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Mutual Fund News

Small really is beautiful

Small-cap funds have been outperforming their larger brethren, and the ride isn't over yet, experts tell GAIL EL BAROUDI

Special to The Globe and Mail

Large, blue-chip stocks have often been seen as a port in a storm by conservative investors, while small-cap stocks have usually been considered too risky and volatile for them.

But that conventional wisdom has been turned on its head throughout the bear market.

Small has been more beautiful than large, if mutual fund results are any indication.

In the year ended Oct. 31, the average Canadian large-cap fund tumbled by 9.1 per cent and the average Canadian equity fund lost 6.8 per cent. But the average small-cap fund posted a comfortable gain of 5.4 per cent.

These returns mirror the performances of the major indexes during the past 12 months closely. The S&P/TSX composite index lost 9.3 per cent while the Nesbitt Burns Canadian small-cap index managed a 6.3-per-cent gain.

And this discrepancy isn't just a one-year wonder. For the three years ended Oct. 31, Canadian large-cap funds lost an average annual 1.3 per cent, Canadian equity funds gained a scant 0.1 per while small-cap funds were up an average 3.3 per cent. Over the same time, the S&P/TSX lost an average annual 4.8 per cent versus an average annual gain of 4.9 per cent for the Nesbitt Burns index.

The reasons for the difference in performance are rooted in the recent past, says Dan Hallett, senior analyst at Windsor, Ont.-based Sterling Mutuals Inc.

"From late 1998 to the spring of 2000, all the emphasis was on high-profile, growth stocks and small caps were completely ignored. But when technology stocks began to unravel, there was a return to value investing and the value was in small caps," he says.

Over the past two years, small-cap funds have convincingly outperformed mid-cap ones, which in turn have done somewhat better than the large-cap ones, he adds. "The smaller the company, the cheaper the stock," making small caps the happiest hunting ground for value investors.

And the ride isn't over yet. James Gautier, fund analyst with Toronto-based Dundee Securities Corp., says that small caps will continue to be outperformers, particularly if an economic upturn materializes. "In any case, small caps are still undervalued relative to large caps. There is still about a 20-per-cent discount and that's where the opportunity lies."

One of this year's stellar performers has been the $60.1-million Bissett Small Cap Fund, which has gained 24.6 per cent. Lead manager Gary Aitken says that in the late nineties, money poured into the large caps. "But when the technology bubble started to burst, people began asking themselves why they should pay 100 times earnings for unproven companies while profitable small-cap ones were trading at 10 times earnings."

Mr. Aitken, vice-president of Calgary-based Bissett Investment Management, a division of San Mateo, Calif.-based Franklin Templeton Investments Corp., and his partner Chris Fernyc, who have managed the fund since 2000, look for growing companies with a record of consistent profits.

"That consistency is very important to us and we tend to find companies like this in consumer goods and industrial products," Mr. Aitken says. "There are no resources in the fund, except for some oil and gas producers."

Among the fund's holdings are Dorel Industries Inc., a household furniture maker, and GTC Transcontinental Group Ltd., a commercial printing company, both based in Montreal. The fund also holds Calgary-based Bonavista Petroleum Ltd., an intermediate oil and gas producer.

In the first quarter of 2000, small caps were trading at a 40- to 50-per-cent discount to large-cap ones, on an aggregate value basis, Mr. Aitken says; today that gap has narrowed to about 20 per cent. But that's still a sizeable enough spread to keep small-caps enticing. "We think this valuation gap will continue to narrow and that small-cap prices will continue to rise, as investors keep focusing on value and fundamentals," he says.

The Elliott & Page Growth Opportunities Fund has also posted impressive returns. Managed since 1998 by Ted Whitehead, assistant vice-president of Toronto-based Elliott & Page Mutual Funds, the $31.4-million fund gained 15.4 per cent in the past year and an average annual 21.2 per cent over three years.

"We use a quantitative model to identify growth stocks, companies with positive earnings growth and positive price momentum, and we follow that up by looking at the fundamentals," Mr. Whitehead says. In the past year, that has put the focus on defensive companies.

Some of the winners for the fund, which contains both small- and mid-cap stocks, have included Masonite International Corp. of Mississauga, which manufactures building materials, and Fortis Inc., a St. John's, Nfld.-based utility.

"My view is that Canada's economic growth will be pretty good this year and that next year it will be further strengthened by a U.S. recovery," Mr. Whitehead says.

"It's the small-and mid-cap companies, in economically sensitive sectors such as consumer goods and manufacturing, that will give the maximum exposure to the recovery when it comes."

Keith Graham, lead manager of the $269.1-million Trimark Canadian Small Companies Fund and vice-president of Toronto-based AIM Trimark Investments, agrees small-cap stocks' superior values have fuelled the sector's rise.

"Two years ago, they were selling at a huge discount -- on the basis of earnings, cash flow and price-to-book multiples -- of anywhere from 25 per cent to 40 per cent and now that discount has narrowed to between 10 per cent and 20 per cent, but we continue to see opportunities," he says.

"Security selection has been the key to our success," says Mr. Graham, whose fund gained 15.8 per cent during the past year and has average annual returns of 20.6 per cent over the past three years. "There are various businesses at the small end of the market, neat, innovative little companies, and not much attention is being paid to them."

But he remains cautious. "There may still be a lot of potholes in the road, so we buy businesses that can do well, even if the economy does not," he says.

Recent winners have included Mississauga-based Canadian Medical Laboratories Ltd. and Bolton-Ont.-based Husky Injection Molding Systems Ltd.

Among the funds that Mr. Gauthier likes are the $84.8-million Saxon Small Cap Fund, run since 1985 by Bob Tattersall of Toronto-based Howson Tattersall Investment Counsel, because of its value approach and its long, impressive record; the fund was up 14.5 per cent in the year ended Oct. 31.

He also likes the Bissett Small Cap fund, saying he is "a big fan of their slow and steady approach."

Among Mr. Hallett's favourites are the $69.2-million Mawer New Canada Fund, up 31.1 per cent for the year, and the $28.7-million Standard Life Canadian Small Cap-A Fund, which gained 11.3 per cent. "The Mawer managers are value-oriented, sensitive to tax issues and invest in the fund themselves. In the case of Standard Life, I like the discipline, size and depth of their management team," he says.

© 2007 The Globe and Mail. All rights reserved.

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