When you focus specifically on medium-sized stocks, you tend to catch companies either on the way up or the way down.
The mid-cap market in Canada is a stepping stone for younger success stories en route to greater prominence, such as Shopify Inc., for example. And it’s a kind of penalty box for companies that have fallen afoul of investors and need to attempt a turnaround, such as BlackBerry Ltd.
“There’s an element of forced buying and selling” as stocks move in and out of the mid-cap space, said Marcello Montanari, a portfolio manager at RBC Global Asset Management. “It’s a structural thing that gives us a bit of a tailwind every year.”
Both Shopify and BlackBerry spent time in the RBC Canadian Mid Cap Equity Fund, which Mr. Montanari co-manages and which had $225-million in assets under management as of the end of September. It was recently recognized by the Lipper Fund Awards for industry-best returns among comparable Canadian funds. Lipper Inc., a unit of Thomson Reuters, handed out awards this week to dozens of Canadian mutual funds and exchange-traded funds for performance across several different categories.
Mr. Montanari spoke to The Globe and Mail about the approach that has generated an average annual return of more than 10 per cent over the past three years – the time frame for which he won the award.
What pool of stocks do you focus on?
We take the S&P/TSX Composite Index [made up of about 250 stocks] and we lop off the 25 per cent largest companies by market cap and we lop off the bottom 25 per cent and we’re left with the middle 50 per cent. When you do that you lose all the big banks, the big insurers, the telecoms and the big energy companies. Mid-cap energy tends to be more skewed toward exploration and infrastructure plays. Real estate plays a bigger role in this fund. You get a much bigger utilities segment, but it’s skewed to a great degree toward renewables. And the industrials space is much bigger. So you kind of get this barbell. Part of the fund is very cyclical and yet it has this stability on the other side in terms of real estate and utilities. [The fund currently has around 80 holdings.]
How are you approaching those sectors in a rising rate environment?
We’re looking for names that can actually show growth to offset the drag from the macro rate environment. Allied Properties REIT is an example. They’re taking B-space in major cities and converting it into space that’s highly attractive to knowledge workers. And they’re not as levered as a lot of the other real estate companies.
Are there common characteristics to mid-cap stocks in general?
They’re a lot more volatile. There’s a lot of growth. And the mid-cap space is prone to a lot of M&A activity. Every year there are two or three companies that we don’t own that get taken out. We didn’t own Enercare Inc., and Brookfield Infrastructure Partners LP came in and paid a hefty multiple for that. So that’s hurting. But we owned Pure Industrial REIT, which also got taken out.
How does the pool of stocks to pick from change over time?
Every quarter when they rebalance the TSX index, companies graduate out of our benchmark, when they become large cap. So we lose them. On the flip side, companies that are having difficulties, they fall into our index. Every year that happens a couple of times with a couple of big names. Bombardier is a good example. We bought it and watched it rise and graduate out of our index again. And if things keep going the way they are, Bombardier will be back in our index soon enough.
When stocks get demoted like that, how do you decide when to get in?
Our resident technical analyst puts things through a technical screen. Then we have a turnaround checklist with about 25 points that you want to see with a company that’s on the right path. The most important things are usually a complete swap out of management. The managers that got you into trouble are typically not the ones that are going to get you out of it. You need to stabilize the financials. And you ask, does the product that this company sells still resonate with its customers? If the answer is no, then you’re just not going to touch it.
This interview has been edited and condensed.