If management ever mattered it would be in small-cap investing. Returns swing wildly among the more than 400 small- and mid-cap mutual funds available for the average retail investor; ranging from more than 20-per-cent gains in the past year to 30-per-cent losses.
With scant analyst coverage, getting information on the millions of small-caps stocks that trade on global exchanges can be challenging even in the information age.
“We go through them one by one and from there the hard work comes in,” says Aubrey Hearn, who manages the $400-million Sentry Small/Mid Cap Income fund. The fund has posted an annual average return of 13.3 per cent over the past five years compared with 1.6 per cent from the average Canadian small- or mid-cap fund and 3.3 per cent for the benchmark BMO Nesbitt Burns Canadian Small Cap Index.
Mr. Hearn starts with a screening process that isolates all Canadian companies with a market capitalization of less than $3-billion and U.S. companies under $10-billion. From there it selects companies with the best dividend potential, free cash flow, returns on investment, price-to-earnings and debt ratios.
Then it’s time for old-school investing, which often means getting on a plane and looking at the company’s operations first hand. “We like to go out and kick the tires just to make sure the assets look decent,” Mr. Hearn says. “Sentry has close to $10-billion in assets so we have good access to management. On average most of the names in the portfolio we probably meet with the CEO or CFO three times a year.”
The fund is mandated to hold at least 65 per cent of its assets in Canadian small and mid caps. You might think that would make it resource heavy and vulnerable to commodity price swings but resource stocks take a back seat to industrial, consumer, financial and health-care stocks.
One holding is air freight transporter Cargojet Inc. with a market cap of $78-million. Thanks to federal ownership rules that require half of all overnight cargo to be shipped by Canadian companies, Cargojet gets a lot of business from big U.S. carriers such as TransForce, Fedex and UPS. “These companies have to partner with domestic companies so CargoJet, being the biggest, gets a good share of the business,” Mr. Hearn says.
Resource-related stocks still play a significant role in the fund. Black Diamond Group Ltd., with a market cap of $867-million, runs drilling camps around the world. “What’s different and what’s nice about Black Diamond is that they have longer-term contracts with some of their clients, so they can withstand a slowdown in drilling,” Mr. Hearn says.
Another resource-related company in the fund is Newalta Corp.– a $787-million industrial waste recycling company. Mr. Hearn says he likes Newalta’s dominant position in the oil sands. “They’re actually using their own technology and sending their own equipment on site to Syncrude or Shell. They tend to be longer term, very profitable contracts.”
Not all small cap mutual fund investors have been so lucky. The average small cap fund has underperformed the index by 1.6 per cent annually over the past five years partly due to annual management expense ratios between 2.5 per cent and three per cent.
Like most asset classes investors are increasingly turning to exchange traded funds for lower cost, small cap exposure. Annual fees are well below one per cent but Mr. Hearn says when it comes to small caps, professional management is worth the price. “I personally think that’s a winning formula over time than buying the bad companies that you can’t avoid in an ETF. It’s not that difficult to figure out what a bad business is, and there are plenty of them. So, why would you own any of them if you don’t have to.”
That’s not how Mark Yamada sees it. As president and CEO of PUR Investing he creates ETF portfolios for his clients. He says buying a basket of small caps is a great alternative to individual small caps. “If you pick three little wee companies there’s a higher likelihood that one of them goes bust,” he says. “By buying 100 or 2,000 of them, the chance that any one going broke will impair your capital is significantly lower.”
In addition, he says a small cap ETFs can diversity risk and potentially boost gains in a broader portfolio. “Small caps are more volatile and if you put a bunch of them together you get some dampened volatility, but still the characteristic of small caps is that they are more volatile than a broad index.”
Mr. Yamada admits the small cap ETF pickings are slim in Canada. “It’s not so much finding one you like. It’s just finding one.” He recommends the iShares S&P/TSX Small Cap ETF, which trades on the TSX under XCS.
One U.S. small cap fund he recommends is the iShares Russell 2000 (XSU), which tracks the top 2,000 U.S. small caps. “It’s U.S. based but it’s very broad – 2,000 of the smallest stocks.”
He also suggests investors consider the wide variety of country specific global small cap ETFs such as Market Vectors Brazil Small Cap (BRF NYSE) or the Guggenheim China Small Cap ETF (HAO NYSE).
He cautions investors that emerging market small cap ETFs are risky and made riskier for Canadian investors because they are not hedged to the Canadian dollar. He suggests they be purchased only to complement a well diversified portfolio.