Analyst’s report: Dynamic focus + small business

Veteran Oscar Belaiche and newly minted co-manager Jason Gibbs are looking pretty smart these days. While most Canadian small-cap funds sport losses in the double digits over the past year, management’s decision to keep cash on the sidelines has shielded the fund from steep losses. They have also done a fairly decent job ferreting out winners in the income trust space. However, high fees tarnish an otherwise appealing offering.

The fund’s cash position is determined by management’s ability to find attractively valued securities as well as its view of macroeconomic trends. It is primarily the latter that prompted Belaiche and Gibbs to increase cash levels as early as April of last year. That move has proved prophetic. With recent troubles in the Canadian small-cap market, the fund’s 33% cash stake has been an effective cushion, making it one of the best performers in the category despite posting a 2.2% one-year loss.

But while this cash allocation strategy has worked in the fund’s favour over recent periods, we don’t expect the duo – or any manager for that matter – to make perfectly timed market calls on a consistent basis. In this case, the fund will likely underperform if the market enjoys a sudden rally and management is slow to put cash to work. As well, its changing asset mix will frustrate investors who prefer to have control over how much they devote to stocks, bonds and cash.

The managers follow a style they call QUARP (quality at a reasonable price). The underlying company must be a leader and retain a competitive advantage in its industry, have sustainable cash flow and possess quality management with a significant equity stake in the business. The managers will sell a security if its fundamentals deteriorate or if it no longer offers sufficient return potential. They attempt to control risk by maintaining informal limits on individual stock and sector weightings. Cash is also used to reduce volatility and is determined by the availability of investment opportunities and macroeconomic indicators.

The fund’s strong performance over longer periods is mainly due to its heavy bias toward high-flying income trusts. Recent homeruns include Crescent Point Energy Trust, an oil and gas producer in Western Canada, and Bird Construction Income Fund, a general contractor with operations in Canada and select areas in the United States.

But ever since the government announced its plans to tax trusts like corporations, there have been mounting concerns about the future of the trust market. However, a possible tsunami of trust conversions shouldn’t materially impact this fund’s prospects. In our opinion, whether a business structures itself as a corporation or a trust is inconsequential when considering factors like valuation, growth prospects, competitive risks and so on. In either case, management’s expertise in analyzing these businesses should continue to work to the fund’s advantage.

Hindering the fund is its chunky 3.08% managementexpense ratio, which makes it one of the most expensive funds in the category. Granted, funds with a tiny asset base like this one are normally costlier than larger funds because they don’t enjoy the benefits of economies of scale. Nevertheless, the fund is affixed with a 2.25% management fee, which virtually solidifies its high cost status.

OF NOTE The fund’s hefty income trust stake makes peer-group comparisons a less than perfect exercise.

While Belaiche and Gibbs are acutely aware that trusts will be stripped of their tax-exempt status in 2011, they believe those concerns are fully reflected in current valuations.

A long-held bias toward real estate securities is a manifestation of Belaiche’s working experience. He is a veteran real estate hand, having worked directly in the industry for several years before joining Dynamic.

Belaiche also runs Dynamic Focus+ Real Estate, which is featured among our Fund Analyst Picks.

KUDOS & QUESTION MARKS •A cash allocation strategy has helped the fund avoid significant losses. •Belaiche’s real estate experience is a definite plus. •Gibbs is fairly new to the portfolio management scene. As such, the loss of Belaiche would cause us to reconsider our opinion of the fund. •Correctly making top-down calls is a tough game to play. •Fees are too high for our liking.

Jordan Benincasa is a fund analyst with Morningstar Canada.