Equity

Small Cap Does Not Have to Equal Big Risk

Portfolio managers Tyler Hewlett and David Taylor defy the conventional notion that equates small-cap stocks with a high amount of risk – with their track record of focusing on quality, growth and value creation for the long term.
January 2018

Tyler Hewlett

CFA, Director & Portfolio Manager, Head of Canadian Growth Equities

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David Taylor

CFA, Vice President & Portfolio Manager, Fundamental Canadian Equities

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Through their successful Canadian investment strategy, BMO Global Asset Management portfolio managers Tyler Hewlett and David Taylor defy the conventional notion that equates small-cap stocks with a high amount of risk – with their track record of focusing on quality, growth and value creation for the long term.

Why Canadian Small Cap is BIG Opportunity

Our approach to small-cap equities is grounded in the powerful idea that compelling investment opportunities are created from market inefficiencies. The small-cap sector, particularly in Canada, is an ideal example of this – spanning a broad set of companies which many institutional investors are unfamiliar with, that are prone to neglect and have minimal research coverage. These effects are exacerbated by markets’ increasing short-term focus.

As managers of BMO Asset Management Small Cap Fund, we seek to exploit these inefficiencies. Our belief is that over the long term, fundamentals ultimately determine relative stock performance, and that’s what we focus on within our strategy – ignoring short-term drivers and benchmark allocations. We seek high-quality growth companies that compound returns and add value over time, offering the potential for significant alpha generation through our high-conviction, concentrated portfolio.

The Canadian market is the prime breeding ground for these value-add opportunities, where we can differentiate ourselves, and improve fundamentals through active management and dedicated asset class expertise: currently, there are roughly 575 companies that we evaluate in our small-cap universe, ranging between $100 million and $4.5 billion in market capitalization – providing an enormous breadth of options.

The potential for excess returns is also stretched further with small caps, given their smaller initial size, growing at higher rates – 15-20% is not uncommon – for longer periods of time than large-cap equities. Another key benefit of small-cap investment is portfolio diversification, providing for different fundamental drivers than the large-cap sector, and a greater chance to achieve outsized returns, with a similar risk profile. As shown below, Canadian large-cap managers, after fees, barely beat their benchmark over the last five years, whereas the incremental value created is more than evident for small-cap managers, and our Fund in particular.

Compelling investment opportunities are created from market inefficiencies, and the small-cap sector in Canada is the ideal example.

5-Year Returns to December 2017

5-Year Returns to December 2017

*S&P/TSX Composite Index for Large Cap and S&P/TSX Small Cap Index for Small Cap.
Source: Morningstar Performance for 5-year period ending December 31, 2017.

Top 4 Reasons to Invest in Canadian Small Cap:

  • Greater potential for excess returns
  • Portfolio diversification
  • Extended growth at higher rates
  • Breadth of opportunity for active management
  •  

Intimate and In-Depth Work Best

Our track record of outperformance is informed by a disciplined process that seeks to minimize risk, and identify the best small-cap ideas with high growth potential, supported by detailed scenario analysis and exhaustive due diligence.

As a vital part of this process, we conduct more than 250 management meetings every year, gaining first-hand knowledge from company leaders on their expansion plans, and strategies to capitalize on this growth. Importantly, we are looking for businesses that can truly add value for shareholders and aren’t just expanding for the sake of it. We believe that intimately knowing your portfolio of trusted companies is the most effective way to manage this risk, and that’s why we dedicate significant time to interviewing management teams, and understanding their respective business propositions – from capital allocation to ESG analysis. Levering our position as one of the larger and more established small-cap strategies in Canada, we also have maximum, top-level access to management teams across the country, allowing us to build better portfolios with companies we strongly believe will achieve success. This level of assurance and conviction – rare attributes in the small-cap sector – is what distinguishes our team the most, offering stellar performance (see graph above) in an asset class where true quality is notoriously difficult to access.

What We Seek: Key High-Quality Value Creators

Before we even start modelling valuations and forecasting cash flows under different scenarios, we must determine whether small-cap companies in our universe meet our criteria for what we consider to be key high-quality value creators:

  • Capable management team
    • History of consistent execution
    • High governance standards
    • Capital allocation discipline
    • Aligned with shareholder interests
  • Sustainable growth opportunity
    • Enduring competitive advantage
    • High barriers to entry
    • Favourable industry dynamics
    • ESG values upheld (e.g., governance, operations)
  • Strong financial metrics
    • Healthy balance sheet
    • High return on invested capital
    • Attractive valuation (underestimated potential)
We are looking for businesses that can truly add value for shareholders, and aren’t just expanding for the sake of it.

As an example, bitcoin has drawn hordes of attention from investors, and while it has certainly peaked our interest from a technology standpoint, these companies are mostly pre-revenue, and led by management teams without established track records – therefore failing to meet our high standards for investment.

Our role is to ensure that there is clear visibility of earnings for each company in which we invest, and a management team that is able to outlay capital efficiently, and strategically, toward growing a business over time. We don’t shy away from companies with little to no research coverage; instead, we focus on identifying a comprehensive and constructive value creation plan through our internal diligence.

