith Wheeler tends to avoid companies that don't have any earnings, or are too leveraged or are too difficult to understand. This effectively eliminates companies such as those in the biotechnology sector whose future earnings are very difficult to predict accurately. Conversely, Slater and Lai will occasionally adopt a contrarian view and gravitate to some stocks in areas that may be under pressure and perhaps shunned by competing money managers. "Uncertainty creates opportunity. Everyone thinks that 
Amazon.com (AMZN) will conquer the retail world. But we are finding pockets of value where we don't think that's the case," says Slater, pointing to a very recent acquisition which he can't identify because of compliance regulations.
While the investable universe is comprised of about 800 to 1,000 companies, only 22 have made it into the portfolio. As a rule, they are established firms with understandable business models. "We need to have a strong basis for approximating the business's long-term economics. If we can't understand it, or develop a long-term view, we can't possibly value it." In addition, the company has to be strong from an operational viewpoint and management must be skilled at allocating capital. Moreover, the stock's price has to be attractive enough so that it is trading below its intrinsic value.
"If we can get all three things and find a business that has the long-term ability to reinvest capital at an attractive rate of return, then you really have a winning hand," says Slater.
Take, for instance, TRI Pointe Group Inc. (TPH), a home builder with a market cap of US$2 billion that is primarily active in California. The firm owns prime land tracts in the San Diego area and the so-called Inland Empire near Los Angeles, some of which were acquired in the 1980s. "But the land doesn't show up accurately in the book value of the company," says Slater, noting that the land is listed at only a fraction of its market value. "We happen to like California and where the home-building cycle is. But the land is the unique piece to TRI Pointe. It has a huge under-appreciated asset."
After talking to management and visiting the firm's sites, Slater and Lai concluded the stock was trading at a discount and took a position last fall. The share price is about US$13.50, or 10 times earnings. "Even though more people know about TRI Pointe now, we still don't think the value is reflected in the share price," says Slater, adding that the stock is trading at an estimated 20% discount to intrinsic value.
Another favourite is Starwood Property Trust Inc. (STWD), a $5 billion real estate investment trust (REIT) that is a lender to commercial property owners. "They are filling a void that a lot of mainstream banks have exited or put less focus on," says Slater. Critical to the investment thesis is that the company is run by Barry Sternlicht, who also heads former parent Starwood Capital Group and is "one of the shrewdest real estate investors in the U.S."
The quality of management and its ability to deploy capital is what attracted Leith Wheeler to the REIT. "Sternlicht and his group have an absolutely stellar long-term reputation in this kind of business. We are backing the best horse on the race track, at an attractive price." The share price is US$21.80, and it trades at 1.2 times book value. It also pays a 9% dividend. Acquired at a slight premium to book value, the stock is still trading at a slight premium.
Year-to-date, the fund has been flat, largely because the 10% appreciation of the Canadian dollar against the U.S. dollar has erased the unhedged fund's gains. Yet undeterred by the foreign exchange challenges, Slater is focusing on careful stock selection and using up the fund's 18% cash to buy more small/mid-cap names that have a limited following. "As long as capital is being well allocated and the stocks are under-valued, we'll keep them."
