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Three smaller-cap picks for the value investor Add to ...

WHAT ARE WE LOOKING FOR? What the pros are buying. This week, we'll check out some of the small-to-mid-capitalization companies in several mutual funds.

Smaller-cap stocks tend to do well in the early stages of an economic recovery. Today, we'll look at Norrep II Class A. You can check its holdings each month at http://www.norrep.com.

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ABOUT THE FUND The $160-million Canadian small-to-mid-cap equity fund has been managed since 2004 by Alex Sasso, who is also chief executive officer of Hesperian Capital Management Ltd.

The fund gained 65.3 per cent for the year ended Jan. 31, compared with 60.5 per cent for the BMO Nesbitt Burns Canadian Small Cap Index. Over five years, the value-oriented fund has posted an average annual return of 7.3 per cent.

"We like to buy inexpensive companies with earnings momentum," Mr. Sasso said. "It's very tough to find, so when we do we tend to take bigger positions. Our top 10 make up half of the fund."

Typically, he likes companies that trade below 15 times earnings, and have a much higher return on equity.

The small-cap cycle historically lasts from 47 to 60 months, so it's a long cycle, he said. "We bottomed in March, 2009, so call it a year into it."

WHAT DID WE FIND? A diversified mix of Canadian stocks off their 52-week highs.

Black Diamond Group Ltd., a Calgary-based provider of temporary work force accommodation to the energy industry and other construction sites, has been in the fund since it went public in 2006.

It converted from an income trust to a corporation at the end of 2009. The company, which has a 6-per-cent yield, trades at 10 times trailing earnings and has a 19-per-cent return on equity, Mr. Sasso said.

"We think the earnings momentum is going to come via the increase in capital expenditures," he said. "They have just increased it from $30[-million]to $65-million, so they have more than doubled it."

Vector Aerospace Corp., another top holding, operates a global aircraft maintenance and repair business. "It has been able to grow the top line and bottom line from 2007 to 2009," Mr. Sasso said.

The Toronto-based company is well-managed and trades at 7.6 times trailing earnings, and has a 21-per-cent return on equity, he said.

"We think they will [also]continue to do acquisitions."

Sino-Forest Corp., which is a Mississauga-based timberland operator in China, has a "very impressive management team," the manager said.

The executives manage the Chinese plantation assets from Hong Kong, and it is one of the top suppliers of wood fibre in China.

"The stock trades at 14 times trailing earnings for 16-per-cent return on equity," he said. "We expect good earnings momentum because the Chinese economy is so strong. ... China has [gross domestic product]growth of about 10 per cent."

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