A Unique Risk Approach to Protect Client Assets

While many institutional investors associate small caps with a higher amount of risk, this is not necessarily the case: to us, risk isn’t simply synonymous with market and stock price volatility, but rather it’s a true reflection of a company’s financial position and long-term fundamentals. Certainly amid the late stage of the current cycle, it’s wise to seek active strategies that are focused on compounding unitholder capital – not benchmarks or peer groups. At BMO Global Asset Management, we truly take the lead – from granular stock selection all the way to portfolio construction and risk management. Our bottom-up, quality focus ensures our approach is benchmark-agnostic, scouring strictly for companies that have the greatest potential on a fundamental basis over the long term; names that have the best risk-inherent profile across different sectors and stages of growth, no matter their representation in the benchmark. Not only does this increase our chances of generating alpha, but it also decreases risk.

For institutions, it is important to understand that within the Canadian equities universe especially, more than 50% of the small-cap benchmark is exposed to the part of the market with the highest volatility – that is, resources. Firstly, we fundamentally believe in the value of a well-diversified portfolio, and that a 50% allocation tied to the prices of resources is too heavy a weighting, given our keen focus on risk-adjusted returns. Within this area, we have also found that individual names (with certain exceptions) haven’t properly allocated capital, falling short of our key quality paradigm.

Consequently, it’s not that small-cap companies are necessarily higher risk, it’s more the composition of the benchmark that actually gives the asset class a riskier reputation than a well-rounded, diversified, small-cap portfolio ever would. This is why we focus on selecting robust companies that can exhibit steady performance throughout different macro environments, whether it’s rising rates, NAFTA risk, or a stronger Canadian dollar. We don’t invest to any degree on where our benchmark might lie from an allocation standpoint: this applies not only to sector, but also to lifecycle stage.

Managers that focus too narrowly on early-stage concept stocks (e.g., a phase 1 healthcare company or a miner with no cash flow) can generate massive upside – and downside – which is why we choose to spread our holdings across various stages of growth to foster a balanced risk management and portfolio construction approach, resulting in the Fund’s lower volatility compared to the small-cap market as a whole. Our strategy appeals to investors because while we allocate the highest weights in our portfolio to companies that offer the most promising risk-adjusted returns (regardless of benchmark weighting), we carefully maintain a properly diversified portfolio.

Four lifecycle stages of growth for a company

Four lifecycle stages of growth for a company

Source: BMO Global Asset Management, December 31, 2017.

Our Growth Stories in Action: Boyd Group Income Fund

What: One of the largest, independent automotive collision repair companies, with nearly 600 locations, mostly in the U.S. market, which was acquired in 2012.

The growth story: When we first considered the business, we quickly realized that acquisitions growth was not properly factored into its valuation, and that it had the opportunity to expand much more than the market was anticipating. Alongside an experienced, knowledgeable management team, with a track record of execution, Boyd operates in an industry with high barriers to entry, as large U.S. insurers continue to push more business to the largest and most sophisticated collision repair companies, offering opportunities for consolidation.

The company has experienced significant growth on a per-share basis over the last several years through improved margins, strong same-store sales growth, and disciplined mergers and acquisitions (M&A). Operating within a highly fragmented market, there is an abundance of M&A potential, and Boyd has a strong balance sheet with which to take advantage, in addition to a long runway of growth ahead.

BYD Share Price Performance

BYD Share Price Performance

Source: BMO Global Asset Management, December 31, 2017.

StorageVault Canada:

What: A company we first purchased in 2016, StorageVault owns, operates, and rents self-storage and portable storage space in Canada.

The growth story: When we first came across StorageVault in mid-2016, it had limited research coverage and low liquidity, but we met with management several times, completing comprehensive analysis and modelling to conclude that the company was a true growth opportunity. On top of 35% insider ownership, and management having a strong track record of growing a private business, the company operates in a large fragmented Canadian market ripe for consolidation, lagging its U.S. counterpart by roughly 15 years.

StorageVault also boasts a large pipeline of future acquisitions in an industry that has high barriers to entry, and “sticky” customers on account of clients not wanting to move their possessions. As the only public player in the Canadian market – where new storage space is limited – we continue to see strong potential to accelerate growth.

SVI Share Price Performance

SVI Share Price Performance

Source: BMO Global Asset Management, December 31, 2017.

A Commitment to Exceed Expectations

Despite the relative underperformance of Canadian markets last year, we have only seen institutional investment into BMO Asset Management Small Cap Fund grow.

This is primarily because the small-cap sector in Canada is fundamentally inefficient, and underserved by analysts, providing an opportunity for an active team like ours that is truly focused on the needs of sophisticated investors – distinguished by our in-depth asset class expertise, disciplined and comprehensive process, value-add track record, and a portfolio construction methodology emphasizing strong risk management. This unique combination works to provide investors with the alpha they crave in today’s environment, while aiming to protect investors on the downside.

While macro variables factor into our scenario analysis and portfolio construction, ultimately, the Fund is a reflection of our high-conviction stock picks: companies that we believe have successful business strategies capable of compounding shareholder capital over several years, and generating superior risk-adjusted returns. Our sole mission is to exceed investor expectations, in any economic climate.

For more information on BMO Asset Management Small Cap Fund, or other ideas to enhance your portfolio, please contact your Regional BMO Asset Management Institutional Sales & Service Representative.

Related Capability

Learn more about our Equity capabilities.

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