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Small-cap sector still holds its value

We now have preliminary numbers for the second-quarter small-cap indexes, so it's time for a sneak preview of those mutual fund statements that will be arriving any day now.

On balance, the news should be good for Canadian small-cap investors. After a disastrous first quarter, when small-capitalization stocks lagged the S&P/TSX composite index by about three percentage points, the tables turned in the three months ended June 30. The S&P/TSX composite returned 10.6 per cent in the second quarter, while the BMO Nesbitt Burns small-cap index rose 12.9 per cent and the CIBC World Markets equal-weight index climbed a more impressive 14.3 per cent. This would normally imply that smaller names within the small-cap universe were recovering faster, but this isn't confirmed by the BMO Nesbitt Burns details, so the jury is still out on that aspect of the small-cap universe.

The net result is that small caps are up somewhere between 5 per cent and 8 per cent year-to-date, depending on your index preference, and this straddles the 6.7-per-cent year-to-date return from the blue-chip S&P/TSX composite. So, the second-quarter surge brings small caps even with the big caps at mid-year.

As usual, there were significant variations in small-cap returns by industry sector. This means that your fund return may be quite different from the index gain of about 13 per cent if the portfolio manager has a strong industry bias. In general, biotech, technology and telecom were the top categories, with quarterly gains in the range of 25 per cent to 40 per cent.

At the opposite end of the spectrum, resource stocks -- golds, base metals and forest products -- rose less than 3 per cent, while energy stocks climbed about 9 per cent. This divergence suggests that Canadian investors expect an economic recovery in the second half of the year, but not so robust that it will ignite fears of inflation or commodity price increases. The other possibility is that investors have reverted to momentum investing and were simply chasing those sectors that already had the wind at their back.

By the end of the quarter there was some support for the second explanation: The top 20 per cent of growth stocks in the BMO Nesbitt Burns universe were trading at more than five times book value. It is tempting to say that they are insanely overpriced, but three years ago they traded at eight to 10 times book value, so it is not smart to be dogmatic on this particular topic.

Even so, a number of commentators have pointed out that biotech valuations in particular leave little room for error, and that all of them can't possibly have a cure for cancer. If you own a biotech or high-tech stock that has run up sharply, I suggest you calculate the market capitalization for the whole company (share price times number of shares outstanding). Compare this value to recent or forecast revenues, total potential market share, or any other number you can rationally defend. If the ratio of market capitalization to potential revenue is more than two or three times, then you are in nose-bleed territory.

At Saxon Funds, we get nervous when market capitalization to trailing revenues exceeds 1.5 times, but we are value investors so we leave the party early.

In spite of the market recovery and some frothy valuations, we see mergers, acquisitions and consolidations confirming that value is still available in the small-cap sector. For example, late in the quarter, BelAir Energy Corp. received a takeover offer from Purcell Energy Ltd., while Glendale International Corp. agreed to sell its electronics division to Circuit World Corp. and AT Plastics Inc. agreed to merge with Acetex Corp.

These transactions were made possible by low interest rates and management recognition that consolidation is inevitable. We don't see these elements changing in the near future and so we expect to remain close to fully invested in our small-cap portfolio.

Robert Tattersall is president and partner at Howson Tattersall Investment Counsel Ltd.

This column first appeared on GlobeinvestorGOLD.com. For more exclusive analysis, please see the Web site.

© The Globe and Mail

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