Canadian small cap stocks have been out of favour with investors for some time and the ongoing global credit crisis plus the prospect of a continuing global economic slowdown is hitting them hard. What should investors in small caps be doing at this juncture? Which sectors in the small cap universe have been the most vulnerable in the correction? How are the specialists in managing small caps dealing with the challenges to their universe? Buy and Sell columnist Sonita Horvitch asked a panel of five star small-cap portfolio managers to provide their insights into these and other key questions.
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Q: How did the Canadian small-cap index perform relative to the large-cap index?
Lane: Year to September 12, the BMO Small Cap Blended Weighted Index, the generally accepted benchmark for small caps in Canada, was down 20.8% versus the S&P/TSX composite, which fell 7.7%.
Carscallen: The BMO blended index, which includes income trusts, has done better than the weighted equity-only index. The equity only index fell 26.4% year to Sept. 12, versus a fall of 20.8% for the blended index. One reason is that the equity-only index has a higher weight in materials. This has been one of the worst-performing sectors in the small-cap segment thus far this year, largely due to weakness in metals and mineral commodity prices. Another reason is that the income trusts, in particular the oil and gas royalty trusts, have assisted the blended index. Energy was one of the best performing sectors in the small-cap segment. Year-to-mid-September, it is the only positive performing sector of the 10.
Ferguson: It is the fifth straight year of under performance for the small caps. Small caps tend to do poorly in times of economic weakness. Over the last four years, there has been considerable concern about the slowing U. S. economy and there is now a high probability that there will be a recession in the United States. Periods such as these, when negativity abounds, typically represent a good entry point into small-cap stocks. The current situation could present such an opportunity for the long-term investor. But, over the next six to 12 months, there could be continued volatility.
Lane: It should also be noted that the S&P/TSX venture index, with its heavy exposure to the metals, is also down sharply this year. This index lost 43.4% to Sept. 12. There is little appetite for risk among investors. Companies quoted on the venture exchange are perceived to have higher risk. Another issue in the small-cap space is that the junior natural resource companies are having difficulties obtaining financing for their projects. The funding window has closed and many projects will not get completed this cycle.
Ferguson: It is a historical pattern in the small caps, with fear coming to fore when there are concerns about the economy. I have not seen such a negative approach to the small-cap segment since the height of the technology bubble, when investors sold small caps to buy tech stocks. But it must be remembered that the equity market precedes the economic cycle and small caps can start to outperform in the middle of a recession.
Carscallen:We are value managers and we look at price to book value per share as one of our key metrics. Currently, using this metric the BMO blended small-cap index is trading at a 40% discount to the S&P/TSX composite index's price to book ratio. We have not seen this kind of discount since the Internet boom, which was roughly in 1999/2000, when the discounted widened to almost 50%. Thereafter, this discount narrowed to about 10% in 2004. During this time period, we saw the small caps substantially outperform their big-cap counterparts. The current large discount could augur well for small-caps.
Law: Our strategy has been to focus on capital preservation and high-yielding trusts/stocks in this volatile stock market environment. At present, the small-cap market is not being driven by valuations. The small-cap mutual funds are being faced with redemptions by investors. There is a flight to liquidity, which favours larger caps. As investors reduce the leverage in their portfolios, there is a rush to raise cash. Stock prices are then driven down, which causes even more selling. The small-cap index is officially in a bear market, down 20.8% to Sept. 12. Looking at the sectors, the worst performing were consumer staples and materials, with sharp declines in both the metals and gold stocks.
Lane: Corporate buyers have been acquiring smaller caps. They are either recognizing the strategic value in these businesses or the fundamental value, which the market is ignoring. There is a disconnect between the equity market's valuation of these smaller companies and their fundamental value. This disconnect cannot continue indefinitely.
Q: The outlook for small caps versus larger caps?
Carscallen: In the short-term, given the ongoing credit crisis, there is likely to be a continuing preference among investors for liquidity, which could result in small caps coming under further pressure. In the medium to longer term, there is a prospect of outperformance by small caps versus large caps, as the valuation discount narrows. The focus should be on small-cap stocks that have a clean balance sheet, solid revenue and profit generation and the ability to sustain the operations internally without need for external funds.
Whitehead: The final quarter of the year is traditionally a strong quarter and might represent a buying opportunity in small caps provided investors have a long-term view, say three to four years. I have been favouring larger caps in the small cap portfolios I manage. In the Manulife Growth Opportunities Fund, I have made full use of the 10% in large caps that I am allowed. But I might swing back and add more smaller caps as valuations are so cheap.
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Tomorrow:The big economic picture, the outlook for earnings growth and the panel's overall strategies for shielding their portfolios.
