Over a year after the coronavirus pandemic quickly derailed small caps, David Barr, manager of the bronze-rated Pender Small Cap Opportunities F, is now starting to see investors coming back to the small-cap space.
“It’s the first time we’ve seen this since probably 2016 or 2017,” says Barr, a portfolio manager at PenderFund Capital Management in Vancouver. “We’ve got some green shoots of interest which hopefully will close the gap between small-cap and large-cap stocks.”
Does this sounds like you? Barr says that for investors considering the small-cap universe, remember that it can be cyclical with higher volatility. “If you want to build a proper asset allocation portfolio with diversification, small caps are a great way if it’s 5% to 10% of your portfolio. You not only get diversification on size of companies but also industry exposure,” Barr says, adding that with the mutual funds and exchange traded funds in the small cap space, it’s pretty easy to get a lot of exposure in the mid-to-large cap space.”
The five-star fund’s investment strategy is focused on buying small-cap companies at an early stage, at a reasonable price, with the potential to grow for a long period of time. It has a portfolio turnover of approximately 30% historically, although the turnover was higher last year because of actions taken during the pandemic. Barr says the managers are really looking five-years out, where a company might be successful in executing other strategies for growth potential.
Geographically, the fund is characteristically weighted about 80% in Canadian equities, with the remaining 20% invested predominantly in U.S. companies.
“We’re looking for companies that can increase their intrinsic value at a double-digit rate of return over the long term,” Barr says. The key stock characteristics are company or industry specific and depend on what can sustain growth. It could be high free-cash flow yield, R&D, or marketing initiatives, for example.
Barr defines small cap companies in Canada as up to $2 billion in market cap. If a company in the mandate progresses from small cap to mid cap, it can remain in the fund but the position is not added to.
Sector in Focus: Technology
According to Barr, the managers have always gravitated more to the technology, communications services and healthcare spaces because they like asset-light, people-driven businesses. Those are the businesses that tend to be more growth oriented in the early innings of the big market. “You can get some really high investment returns on capital in these asset-light businesses,” Barr explains.
The technology sector, among the approximate 60 holdings, remains highly favoured in the portfolio, with more than a 40% weighting. But what makes ‘technology’ has changed, Barr notes. “Historically a lot of people would look at 42% in technology and think that if computer retail or tech product sales slow down, you’re in a lot of trouble with that portfolio. But a lot of the technology world is now selling things to the oil and gas industry or into the healthcare industry.”
For the 13-member investment team, including Barr, when they look at the risk overlay in the mandate, it’s always about asking where the revenue is coming from. Barr says the managers are business analysts, so it’s very much a bottom-up approach. Trying to assess and understand the quality of a business, the individual opportunities of a company, and the risks involved, are critical in the small-cap space where there is not a lot of research coverage.
“You have to get to a way higher level of conviction. You really have to dig in and understand first the industry, the company’s position within that industry, and the management team,” he says.
In positioning the fund, the portfolio managers are closely aligned with unit holders for performance. “I’m 100% invested,” says Barr, “but I’m not your usual investor.”
Top Holdings
Among the top 10 holdings favoured today is Sylogist (SYZ) a Canadian-based software company focused on servicing not-for-profit organizations and government. “Sylogist turns out to be 40% free cash flow,” says Barr, “it’s a very profitable business, and very well run.” In addition, the company’s management team is really focused on R&D, so it should be able to increase its organic growth rate over the next 12 months, and then also grow through acquisitions. Before investing in the company, the investment managers “stayed on the sidelines” until the company made initiatives to address ESG issues of concern. “We’ve always been big proponents of ESG investing,” says Barr.
Also among the top 10 holdings is Sangoma Technologies (STC), a Canadian-based hardware and software provider that enables Internet protocol communications for both telecom and datacom applications. Barr points to specific tailwinds as a result of the COVID-19 pandemic. “We’ve all moved to working from home. If you move from the traditional analog telephone system to digitized Internet protocol, (the software) truly enables remote working, which I think is a trend that I think is going to continue for quite a while.” As well, most of the company’s revenue is now re-occurring revenue and the company is attractive from an absolute value perspective.
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