A cap-size view of Canadian equities

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For decades, the Canadian equity market has been criticized for its small position in the global market, its risky concentration in the financial and resources sector, and not all that long ago, the federal government’s hand in regulating the banking system and squelching mergers.

Sentiment has changed dramatically in the aftermath of the U.S. credit crisis that’s turned Wall Street financial giants that were once household names into mere footnotes in academic case studies.

In the ensuing market nosedive, the Canadian financial system stood strong and the world has taken note. That said, many Canadian investors are still feeling the impact of the 2008 market decline on their portfolios and remain concerned during these uncertain economic times.

To get the lay of the land for Canadian equities, we’ve tapped into the collective experience of four investment managers, who offer their views across the capitalization markets. Most are bullish moving about the future, but still retain an air of caution in their overall sentiments.

While it’s true Canada offers a smaller investment market compared to bigger countries, there are over 1,500 stocks to choose from that span all sectors.

Large-cap

The blue-chip, large capitalization area usually comes to mind when investors think Canadian equities, so we’ll start with this category.

As a predominantly large-cap portfolio manager, Doug Warwick, managing director, TD Asset Management has seen his TD Dividend Growth Fund grow from $25 million in assets under management to $4.2 billion.

With the benefit of hindsight, Warwick credits time and patience for the double-digit returns, along with its mandate for dividend-paying companies.

“We’ve found that it’s often the large-cap companies in the Canadian universe – the dividend players and the dividend growers – that actually do the best and have stood the test of time,” says Warwick.

He believes after “the big snap down in prices” and subsequent recovery, there are many stocks in Canada, and worldwide, that offer dividend yields in excess of available interest rates. “So I think it’s a golden opportunity to increase your income when the principal could grow reasonably well over inflation, over time,” says Warwick.

“We’re a country with lots of resources, lots of materials and lots of energy that we can sell to the world,” he adds, “so I think Canada is a great place to be.”

The big banks

While cyclical swings and market volatility can affect the best of blue-chip companies, Warwick believes the big, dividend-paying banks offer the safest haven.

The further you go back in time, the greater your return from dividends and the magic of compounding. Warwick cites the example of the S&P 500 Index over the last 20 years, where 45% of the return has been from dividends, but over a longer period, “I’ve seen numbers of 75% or more coming from the compounding of those dividends over time.”

“If you look at the Canadian bank stocks over the last 50 years, or almost any period, they’ve outperformed the TSX on a total return basis,” says Warwick. “To me, the lesson there is you own them all.”

The meltdown, failure or bailout of many large American players silenced most critics, and looking ahead, Canada is considered to be in the best shape of the G8.

Still, that logic and soundness doesn’t always play well with investors. For example, whenever people ask Warwick for ideas for their RRSPs, he recommends a couple of bank stocks, noting they can grow 8% to 12% a year, and a dividend re-investment program adds the power of compounding.

“Then they hear about this little gold stock, that seems to promise a lot higher returns in a year’s time,” says Warwick, “and they will buy that stock every time.”

The mid-cap zone

An area that sometimes doesn’t garner much attention in Canada is mid-cap equity, yet with about 170 members in that universe, it is nearly three times larger than the large-cap S&P/TSX 60 index.

Anish Chopra, vice-president and director at TD Asset Management Inc., defines the capitalization in this group as between $1 billion and $5 billion. As the portfolio manager of the TD Canadian Value Fund, Chopra sees great investment opportunities in this group.

“The mid-cap area has a lot of solid companies that you wouldn’t think of as mid-cap,” says Chopra. For example, among the current top 10 constituents by market cap is Great-West Lifeco Inc. and RioCan Real Estate Investment Trust. “So in the mid-cap space, it’s not just materials, oilsands and energy; there is a blend of other businesses as well.”

Chopra’s stock-picking strategy for this range looks at the same fundamentals as large caps: solid balance sheets, sustainable revenues, competitive advantages, good management teams and higher returns on capital. But more prudence is needed in mid-cap territory, since the liquidity isn’t as high compared to some of the large cap stocks.

Small-cap

Alexander Lane, vice-president at Goodman & Co., Investment Counsel Ltd., would like to dispel the myth surrounding small-cap stocks.

“The perception is that it’s a very risky asset class,” says Lane, “and that the people who are in it are always trying to hit home runs with every swing. I do not subscribe to that theory.”

His recommendation for the average investor is a 5% to 10% allocation to small-caps as a “return enhancement, risk reduction tool” within the overall Canadian equity exposure.

Among the investment universe of small-cap companies, the definition varies, but is generally considered $1.5 billion or less in market capitalization.

An important thing for people to keep in mind, says Lane, is all the best and largest companies in the world started out as small companies.

That’s not to say Lane isn’t cognizant of the risks that lie in the small-cap arena – especially during a market decline. First is liquidity risk, the second is financing risk, but also important is how economically sensitive the company is.

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“I felt very alone in 2008,” he says, “it was a very dire environment.” But conversely, as sharp as the downturn was, the recovery should also be as sharp, he adds.

Looking at recent performance in the small cap area, recovery seems to be in play. “It’s completely normal to what happens in an economic recovery,” says Lane. “Here I am, pounding the table on my space, because I see three to five years of runway here, if not more.”

He thinks the probability of outperformance in this asset class is exceptionally high, based on all historical analysis. “Our belief is that we’re in an economic recovery, and small-caps are absolutely beating the pants off almost any other asset class out there, except for precious metals,” he says.

Allan Jacobs, director of small cap investments and senior portfolio manager at Sprott Asset Management, shares Lane’s positive sentiments moving forward.

“Small-caps have historically outperformed for approximately three years following recessions, so we’re in a good cycle, I think,” he says. “The other thing is there’s tons of choice in small companies, and some of them are doing very well despite a challenging economy.”

As a small cap veteran, Jacobs is well versed on the performance nature of the small cap universe. “They’ve underperformed for five years in a row, which is not unusual, considering the cycles are very long – they’ve been roughly four to seven years.

“But stocks aren’t nearly as cheap as they were a year or a year and a half ago – they were completely bombed out when the world almost ended – but I think there’s a lot of good value still.”

Micro-cap

Compared to small-cap companies, Jacobs says micro-caps have a bigger weighting in mining stocks, including drilling and exploration, which have moved a lot in the last couple of months.

In the technology area, his team has found a few micro-caps that have done very well, “but you’ve got to be careful with micro-caps,” he says. “You don’t buy a lot of them; they don’t have any earnings, and there’s the liquidity risk.”

A lot of small companies start off as micro-caps and you make the most money in the first six or 12 months, when the valuations are so low. But you’ve got to know what you’re doing, and the liquidity risk is obviously higher.

“Sometimes people try to buy micro-caps themselves from someone telling them something,” says Jacobs, “but they often don’t work out. It’s like everything, you should have a diversified portfolio, it’s very important;” says Jacobs.

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Diana Cawfield is an award-winning freelance writer, specializing in finance.

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Diana Cawfield