Historically Low Valuations Offer Rare Opportunity for Long-Term Alpha Generation
The Canadian universe of small-cap stocks can sometimes be overlooked and is often misunderstood, creating a high degree of price inefficiencies—as well as opportunities. This year’s market has been a nearly unrivalled example of that, writes Valentin Padure.
The country’s market leader in specialty pet retail operates a high-quality business underpinned by enviable margins and return on invested capital with a visible runway for high-single to low-double digit growth over the next five to ten years. The company’s strong visibility is driven by best-in-class franchise economics, which has cultivated a large and growing pipeline of new stores. Yet Pet Valu’s stock has suffered through much of 2023, driven by multiple contraction mostly as a result of, in our view, an overstated risk posed by a new e-commerce entrant to the Canadian market as well as misplaced fears of weakening consumer discretionary spending.
Pet Valu is an excellent example of the disconnect that can routinely arise in small cap between valuation and fundamentals. Macro drivers such as ongoing recession risk and monetary policy can also widen that disconnect, and not merely on individual names but Canadian small cap as a whole—which is exactly what we have seen.
The small cap market
Historically in times of volatility and uncertainty in the market, small cap companies underperform. They’re viewed as higher risk owing to their smaller size, higher cost of capital, lack of track record, yet most importantly, higher volatility–the conventionally accepted measure of risk. While small cap stocks tend to be more volatile, we look at risk from a business owner perspective, and take the view that stock volatility is not an automatic indication of business volatility.
With concerns over a recession and deteriorating earnings outlook rising, current valuations reflect a significant performance divergence between Canadian large and small cap equities, with small cap companies trading at a historic discount to larger peers. The graph below shows the forward P/E ratio for the TSX Small Cap Index versus the TSX. The valuation discount is at the widest level we have seen since 2002. This corroborates what we are seeing in small cap – extreme dislocations and very compelling opportunities for long term investors.
Source: Scotiabank GBM Portfolio Strategy, Refinitiv, as of July 24, 2023.
There is also a compelling case for allocating to small caps within Canada specifically vis-à-vis obtaining exposure through U.S. and International markets on a relative value basis. As shown in the charts below, Canadian small caps are trading well below the three-year moving average versus U.S. small cap peers, and one standard deviation below global peers (a support level going back to 2009).
Canada vs. U.S. small caps: Relative forward P/E ratio
Source: Scotiabank GBM Portfolio Strategy, Refinitiv, as of July 24, 2023.
Canada vs. MSCI ACWI small caps: Relative 12-month forward P/E ratio
Source: Scotiabank GBM Portfolio Strategy, Bloomberg, as of July 24, 2023.
We characterize companies in our investable universe on a quality spectrum ranging from 1 (highest quality) to 4 (lowest quality). The characteristics we look for are profitability, durable and predictable growth, strong balance sheets, and sustainable competitive advantages. We aim to own Quality 1 or 2 companies, with 95% of our portfolio is invested in such firms, which compares to 20% for the broader index.
There are short term periods where lower quality businesses do outperform. Yet higher quality companies historically generate much stronger outperformance over time, as valuations reflects superior fundamentals over intermittent positive sentiment.
TSX Small Cap Index Low Date | TSX Composite Index | TSX Small Cap Index | Small Cap Alpha |
|---|---|---|---|
20-Nov-08 | 39.9% | 45.7% | 5.8% |
04-Oct-11 | 3.3% | 4.5% | 1.2% |
19-Jan-16 | 23.2% | 50.8% | 27.6% |
24-Dec-18 | 18.9% | 16.8% | -2.1% |
23-Mar-20 | 55.7% | 91.4% | 35.7% |
Average 2008 – 2020 | 13.6% | ||
26-Sep-22 | 13.7% | 11.0% | -2.7% |
TSX Small Cap Index Low Date | TSX Composite Index | TSX Small Cap Index – Quality 1 Stocks | Small Cap Alpha – Quality 1 Alpha |
|---|---|---|---|
20-Nov-08 | 39.9% | 45.3% | 5.8% |
04-Oct-11 | 3.3% | 25.1% | 1.2% |
19-Jan-16 | 23.2% | 54.1% | 27.6% |
24-Dec-18 | 18.9% | 23.1% | -2.1% |
23-Mar-20 | 55.7% | 114.3% | 35.7% |
Average 2008 – 2020 | 13.6% | ||
26-Sep-22 | 13.7% | 13.1% | –0.6% |
The small cap market bottom that began in September 2022 is the first time Quality 1 businesses have underperformed going back two decades. In a recovery scenario not only do small caps outperform their large cap counterparts, historically Quality 1 businesses tend to outperform the small cap market. The business models of our portfolio companies have proven to be resilient in a recession, which gives us conviction in their abilities to navigate uncertain times.
Misunderstood and mispriced
The Canadian small-cap universe consists of listed companies with market capitalizations of between $100 million and 0.2% of the S&P TSX Composite Index, which is about 400 names in total.
As noted above, the Canadian small-cap market is often overlooked and misunderstood, which can create a high degree of inefficiency with respect to valuations. Smaller companies are viewed as higher risk due to their size, more restricted access to capital and the perception of limited track records and operating history.
We agree with the fact that the companies we invest in are smaller in nature but disagree with the notion that they are unproven. The average founding year of our top 10 holdings—which represents 40-45% of the entire portfolio—is 1986. That represents nearly four decades of performance through several economic cycles that can be analyzed. The majority are led by management teams which have been in place for more than five years, and the overall average is roughly 12 years.
BMO small cap strategy top 10 analysis
Ticker | Name | Year founded | CEO | Year leadership joined | Avg 5-yr ROE/ROIC | 5-yr revenue ZAGR | 5-yr adj EPS/FFO CAGR | 1-yr return | 5-yr return |
|---|---|---|---|---|---|---|---|---|---|
SCI | Storage Vault Canada | 2007 | Steven Scott | 2015 | 20% | 28% | 18% | -4% | 52% |
AND | Andlauer Healthcare Group | 1994 | Michael Andlauer | 1994 | 25% | 24% | 21% | -8% | 133% |
TSU | Trisura Group | 2006 | David Clare | 2018 | 14% | 43% | 33% | 8% | 251% |
PLC | Park Lawn Corp | 1892 | Brad Green | 2020 | 15% | 27% | 12% | -29% | 6% |
PET | Pet Valu Holdings | 1976 | Richard Maltsbarger | 2018 | 27% | 16% | N/A | -7% | N/A |
DCBO | Docebo Inc | 2005 | Claudio Erba | 2005 | N/A | 52% | N/A | 32% | 220% |
NOA | North American Construction Group | 1953 | Joe Lambert | 2013 | 12% | 17% | 40% | 76% | 211% |
CJT | Cargojet Inc | 2001 | Ajay Virmani | 2001 | 10% | 21% | 70% | -30% | 50% |
NBLY | Neighbourly Pharmacy Inc | 2015 | Skip Bourdo | 2023 | N/A | 49% | N/A | -32% | N/A |
EFN | Element Fleet Management Corp | 2007 | Laura Dottori-Attanasio | 2023 | 16% | 8% | 72% | 52% | 282% |
Average | 1986 | 2011 | 17% | 28% | 38% | 6% | 150% |
Our portfolio companies have wide moats, are well-capitalized, growing businesses selected deliberately for their longevity and sustained performance metrics.
Please contact your BMO Institutional Sales Partner to learn more about the BMO Global Asset Management small-cap equity team, and related opportunities, including the BMO Canadian Small Cap Equity strategy.
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