Smaller companies have recently been doing better than their larger
counterparts.
The small cap sector refers to companies with market capitalization of
less than $500 million in Canada and $1 billion US in the United States.
Year to date, American small-caps have outperformed large-caps by more
than 400 basis points, or four percentage points, while Canadian small
-caps, as measured by the TSE 200, have outperformed large caps by 600
basis points.
Given such strong performance year-to-date and since the lows of
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September 2001, it leads to the question of how much growth is left.
Small-cap stocks appear poised for a solid year in 2002. All of the
indicators remain positive:
- The interest rate environment is favourable even if rates move
100-125 basis points higher.
- Historically the trough-to-peak returns average 67 percent and small
caps stocks are up 25-30 percent since September 2001.
- The historical recession cycle shows 12-15 months of recovery before
a pause followed by a further two years of outperformance.
- Most importantly, overall valuations in the small cap sector are well
below their historical benchmarks.
Some argue that after accounting scandals and other events such as the
Enron mess that have affected larger-cap companies, many investors are
putting a premium on the simplicity of small-cap financial statements.
The consumer and industrial product areas offer excellent opportunities.
The current environment sets the stage for a stock-picker’s market.
Investors should focus on companies that have sound business models,
clean balance sheets and the ability to use their cash flow to grow.
Many of the basic industry companies fit the mould.
Although economic data remains mixed, the factors that drive the
building materials sector have been resilient.
There is a chance that these stocks could weaken a little in the near
term because of continued job losses; however, it appears that stable
interest rates will provide a much softer landing than originally
thought.
As such, the fundamentals look good for the balance of the year, at
which point interest rate tightening could hurt share prices.
The furniture sector might be soft in the short term, but the longer
term looks better, following all of the home building sparked by low
interest rates and the heightened trend toward cocooning at home since
Sept. 11.
The best bets are companies that display market share gain
opportunities and have cash on the balance sheet.
Some small-caps you may want to consider are Richelieu Hardware and
MAAX, in the building materials sector.
Richelieu continues to meet earnings expectations, despite its higher
multiples, and MAAX provides for a clean balance sheet and strong
potential to capitalize on potential acquisition opportunities.
In the furniture sector it appears Dorel is well positioned for an
economic turnaround given several operational improvements and enhanced
product lines.
FirstService Corp., which provides property and business services to
commercial and residential customers, looks like a good hedge against
an uncertain economy, considering its revenue and cash flow stream and
especially since the stock price has weakened.
Also, IPL, a leader in the North American plastics industry, is an
interesting play given its diversified revenue base and potential to
profit as the economy recovers.
If you don’t like to invest directly in stocks, you might want to
consider a mutual fund that focuses on small cap companies.
Trimark Canadian Small Companies, Fidelity Small-Cap America and the
Templeton Global Smaller Companies funds provide exposure to Canadian,
U.S. and international small-caps.
All of the aforementioned are long-term top performers within their
respective peer groups.
Ian Morrison is a financial consultant with Wood Gundy Private Client
Investments in Calgary and is licensed to sell insurance products. His
views do not necessarily reflect those of CIBC World Markets Inc. or
The Western Producer. Morrison can be reached at 800-332-1407 or by
e-mail at ian.morrison@cibc.ca.
