If you’re a small-cap investor with a value bias, challenging headwinds may be shifting in your favour. Based on recent data, that’s the favourable view of David Barr, manager of the gold-medallist Pender Small Cap Opportunities fund at PenderFund Capital Management in Vancouver.
“It’s quite the contradiction to what people are saying about large-cap stocks: we’ve had this great 10-year bull run - it must be ending,” says Barr, “Well, it’s [already] dead in the small-cap space.” And if you look at small caps today from a contrarian standpoint, “[it’s] ripe with opportunities,” says Barr.
Decades-low P/E ratios
Barr says if you look at the U.S., and take out one-third of the companies that are not profitable, the current price-to-earnings ratio hasn’t been this low since March 2009, in the middle of the financial crisis. “So we’re quite optimistic on the small-cap market right now, but we’ve seen tremendous headwinds over the past 18 to 24 months.”
If you look back even further, Barr says the research shows that small-cap stocks are lagging large-cap stocks to the greatest degree since 2003.
The investment strategy focuses on sub-$1 billion market cap companies with an average market cap size of about $200 million in the portfolio. In the larger small caps and mid-cap space, Barr says you really have to be contrarian in order to generate an adequate return over passive indices. “A lot of the time it’s buying companies when they’re out of favour,” says Barr, “or in a quarter when the market overreacts adversely with news that comes out.”
Bet on the business case first
Reflecting on the performance of the fund, Barr credits the investment team of 13, including himself, to really digging in as a business analyst, as opposed to a stock analyst. The quantitative and qualitative research is on understanding the key drivers of the business, the quality of the management team, the competitive landscape and the product or service they offer, among other attributes.
“When you get down into the weeds in small caps land,” says Barr, “that’s where you can find those pricings where we can have an analytical edge. We’re just participating in a sandbox where no one else is playing."
For example, among the top 10 holdings, “the wonderful little software business, ProntoForms Corp. (PFM)”, says Barr, “is totally off the radar screen.” The Canadian-based business offers companies a simple app for smartphones for field-services workers. According to Barr, ProntoForms has recurring revenues that are growing, 34% annualized for 2018, and really high customer attention over 90%. Currently, the business is out-of-favour, heavily reinvesting for growth, so it looks like it’s losing a bit of money. “But we’re quite comfortable in those situations,” says Barr. “They’re making the right capital allocations to reinvest in the growth to keep that high growth rate going.”
Another top holding is Diversified Royalty Corp. (DIV), a Canadian-based multi-royalty financial company. The company offers a diversified stream of royalties from four Canadian brands - Sutton, Mr. Lube, Air Miles and Mr. Mikes - with market-leading positions. According to Barr, the company has consecutive years of positive sales growth and the founder-run business has a strong track record of adding new royalties to the portfolio. “It’s a very capitalized business model,” says Barr, “essentially you get a top-line royalty from all these businesses. It has highly incremental free-cash flow, currently trades about an 8% dividend yield, and is very attractive today.”
Also among the top 10 holdings is Canadian-based Freshii Inc. (FRII), a fast, casual restaurant chain with healthy options. “The company,” says Barr, “has grown quite dramatically since inception. It’s totally on trend with healthy eating.” The business model is favoured for its use of fresh foods with little cooking required. As well, the company is very capital-light for franchisees to start up, is very affordable, and very entrepreneurial. “They overpromised on their growth expectations,” says Barr, “but we think the management is doing all the right things in terms of the business and the stock is attractive today.”
Overall, if the Pender team can determine what the business they’re looking at is worth, and if they can buy it at a discount – depending on risk factors and growth rates – they believe their portfolio can set be up for long-term potential. The target is a five-year plus investment horizon.
Risk management includes the use of automated tools to monitor weightings in the portfolio and minimize excessive industry exposure. Balance sheet risk is a key emphasis. Qualitative insights are sourced from talking to competitors, the management, attending trade shows and talking to customers.
Canadian concentration – but not heavy on energy
In positioning the fund, the weighting of 74% in Canadian equities and 20% U.S. has been the case for a while. Currently, the managers are finding more opportunities in the U.S. in the technology space.
The fund has held about 40% in technology since inception of June 2009. The positioning reflects the underlying investment strategy to focus on businesses that are not capital intensive. “The Canadian landscape,” says Barr, “is very resource driven, which is highly capital intensive, and we tend to avoid that.”
Managing the portfolio to remain nimble for investing, the fund was closed for four years and the managers are looking to close it again in the future. “We’ve reopened it,” says Barr, “because we’re just seeing so many great opportunities today in the small cap space.”
