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What are we looking for?

Steadier small caps.

The screen

For most investors, companies with a small market capitalization pose a couple of key risks. First, the illiquid nature of the companies can make it difficult to enter and exit positions at a reasonable price. Second, there’s the task of finding information about the companies themselves, which can be less readily available than their large-cap counterparts.

All this said, there may be some space in an investor’s overall asset allocation for small-cap stocks, especially if you have a long investment time horizon, which expands your risk capacity (or ability to endure losses). Further to this, not all small-cap stocks display the same levels of volatility. Today, I use Morningstar CPMS to look for steadier small caps, by ranking the 700 stocks in our Canadian database on the following factors:

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  • Five-year average return on equity;
  • Five-year growth rate in earnings per share;
  • Five-year deviation of earnings and total return (recall that deviation is a measure of volatility. Here we look for lower deviations of both reported earnings and the movement of the stock);
  • Five-year beta (recall that beta measures the historical sensitivity of a stock to an index. In trending markets, a stock with a beta less than one has moved less than the index, which we prefer in this case).

Only companies with a market float greater than $70-million and less than $1-billion were included. As a reminder, market float refers to the total value of shares available for trading and not owned by majority shareholders.

More about Morningstar

Morningstar Research Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Morningstar offers an extensive line of products and services for individual investors, financial advisers, asset managers, retirement plan providers and sponsors, and institutional investors. Morningstar Direct is the firm’s multi-asset analysis platform built for asset management and financial services professionals. Morningstar Canada on Twitter: @MorningstarCDN.

What we found

I used Morningstar CPMS to back-test this strategy from January, 2004, to April, 2021, using a maximum of 15 stocks with no more than four per economic sector. Once a month, stocks were sold if they fell below the top 35 per cent of the index based on the aforementioned metrics and replaced with the highest-ranking stock not already held in the portfolio. To account for the inevitable liquidity concerns, I assumed a liquidity cost of 2 per cent on each trade. This assumes that stocks were sold for 2 per cent less than their closing price on the last day of each month, and purchased for 2 per cent more. On this basis, the strategy produced an annualized total return of 15.5 per cent, while the S&P/TSX SmallCap Total Return Index produced 4.2 per cent.

The stocks that meet the requirements to be purchased today are listed in the accompanying table. This article does not constitute financial advice. It is always recommended to speak with a financial adviser or professional before investing.

Select Canadian-listed small cap stocks 

RankCompanyTickerMkt. Float ($ Mil.)5Y Avg. ROE (%)5Y EPS Grth. Rate (%)5Y Dev. of Ttl. Rtn. (%)5Y Dev. of EPS (%)5Y Hist. BetaDiv. Yld. (%)1Y Ttl. Rtn. (%)Recent Close ($)
1TerraVest IndustriesTVK-T187.417.334.330.917.
2Cogeco Inc.CGO-T796.018.97.727.
3Olympia Financial Grp.OLY-T77.358.812.630.519.40.85.630.048.99
4Pollard Banknote Ltd.PBL-T482.522.819.535.721.40.60.3289.758.30
5Leon's Furniture Ltd.LNF-T736.513.013.424.
6Andrew Peller Ltd.ADW-A-T320.213.910.
7Information Serv. Corp.ISV-T202.818.83.921.610.
8Stingray GroupRAY-A-T315.724.113.635.
9Algoma Central Corp.ALC-T267.54.722.824.818.61.24.0112.217.09
10First National Fin'lFN-T891.042.85.329.
11Altius Minerals Corp.ALS-T672.64.529.135.431.
12Lassonde IndustriesLAS-A-T509.912.53.627.710.40.01.443.4191.50
13Yellow Pages Ltd.*Y-T74.34,907.44.647.830.41.13.530.912.65
14Firm Capital Prop. TrustFCD-UN-X183.97.32.627.
15Park Lawn Corp.PLC-T992.86.914.

Source: Morningstar CPMS, data as of May 4. 

* Note that the average ROE for Yellow Pages Ltd. is exceptionally high owing to the low or negative book value of equity historically. This extreme value was accounted for in the ranking process. 

Ian Tam, CFA, is director of investment research for Morningstar Canada.

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