With the interest rate tightening cycle seemingly on its way out, small-cap stocks are stirring to life after a couple of years of stagnation, and that’s lighting a fire under Mackenzie Canadian Small Cap.
“The environment of rising interest rates and high inflation was a tough period for small-cap stocks,” says Dongwei Ye, Toronto-based vice president and portfolio manager at Mackenzie Investments. “But we’re seeing that trend change. Yields are dropping in financial markets, and we’ve seen small-caps rebounding strongly from last October’s lows. We expect strong performance to continue in 2024.”
Ye co-manages the $157 million Mackenzie Canadian Small Cap along with Scott Carscallen, vice president and portfolio manager, Erik Sjoberg, vice president and portfolio manager, and analyst Rob Wiens. In total, the team oversees $1.6 billion in small-cap portfolios at the affiliated firms of Mackenzie Investments, IG Wealth Management and Canada Life Assurance Co.
The four-star fund is ranked bronze by Morningstar and the F Series (also available in D series) showed an average annual compound return on Jan. 2 of 7.04% for one year, 12.03% for five years and 6.8% for 10 years, beating both the Canadian Small/Mid Cap Equity Category and benchmark index for all time periods. Its three-month gain of 8% is a sign of the recent uptick in momentum.
Conditions Improving for Small Cap Stocks
Small-cap stocks typically lag during tough economic periods or times of rising rates but snap back quickly in the early stages of recovery. They benefit when interest rates fall as they often rely on short-term or floating-rate debt.
Ye and other market observers are expecting that interest rate hikes controlled by central banks have levelled off and may decline this year. With lower rates, more money will migrate out of safe harbours like cash and into higher-risk asset classes like small-caps and regular equities.
Recession’s Still in the Cards
However, the rally is vulnerable to reversal if the expected soft economic landing turns into a more severe recession, or if inflation does not recede as quickly as central bank officials in the U.S. and Canada expect and interest rate drops don’t materialize.
“We’re expecting a soft landing, and in that environment small-caps will continue to outperform,” Ye says, “When economies reopen and there is increased risk appetite, small-caps are typically first out of the gate and it’s a fast recovery. A lot of names were beaten down and there is room for significant multiple expansion as confidence returns to the market.”
Avoiding Energy and Commodity Small-Caps
Although there are many small-cap companies in Canada in the commodities and energy sectors, Ye and the team are avoiding these cyclical areas. Instead, they are focusing on opportunities in the industrial and financial sectors, as well as companies that benefit from rising consumer spending.
“Sectors like energy and materials typically don’t meet our investment criteria,” she says, “Their results are dictated by commodity prices that move up and down, and stock prices in those sectors tend to move as a homogeneous group.”
Instead, the team is focusing on high-quality companies with strong balance sheets that have demonstrated resilience throughout the economic cycle and resistance to recession. It’s also often a plus when companies have exposure to the U.S. market where the slowdown has been less pronounced than in Canada.
Top Small-Cap Stock Picks
Holdings include Stella-Jones Inc. STLJF, North America's leading producer of industrial pressure-treated wood products; Boyd Group Services Inc. BYD, one of the largest operators of non-franchised collision repair centres in North America; and Stantec Inc. STN, an engineering services company. The team has also found attractive opportunities in financial companies such EQB Inc. EQB, a branchless banking firm; Element Fleet Management Group EFN, a provider of management and financial services for commercial fleets; and iA Financial Group Inc. IAG, an insurance and wealth management firm.
“People need banking and insurance products regardless of whether there is a recession or not,” Ye says, “And anything related to consumer spending will have more torque in a recovery environment.”
Currently there are 53 companies in the fund, and holdings are influenced by differing economic factors to provide diversification, Ye says.
On the consumer side, stocks include women’s fashion chain Aritzia LP ATZ, mattress retailer Sleep Country Canada Holdings Inc. ZZZ and natural health products firm Jamieson Wellness Inc JWEL .These companies have shown resilience in tough times and have invested in growth through expansion and acquisition. For example, in 2023 Aritzia opened a giant distribution center in Toronto and is positioned for deeper penetration of the U.S. market, and Sleep Country acquired innovative sleep product producer and retailer Casper Sleep Inc.
Strong Enough to Survive but Built to Thrive
“These companies have strong balance sheets and have made accretive acquisitions,” Ye says, “They are strong operators who can manage margins even when the top line is declining, and they will be winners when the tide turns.”
The market cap of most of the companies in the fund typically falls between $1.5 billion to $7 billion, although there are also a few microcap holdings and a handful with a market cap higher than $7 billion. All are Canadian companies.
The portfolio is “high conviction” but not concentrated, Ye says. Few holdings would exceed more than a 3% weight in the fund.
The team has the ability to move up or down the scale in terms of the market capitalization of its picks, and in more volatile markets the managers typically tilt toward the higher end of the capitalization range.
“When we are more confident in the outlook, we have more exposure to smaller names and microcap,” Ye says.
The team has been adding more names at the smaller end, still focusing on quality but seeking out names previously beaten down but now showing promising recovery potential. End-of-year tax loss selling created some attractive buying opportunities, Ye says.
Optimistic Positioning
“It’s hard to time the turn of the market, but you have to be there ahead of time,” Ye says, “With small-caps, it’s more difficult to get in quickly at the last minute (than with more liquid large caps). We are not defensive right now. We want to capture the upside.”
