Sionna Canadian Small Cap Equity is run using a firmwide value investing philosophy that targets underpriced companies, with the expectation that stock prices will return to their intrinsic fair value over the long term. Over the long term, this approach has generated benchmark and category-beating results. The past couple of years ending October 2016 have been a challenge, though, as the fund returned negative 2.5%, trailing both the index and the category average by more than 5 percentage points. In the wake of these shorter-term return woes, the team has remained patient and steadfast, adding to names that have sold off but where they believe long term value exists.
The team employs an intrinsic value model which screens and ranks the Canadian universe on the basis of book value, historical return on equity and relative price/earnings ratios. The team then focuses its attention on those stocks trading 30% below their intrinsic value. Despite the model being fairly basic, it is effective at focusing the team’s attention on the most attractive opportunities. Sionna typically embraces companies experiencing cyclical or operational troubles as they claim these firms are often misunderstood by the broader market. The team eschews high levels of financial risk though and will avoid companies with too much debt, resulting in a portfolio with a quality bent. This is particularly true in the smaller-cap space where the manager thinks it is easier to find high-quality names trading at attractive valuations.
Stocks that screen well are examined under a fundamental lens to develop a robust understanding of a company’s prospects and risks. Importantly, the team leverages a singular research questionnaire and seeks to answer the same questions about each company, providing consistency and comparability. The questions range from ones on company management’s background and capital allocation history to questions geared to understanding the business’ cyclicality. The whole team then debates potential buys in a group setting and strives for consensus before making a decision. Further, the team meets regularly to deconstruct the portfolio and examine it under many different lenses to ensure exposures and position sizes are justified by their views.
Sionna’s portfolio of 30 to 55 names is notable for its true small-cap focus. Its weighted average market cap as of July 2016 equaled $680 million, which is far less than the $2.6 billion for the Canadian small/mid-cap equity category. The large majority of positions have a market cap less than $2 billion, solidly in the small-cap arena.
Even though Sionna generates and researches ideas here in the same manner as it does with large cap names, the small-cap portfolio looks slightly different. The manager feels the underfollowed nature of Canadian small caps means it is easier to find attractively valued companies that also have higher-quality aspects. This results in the portfolio that skews to quality over value, exhibiting higher returns on equity, returns on invested capital, and lower debt/capital than the BMO Small Cap benchmark and category average. For example, the fund’s ROIC is 7.4%, which compares favourably with the index at negative 4.3% and the category average at 4.8%. Meanwhile, value characteristics are less prominent. The price/earnings ratio of 14.9 is less than the benchmark’s 16.8 and category average’s 15.3 but price/book and price/cash flow ratios are similar-to-higher than the benchmark and category average.
In another departure from its large-cap sibling, the team constructs the portfolio in a benchmark-agnostic manner; avoiding exposure to junior oil and gold companies with little to no revenue and instead concentrating on companies with more stable, long-term track records. This corresponds to a greater than 20% overweight in financials and a 7.5% overweight in consumer discretionary, while the materials and energy sectors are underweight at approximately 20% and 3%, respectively. The portfolio is also absent holdings in healthcare and utilities.
The appeal of the small-cap strategy comes from its strong risk-adjusted returns. The fund’s Sharpe ratio ranks in the top quartile of the Canadian small/mid-cap equity category since its first full month in January 2007 through October 2016. Indeed, the fund outperformed the category and BMO Small Cap benchmark in down markets such as 2008, 2011 and 2014, while managing to hold its own in strong up markets. Overall, the fund has an annualized return of 5.4%, outperforming the index return of 2.0% and the category average return of 4.1%.
In 2015, the fund suffered from its exposure to the energy sector as energy services holdings like Calfrac Well Services (CFW) and Akita Drilling (AKT.A) slumped on much lower drilling activity. Also, industrial equipment dealer Wajax (WJX), which supplies the energy industry, and AutoCanada (ACQ), which has a dealership network concentrated in the oil-producing Western Canadian region, both suffered from declining demand. Some of the fund’s energy names like McCoy Global (MCB) and Pulse Seismic (PSD) have continued to do poorly in 2016 despite a turnaround in the price of oil. Further, junior mining companies have rallied significantly on better commodity prices but the fund’s large underweight in these companies means it didn’t share those gains. However, long term, the fund has done very well in both the energy and materials sectors. Morningstar’s attribution, from January 2007 through October 2016, shows stock selection in the energy and materials to be the biggest contributors to outperformance.
The fund’s fees rank in the middle of the pack in the Canadian small/mid-cap equity category. The A share class, with a 2.57% management expense ratio, is roughly on par with the category median in the commission-based distribution channel. The F share class, with a management expense ratio of 1.49%, is more expensive relative to the fee-based distribution channel though, clocking in 0.17% higher than the median.
The fund’s portfolio turnover has ranged between 25% and 60% over the past five years. This below average turnover gives it one of the lowest trading-expense ratios in the category, averaging 0.13% over the last five years. While this improves the fund’s relative ranking on a total cost basis, overall it still ranks just slightly better than median.
