Investing tips from small-cap experts

By Helen Burnett
Globe Investor Magazine Online, June 16, 2008

Plagued by economic uncertainty, small-capitalization stocks have had a tough time this year. The BMO Small Cap Index (Blended) was up 0.2 per cent as of the end of May and would have been a lot worse off if it weren’t for energy stocks. In comparison, the S&P/TSX composite total return index returned 7.5 per cent.

“Small caps tend to underperform when there’s a lot of fear in the market, mostly fear of a recession,” said Martin Ferguson, manager of the Mawer New Canada Fund. “Fear of slowing economies or tougher times causes people to try to avoid risk, so they’ll sell their small-cap companies. They equate illiquidity with risk, but that’s not always the case.”

“What we’ve seen so far in 2008 is a lot of small caps really getting hammered, simply because they’re smaller companies, not because that they are poor companies,” he said.

If you can stomach the risk, it may be a good time to look for small-cap bargains. Here are some tips from small-cap experts that will help you unearth some companies with lots of potential.

1. Look for companies with competitive advantage, whether internal or external.

In order to have high returns on their capital, Mr. Ferguson said that a company has to have a competitive advantage, and hopefully more than one – whether it’s pricing power, power over customers or suppliers, barriers to entry in the business, or companies that have patents.

“It’s these competitive advantages that allow a company over the long term to generate a higher return on their capital,” he said. “So those are the companies that we’re focused on and that is a way to find good companies in rough markets,” he said. One example of a small cap like this that Mr. Ferguson has found is Parkbridge Lifestyle Communities Inc. (PRK-TSX), Canada’s largest owner and operator of land-lease communities, also known as manufactured home communities. The company has a good real estate business model, said Mr. Ferguson, and its competitive advantage is attributed to its very low turnover of tenants, the little capital expenditure that is required, built in growth opportunities, experience managing the properties and unlevered balance sheet.

He also points to ZCL Composites (ZCL-TSX), a leader in underground storage tanks, as another example of a company with competitive advantage, because of their ability to make underground storage tanks that don’t corrode, rather than those made of steel. They are also gaining market share, and are taking their best-of-breed product into the United States through the purchase of another company.

2. Growth.

As small-cap companies are riskier by definition, you want to identify companies that have superior growth prospects. “To go to a small-cap company, you want something that can provide you with a greater potential for growth than you would with a similar large-cap,” said David Whetham, manager of the Scotia Canadian Small Cap Fund. Growth can come from superior service, products or pricing, he said. “If it’s a company that’s sort of a ‘me-too’ type company, then you sort of have to question whether the growth is sustainable and whether it’s realistic,” he said.

3. Management.

By their nature, small-cap companies will have less depth in management and on their boards. Good management is therefore a key issue with small caps.

“Certainly in cases where it’s an entrepreneur, where the entrepreneur continues to control the company, they’ve gone public but maintain control, you do have to be a little more careful and make sure that they’re actually running it as a public company for the benefit of all the shareholders,” said Mr. Whetham.

Investors should also understand how management plans to reinvest the cash flow it is generating.

“The company has to understand what their strengths are,” said Mr. Ferguson. “You quite often see small companies a) take too much risk, so when you’re assessing management, find out how much risk they’re taking and b) they don’t stick to the company’s strengths.”

Mr. Ferguson said he will never invest in any company until he talks to management to know how they’re going to reinvest, or to know how they think. He notes that it is hard for individual investors, as they don’t have the same access to management, but they can still read annual reports and quarterly reports.

4. Make sure you don’t take on too much risk.

As an investor in small caps, you do have to be a bit more cautious, as companies have less flexibility than their larger counterparts.

“You have to be a little more careful just because problems in a smaller company are going to be accentuated with the size of the company,” said Mr. Whetham. Smaller companies can be dependent on a single product line or asset and are less diversified. “If you can, you want to be a little more careful about companies that are dependant on one specific large customer and just make sure that if that’s the case, it’s a good relationship,” he said.

5. Be patient.

With small caps, no matter the quality of the company you find, it will be affected when the market goes down, said Mr. Ferguson. “Don’t be afraid of that and again, don’t move off the small caps because there’s risk,” he said. “Quite often the best time to buy small caps is when other people are anxious or are worried about the market or the economy because then we get people selling for reasons of fear.”

Special to The Globe and Mail