While Canadian small cap stocks took it on the chin late last year, along with other equity categories they have rebounded and are more or less back to levels seen before the fourth quarter crash. Despite the recovery, growth-oriented manager Tyler Hewlett argues that current market conditions call for selectivity and avoiding excess risk.
“The fourth quarter was a classic risk-off environment,” says Hewlett, head of Canadian growth equities at Toronto-based BMO Asset Management Inc., and lead manager of the $342.5 million, 4-star rated BMO Canadian Small Cap Equity F series. “It started with a sell-off in growth names, globally. Technology, for example, had done very well. But the market viewed it as expensive and it had run too far. It turned into a sell-off that was characterized by fears for the global economy.”
The first quarter rebound is due in part to the fact that the market was over-sold. “Part of that is that some of the concerns are starting to abate,” says Hewlett, a 18-year industry veteran who graduated in 2001 from Queen’s University with a B.Comm and joined BMO Asset Management in 2007, where he oversees about $1 billion in assets, the bulk of which is held by institutional clients.
“There were fears over China and uncertainty about monetary policy and trade,” Hewlett continues. “A lot of those things have started to ease, or at very least have not gotten any worse. The combination of the two has led to a strong rebound in Q1, which basically has brought us close to where we were, on most measures, before the sell-off.”
Energy exposure dragged in Q4
Small-caps are traditionally regarded as speculative and less liquid, compared to large-cap stocks. But energy took the brunt of the sell-off in 2018, especially when the oil price plunged. “Energy is one of the classic signals of risk-on behavior. Demand for oil is based on global growth, so it was not surprising when there was a global growth scare that it would impact oil and gas stocks. Energy was the worst performer within the Canadian small-cap index and was down 30% in Q4.” In a similar vein, Hewlett notes that the materials sector, which represents a wide assortment of stocks many of which are also tied to global growth, was down 17% in the same period.
The sell-off was a case of “throwing the baby out with the bath-water. But that’s not unusual for sell-offs, especially when you deal with an asset class that is perceived to be higher-risk. Panic sets in at some point. We saw a lot of that.”
Canadian small-caps have recovered, but they still lag their large-cap counterparts. For instance, S&P/TSX Small Cap Index is up about 12.5% year-to-date. In contrast, the S&P/TSX Composite Index is up 15.5%. BMO Canadian Small Cap Equity Series F, which does not seek to replicate the small-cap index, is up 15.5%.
Hewlett notes that back in 2012, when there was a change in leadership away from resource stocks, one could find non-resource stocks at very cheap valuations, given their strong fundamentals. “Since then, we have not seen valuations that low. But they came very close to those levels. The fundamentals for many of the companies we own got better in 2018. Then we had a sell-off and we could find high-growth companies for very reasonable valuations.”
Now that the market has bounced, valuations are more elevated. “But along the way, the fundamentals of many companies have kept improving,” Hewlett observes. “Valuations are by no means cheap. But they are not at extreme levels that would worry us either.”
Foundation first, then go for growth
A stock picker who favors growth companies, Hewlett seeks, above all, firms with strong management. “These tend to be early-stage companies that don’t have established brands and infrastructure to survive bad or mediocre management. If we can’t get comfortable with management then we will not invest in the stock.” Second, Hewlett requires a long-term opportunity for growth and, third, growth potential that is underestimated by the equity market. “We are not dumpster-diving for cheap, broken stories. We want to make sure we are buying high-quality names and we’re not over-paying for them.”
One of the top holdings in a fund with about 55 stocks is People Corp (PEO), a Toronto-based human resource consulting firm which provides group benefits and group retirement solutions. “It’s a very fragmented market and we have a management team that has a track record of growing and acquiring these types of businesses,” says Hewlett. “It has a high degree of recurring revenue and a very stable and predictable business. And it has a strong balance sheet. We see this as a company that can grow at rates of 20%, or greater, at both top and bottom lines for many years.”
The stock is trading at 12 times enterprise value (EV) to earnings before interest taxes depreciation and amortization (EBITDA). Based on the current price of $7.65, Hewlett believes the shares are reasonably valued. The company has an ability to grow 15-20% per annum, and Hewlett believes the share price has the potential to appreciate in a similar magnitude for the next few years.
Another favorite is Park Lawn Corp. (PLC), which operates cemeteries, crematoriums and funeral homes throughout Canada and the U.S. “It also has a very disciplined management team. And it’s in a fragmented market. There is an opportunity to make acquisitions and improve the operations of the firms that it buys,” says Hewlett, noting that the firm has expanded into Michigan and Illinois.
It took a while for some acquisitions to show results, but Hewlett expects to see earnings growth from some of the recent acquisitions. “This can drive earnings growth for many years into the future. It’s a fairly predictable business.” Park Lawn is trading at $25.30, or about 11 times EV to EBITDA. The shares could grow about 15-20% for the next few years, says Hewlett.
Another top holding is Kinaxis Inc. (KXS), an Ottawa-based provider of supply chain management software for global firms such as Toyota and Honeywell. “They are seen as having the leading-edge product in the field,” says Hewlett. “They help their customers optimize their supply chains, which leads to greater efficiencies.” Benefitting mostly from organic growth, Kinaxis’s top and bottom lines have been growing at over 25% a year. Not surprisingly, the shares are trading at about 25 times EV to EBITDA for fiscal 2020. “It looks expensive today. But when you look back in three or four years from now, it will end up being more reasonable.”
Looking ahead, Hewlett is cautious about the near-term. “They say, ‘Bull markets don’t die of old age.’ Just because we had a decent run since the 2008-09 financial crisis, that doesn’t necessarily mean it will end tomorrow,” says Hewlett. “That being said we are likely closer to the end of the economic cycle, than the beginning. We try to watch out for signs of excessive risk-taking. There are no flashing red lights now,” Hewlett continues. “But we are conscious that there is lots of uncertainty that could create sell-offs like we saw in Q4. We try to have high exposure to companies that can survive a recession, should it happen. They will continue to grow their businesses, going forward.”
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