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‘Turning over the stones’ to find small-cap gems

Individuals wanting exposure in this sector – especially in the U.S. – may find it easier to turn to a well-managed mutual fund to get potential growth

By: TERRY CAIN

Date: May 14,2014

Canadian investors have a natural tendency to do much of their investing in the domestic market. After all, why not buy companies that are based nearby, that you may know first-hand, and also avoid complications such as currency exchange rates?

The main problem with this strategy is that it ignores the vast majority of the investing world. As well, it usually results in Canadian investors being insufficiently diversified. That leaves them susceptible to unexpected ups and downs in the domestic economy – as well as overly concentrated in just a handful of industries, most of them linked to natural resources.

Many Canadians may look to rectify the situation by turning to the huge economy and financial market to our immediate south. There are certainly many American blue-chip companies that are world leaders, and can fill in the gaps of a Canada-focused portfolio. But smaller U.S. companies may be an even more attractive area for investors to consider.

Steve MacMillan is the manager of the Fidelity Small Cap America Fund, as well as the Fidelity American Equity Fund. The Small Cap Fund has been in existence for nearly 20 years, with an average annual return of more than 10 per cent. It has been one of the top performers in its group in each of the past five years.

Mr. MacMillan says his investing approach differs from common perception.

“People may have this idea of small-cap investing as ‘high-risk, high-return, high-volatility’ stocks. But if you look at our fund, it’s quite the opposite. I’m not looking for stocks to double or triple – I want consistent returns. High-quality businesses with high return on equity, high cash flow, high earnings stability, and a high level of confidence they will still be around in five to 10 years.”

Mr. MacMillan says this approach leads him away from speculative areas such as biotechnology and Internet stocks. Instead, he focuses on consumer stocks, service companies with recurring revenue and smaller companies that dominate their niche.

Mr. MacMillan points to one of his fund’s top holdings as an example: Hanesbrands Inc., an American clothing company based in North Carolina.

“You can’t get more boring than T-shirts and socks,” he says. “It’s the kind of company I like – a strong brand, it can price its products above its peers, very stable demand.”

He bought into the company when its growth potential was not priced into the stock – but Hanes has managed to expand its sales and margins and make successful acquisitions, leading to a near-doubling of its share price last year.

Mr. MacMillan points to a number of major differences in small-cap investing in the United States compared with Canada. One is simply size. The average market capitalization of companies in the Russell 2000 small-cap index is $1.85-billion (U.S.). For the S&P/TSX Small-Cap Index, it is $625-million (Cdn.).

A second difference is the breadth of the two countries’ markets. The TSX Small-Cap Index is made up of 216 companies compared with 2,000 firms in the U.S. Russell 2000 index.

A third difference is sector diversification and concentration. Over all, the TSX is made up of 30 per cent energy stocks and 22 per cent materials (mainly mining). That means more than half of the index is driven by commodities. In the United States, four sectors account for roughly 20 per cent each of the Russell – financials, technology, health care and consumer goods. It’s also worth noting, Mr. MacMillan says, the last three of those are under-represented in the Canadian market.

Yet another difference is the focus, or concentration, of the businesses in each country’s small-cap sector. About 85 per cent of the revenue for the Russell 2000 companies is generated within the United States. In contrast, the commodity weighting of the Canadian market means it is much more exposed to the ups and downs of the global economy and world demand for resources.

Douglas Cumming studies small-cap investing as part of his work as a professor and the Ontario Research Chair at the York University Schulich School of Business in Toronto. One difference between Canada and the United States he notes is the “significantly lower” listing standards on the TSX Venture Exchange than the TSX – and standards for both are significantly lower than the Nasdaq and New York Stock Exchange. On the other hand, Prof. Cumming has researched the rate of detected fraud in the two countries, and found it to be higher in the United States than in Canada.

For individuals wanting to successfully invest in small-cap stocks in any country, Prof. Cumming says there is one key. “Due diligence. Read the company’s prospectus and follow their news announcements before deciding whether or not to invest.”

Prof. Cumming also points to risks, including lack of liquidity, higher trading costs and higher volatility. He also notes that despite all the buzz over “hot” IPOs, or initial public offerings, new public companies typically underperform in their first year of listing.

Mr. MacMillan at Fidelity agrees that there are difficulties for individual investors wanting to play the small-cap sector – especially in the United States.

“It’s the breadth of the market – trying to ‘turn over the stones’ to find the gems. Last year I saw about 400 companies and invested in 10 of them. That wouldn’t be practical for individuals. Having a professional dedicating their time to it just makes sense.”

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