The Globe and Mail

Who:
Hugo Lavallee, manager of the Fidelity Canadian Opportunities Fund

The Strategy:
To sift through the hundreds of small- to medium- sized companies in Canada and come up with winners.

“When you go down market cap, there's a lot less Street coverage, so it's easier to get an edge because there's less competition,” Mr. Lavallee says. Fidelity's size and team of analysts mean the fund can cover more stocks than anybody else in Canada, he adds.

Generally, Mr. Lavallee's picks come from among companies with a market capitalization of anywhere from $50-million to $30-billion. “If it's below $50-million the story really has to be compelling.”

He takes a contrarian approach, “investing against the tide,” searching for companies whose “profit margins are bottoming” and holding them for up to three years until their margins, and stock price, improve. “It could be new management, cost cutting, a new product, different regulations.”

His first question: How much money could we lose? Small-cap funds “can really blow up spectacularly if you pick the wrong stock.”

For downside protection, Mr. Lavallee looks especially for companies that are well capitalized and have a low price-to-book or liquidation value.

“We buy on the balance sheet and sell on earnings.”

An example is Canaccord Financial Inc. CF-T He bought the stock in 2008 when it was mired in problems over asset-backed securities. “It was a $4 stock, its book value was more than $6 a share, it had close to $800-million of cash on its balance sheet and $25-million of debt.”

In the previous market cycle, Canaccord had been quite profitable, earning $2 a share.

“Say this cycle it's going to make $1 a share, at $4 that's still only four times its earning power.” The stock is now trading at $8.72.

When it works best:
“A year ago, it was a lot easier to do than it is today,” Mr. Lavallee acknowledges. Small caps tend to lead when the market rebounds, so he has been taking profits and shifting into larger, more defensive companies.

“We're not a micro-cap fund with the pedal to the metal all the time,” he says.

“We're going into more shareholder-friendly management teams, better balance sheets, more liquid names with an emphasis on dividends.” The average market capitalization of companies in the fund has climbed from $1.5-billion a year ago to nearly $5-billion today.

“I don't know what the market is going to do, so we're taking a bit of risk out of the fund, trying to protect capital,” he says. Dividends are back in focus so utilities and income trusts are coming to the fore. “There's some decent yields, you just have to scratch the surface a bit.”

What could go wrong:
“With a small-cap fund you can really hurt yourself with bad stock picking. You have to know where we are in the cycle, when to put your foot on the gas pedal,” he says. With small, illiquid companies, “a year like 2008 can really kill you.”

How is he doing?
Year to date, the fund is down by 0.8 per cent, but in 2009 it soared an impressive 60.7 per cent. In 2008, the year the market crashed, it was down 36.5 per cent. Over the past five years, it has handily beat its benchmark, rising an average of 7.4 per cent a year. Over the past five years, the S&P/TSX completion index rose 4.1 per cent.

Market outlook:
“This year stock picking is going to matter,” Mr. Lavallee says. “This year, the market is probably going to narrow in terms of which stocks are going to do well.”