With a decade of experience in navigating the swings in small-cap stocks, Lesley Marks believes the next move in this market segment will be up.
"After going through a year where returns are down 40 to 50%," says Marks, "it's evident that this would be an attractive time to look at small-cap investing. They do tend to lead in a recovery, and because they are the most beaten-up names in valuation, you tend to get the best performance out of small-cap names in a recovery as well."
Marks, vice-president and portfolio manager, Canadian equities, at Jones Heward Investment Counsel Inc., has led the $210-millionBMO Special Equity since joining the firm in October 1998. She is a member of the equity team consisting of five other managers and one assistant portfolio manager, headed by veteran Michael Stanley.
Last summer, Marks moved into more liquid, mid-cap names to mitigate the impact of the downturn. Currently, the portfolio holds about a 50-50 split between small-cap and mid-cap companies -- "definitely higher in our range of mid-cap than we've ever been," she says.
The team uses what Marks describes as a five-step process to determine which companies meet the criteria for the portfolio. The first step is a strategic analysis to assess the management of the company. The second is fundamental analysis to try to determine future earnings, along with future capital requirements.
The third step is to examine potential earnings surprises and earnings momentum and other quantitative factors. The fourth step consists of looking at growth in the industry and assessing the company's ability to capitalize on opportunities.
Finally, says Marks, the team looks at "adaptive factors" such as the current macroeconomic environment and comparing other businesses in the small-cap space. The team uses valuation and "stress tests" of the business under different scenarios.
While reaching a target price is part of the adaptive strategy, it is used as an opportunity to reassess whether or not the target price is appropriate. Marks says the most important factors in the sell discipline are changes in fundamentals or in management strategy, or earnings disappointments.
Portfolio turnover is commonly about 40 to 50% annually, but market conditions influence the sell discipline. "Even though we may have a longer, one- to two-year investment horizon," says Marks, "things can change pretty fast."
Marks will personally meet with executives of about two-thirds of the roughly 200 companies that the team holds meetings with each year. The strength and strategy of company management is a key element of the success of small companies, she says.
Marks, 38, brings a variety of experience in the financial industry and in academia to investment management. In 1992, she received a bachelor of commerce degree from Queen's University. After graduation, she joined State Street in Toronto in the portfolio accounting department.
In March 1994, she moved on to a small investment counsellor that no longer exists, where she was involved in equity research and trading. In June 1995, she joined Manulife Financial to concentrate solely on equity research.
Marks received her CFA designation in 1996. In October of that year she left Manulife, joining Canagex Investment Management Inc. to become a portfolio manager. Two years later, she moved to Jones Heward. In 2002, she received an executive MBA from the University of Western Ontario while working at the firm.
During Marks's tenure, the Morningstar 3-star rated BMO Special Equity has an annualized 10-year return of 6.3%, compared with the median Canadian Small/Mid Cap Equity return of 5.2%, as of April 30. Over the most recent 12 months, the fund has lost 38.7%, compared with the median loss of 36.3%.
Marks considers the best growth opportunities to be in consumer discretionary, information technology and industrials. In a rising market for commodities, she will also generally favour the materials sector. But the fund currently has an underweight position in materials with about a 20% weighting at the end of April, compared with around 35% in the benchmark BMO Small Cap Index.
Acting on valuations that haven't been seen for a very long time, the team has been putting more money into the market. They have halved BMO Special Equity's cash weighting to 10%, down from 22% in December. The portfolio is also more concentrated now, with fewer than 50 names.
Among Marks's current holdings is the Canadian construction company Aecon Group Inc. ( ARE/TSX). With increased government spending on infrastructure, the fundamentals could be very strong for demand in Aecon's business, she says. When Aecon purchased one of its competitors last year, it was considered an attractive opportunity. With its astutely managed balance sheet, quality management and strong fundamentals underpinning the business, says Marks, "this was one we felt comfortable adding."
Reflecting on the current environment, "this is much more of a stock-picker's market," says Marks, "where the better companies, with sound strategies and a healthy balance sheet, will make it through to the other side of this downturn and have great earnings leverage."
