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Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

If you check the official stock index returns for Canada, you will definitely conclude that 2013 was a poor year for small-cap investors. The benchmark S&P/TSX Composite was up 9.6 per cent for the year, the S&P/TSX Small Cap index lagged with a modest 4.4-per-cent gain, and the Venture index essentially cratered, with a collapse of 23.7 per cent. Clearly, a bad year for small cap, risk-oriented investors. So, I was surprised to read an article in this weekend's Financial Times that extolled the virtues of small-cap investing last year.

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It turns out that Canada was one of the few countries where small caps lagged during 2013. In fact, we didn't even get a mention: Brazil and Mexico were identified as the only laggards in the MSCI small-cap index, with the standout winners being Portugal, Japan, Italy and the United States. Some of these countries are not easily accessible for individual investors, but the U.S. was a goldmine for the adventurous. The benchmark S&P 500 Index was up a healthy 29.6 per cent, but the Russell 2000, a small-cap index, rose by a stunning 37 per cent. More important, the article points out that, based on MSCI data, since 2000 "small caps have beaten rival large-cap indices by 6.7 percentage points a year – an astonishingly large gap."

Is this a case of risk-averse Canadians simply not recognizing opportunity when it stares us in the face? No, it just reflects the profile of our small-cap universe, which is heavily exposed to the resource sector. As a group, commodities sold off sharply during 2013, with only natural gas recording a meaningful gain. Commodities make up a large part of the Canadian small-cap universe and fell by more than 30 per cent. In contrast, there are not many Canadian small-cap banks or insurance companies. They make up 35 per cent of the large-cap benchmark and were up 19.1 per cent for the year. So, Canadian small-cap index returns tell us a lot about the industry composition of the index and not much about our attitude toward risk and return.

After a stellar year in 2013, the Financial Times is naturally restrained in its enthusiasm for small caps this year. Their long-term outlook remains positive, however, simply because most investors are too risk averse and perennially underprice the sector. For Canadian small-cap investors who missed out on last year's global bonanza though, 2014 could be the year in which financially sound small-cap resource stocks turn the tables on the benchmark indexes.

If you are a value investor, why not start your search for out-of-favour resource stocks with the Ben Graham net-net working capital screen? Stocks that pass this screen are trading below the liquidating value of their net assets, so that should leave a healthy margin of safety. As it happens, three of the nine Canadian stocks that passed the net-net working capital screen at the end of last year were resource plays listed on the Venture Exchange: Monument Mining Ltd., Energold Drilling Corp. and Mirasol Resources Ltd. Needless to say, do your own research on these companies – "net-net" stocks are cheap for a reason.

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About the Author
Robert Tattersall

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments. More

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