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Got patience and a strong stomach?

'You have to be prepared to accept volatility so you don't end up selling at the bottom'

Small caps are hurtin' big time. In January alone the average global small- to mid-cap fund lost more than 7 per cent of its market value and Canadian small- to mid-cap funds took a bigger drubbing with a 7.8-per-cent loss.

In both asset classes the January slide amounts to last year's entire loss. It's a long way down considering the annual five-year return for the average global small- to mid-cap is holding up at 12.3 per cent and the annual 5-year return for the average Canadian small- to mid-cap fund is up 16.5 per cent.

The global credit crunch and resulting broad equity market sell-off are mostly to blame, but two different factors are adding to the pain: returns from foreign denominated smaller-cap stocks are being diminished by the strong Canadian dollar and Canadian smaller caps are suffering for their reliance on commodity prices, as things like crude oil and base metals come under pressure from a global economic slowdown.

"These [Canadian] names are very much levered to global economic growth as opposed to other economies where the small-cap market might be more focused on domestic growth," says Lesley Marks, vice-president of Jones Heward Investment Counsel Inc. Her $370-million BMO Special Equity fund holds Canadian stocks with market capitalizations between $100-million and $1-billion - nearly half of which are connected to commodities.

Ms. Marks says the key to making money from smaller caps is a mixture of patience and a strong stomach. "You have to be prepared to accept volatility so you don't end up selling at the bottom," she says.

She expects commodity prices to hold steady or rise in the short-term and is reacting by buying well managed companies she feels have been unfairly beaten down by the broader sell-off. Those companies include gold miners such as Toronto-based Detour Gold Corp.

She's also buying into the abundance of small-cap companies involved in natural gas production. "They're just starting to show strength because of the slowdown in drilling and the depressed prices we have seen over the past 12 months," she says.

The tradeoff for all that risk in smaller caps is potential for rapid growth, which could either transform a small company into a large cap or a takeover target with a tasty premium.

That potential for growth is why the BMO Special Equity fund has an 11-per-cent weighting in the information technology sector. Ms. Marks considers Vancouver-based Absolute Software one of the fund's most promising holdings. "We've experienced some top line slowdown in some of our names but generally there's still opportunity in this group," she says.

An estimated 80 per cent of all publicly traded stocks in the world have market capitalizations under $20-billion - the general definition for global mid caps. They have performed better than their big brothers in the large-cap arena lately. In Canadian dollars, the benchmark Globe Global Small/Mid Cap Equity Peer Index fell 11.1 per cent last year and gained an average 12.3 per cent annually over the past five years. In comparison, the large-cap MSCI World Index fell 15 per cent last year and gained only 7 per cent annually over the past five years.

"Over the long haul, small caps should outperform large caps," says Bob Tattersall, executive vice-president of Howson Tattersall Investment Counsel. He holds a 70-per-cent small- to mid-cap weighting in his $331-million Saxon World Growth fund - and he's looking to buy more in the U.S. where the benchmark Russell 2000 index fell 23.3 per cent last year.

"I'm hoping that much of the negative sentiment associated with being small has already been reflected in the market action during the second half of last year," he says.

Managing a global equity fund allows Mr. Tattersall the opportunity to choose any stock, anywhere. While 40 per cent of his holdings are in the U.S., he has also begun to take a shine to Canadian smaller cap natural gas plays. "They are now at valuations we find quite attractive," he says.

Paul Vaillancourt specializes in asset allocation for Fiduciary Trust Company of Canada. According to his model, a typical investment portfolio should devote one-quarter to one-third of its total equity assets to small and mid caps - depending on the individual investor and the extenuating market climate.

He says the superior growth potential for smaller companies can help give a jolt to the overall portfolio but it's good to dilute the risk with bigger stocks. "They typically don't have the ability to diversify their business by different product lines so they're going to be more volatile than larger cap companies," he says.

Growth also requires access to capital - one other factor that makes smaller caps riskier in the age of tightening credit. "They have fewer options for sources of capital than more established, larger companies," he says. "With a global slowdown, we'd prefer to go with larger cap multinational companies."

Within his small- to mid-cap portfolio, Mr. Vaillancourt agrees valuations are attractive in the Canadian natural gas space. However, the recent run-up in commodities and the resulting run-up in the Canadian dollar could mean investors can get more bang for their small-cap buck outside the country.

"From a growth and valuation point of view, global small caps would appear more interesting to us than Canadian."

Dale Jackson is a producer

at Business News Network.


Top five-year performers

Canadian small- or mid-cap equity funds

FundAverage annual return
Sceptre Equity Growth+31.0%
Norrep Fund+26.6%
Dynamic FocusPlus Small Business+25.7%
Norrep II Class-A+24.6%
Northwest Specialty Equity+21.1%

Global Small- or mid-cap equity funds

FundAverage annual return
Mackenzie Cundill Recovery 'C'+23.7%
AGF Aggressive Global Stock+15.3%
Dynamic Global Discovery+14.8%
AGF Aggressive Growth+12.7%
IA Clarington Global Small Cap+12.3%


© 2007 The Globe and Mail. All rights reserved.

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