Only small at the start

The small cap sector has more than its share of long shots and one-trick ponies, but if you pick a winner, the returns can be spectacular

By Sean Silcoff
Globe Investor Magazine Online, Feb. 19, 2009



After 35 years as a fund manager, Sebastian van Berkom considers himself to be more of a psychologist than a financial analyst. He figures you have to be, when your specialty is investing in small cap stocks. "I realized early on what is really important is to understand and get inside the heads of CEOs, to understand their motivations and psychology and character, because that was ultimately the most important driver of their success," says the 62-year-old CEO and majority shareholder of Montreal-based Van Berkom and Associates. "The three most important criteria to successful investing in small caps are management, management, management."

Sizing up management is particularly important when you specialize in small cap firms-in Canada, these are the companies that have market capitalizations of between $75 million and $1.5 billion. This sector of the market is dominated by undiversified companies that are typically led by iconic entrepreneurs; are largely ignored by institutional investors; and are spottily covered by sell-side analysts. Make the right bet, and you can earn enormous returns. Pick the wrong one, and the stock can quickly collapse, or disappear altogether. As a shareholder in a small cap company, you need to be very comfortable with its management. "If you don't know your partners, how are you going to make money?" asks van Berkom, whose firm manages about $1 billion in small cap holdings for Canadian pension funds.

It is hard to find anybody, whether shrink or analyst, who has made money in small caps recently. Last year was a nasty one for markets overall, but it was particularly brutal for small caps: The benchmark Canadian BMO small cap weighted index fell by 46.6% compared to a 33% drop for the TSX composite, and Canadian investors pulled more than $1.4 billion out of small- and medium-caporiented mutual funds through the end of 2008. Van Berkom, for his part, beat his index in 2008, but still posted a dismal 33.8% loss.

Small returns have in fact been the norm for small caps for quite a while, with similar relative underperformance showing up in 2007, 2006 and 2005. But for van Berkom and his fellow Canadian small cap managers, this is hardly cause for despair. If anything, they're rubbing their hands together in anticipation. "Small cap stocks are certainly the cheapest they've been in a decade," says Robert Tattersall, vice-president of Howson Tattersall Investment Counsel of Toronto and manager of the 23-year-old Saxon Canadian Small Cap Fund.

Several studies bear out the fact that, over long periods, returns from small caps handily beat those of large cap companies. The best-known research, by Ibbotson Associates in the United States, shows that small caps increased in value, on average, by 11.6% a year from January, 1926, through November, 2008, compared to a 9.6% annual increase for large companies. Over any 10-year period within those eight decades, small caps outperformed large caps two-thirds of the time, according to Ibbitson. And Sionna Investment Managers of Toronto says that small cap returns, as measured by the BMO index, have trounced the S&P/TS X composite index by an average of 13.1 percentage points in the last five downturns. In the U.S., small caps have outpaced the S&P 500, on average, by 11.9 percentage points in the year following each of the last nine recessions.

If now isn't yet the time to buy small caps, it soon will be. "When we come out of this cycle and the economy improves, we'll have a pretty dramatic snap-back in small caps," says Steve Arpin, who, as vice-president of Toronto fund manager Beutel Goodman & Co., oversees $650 million worth of small cap stockholdings, including the $170-million Beutel Goodman small cap mutual fund.

Sebastian van Berkom wa s convinced that convenience store retailing was "one of the worst businesses you can get into." Then he met Alain Bouchard. It was 1994, and Bouchard ran a small Quebec convenience store company called Alimentation Couche-Tard. Today, Couche- Tard is North America's second-largest c-store operator and an industry leader in improving store productivity and profitability. "What particularly caught me in that meeting was his clear long-term vision," says van Berkom, his chin resting in his hand as he gazes out the window of his 10th-storey office in downtown Montreal. "He had this passion. You could easily identify it from the first meeting; he was going to be the major player in Quebec, then Canada and North America."

It's not hard to see why van Berkom still gets jazzed about small companies. "The joy of picking the next winning company, to make 10 times, 20 times, 100 times your money, is only available in this space," he says.

Van Berkom's introduction to small caps dates back to 1974, when he was working as an analyst for Bell Canada's pension fund. He couldn't understand why so many investors were enamoured of the Nifty Fifty-the stocks of the biggest U.S. companies-which were trading at vastly overinflated prices when there were lots of solid, smaller companies growing at a brisk pace and selling for just five times earnings.

So van Berkom did his own study to confirm that small caps outperformed larger companies over time. He has been investing in the sector ever since, and in 1991 founded his eponymous firm. Since June, 1992, his small cap portfolios have earned annualized returns of 11%, compared to 6.8% for the BMO index and 8.3% for the TSX/S&P composite.

The sector is a volatile one. Small caps are less liquid and more economically sensitive than larger companies, and generally have a harder time accessing capital when credit conditions tighten. And too much debt for a small cap is "a terrible thing," says van Berkom. "As soon as we see debt going up too much, we sell. When we have a recession or a credit crunch, banks are much more comfortable lending money to Bell than to [smaller companies]."

Small cap stocks also underperform larger companies as the economy worsens: Investors "flee to quality" (i.e. larger and more stable) stocks, and small caps tend to fail in greater numbers than big companies. "I know this from the number of files I throw out every year," says Steve Arpin. "You need to demand premium rates of return to invest in this area." Given the heightened risks, small caps never trade much higher than at a 10% to 15% discount to the composite index. Small cap stocks also tend to do best in January, following year-end taxloss selling, says Saxon fund's Robert Tattersall.

But small caps are also built to make big gains as the economy strengthens: Since many small companies focus on only one business, they are highly leveraged to demand growth in that area. In addition, says Arpin, they gain business from larger companies that need to add extra capacity in a hurry as demand picks up, and from customers who are more willing to try out new sources of supply in better times.

For small cap investors, diversification is key. "A lot of catastrophes can occur to small companies, and they don't have the resilience to bounce back and are not too big to fail," says Tattersall. He likes to have 70 to 80 names to spread out the risk; Arpin keeps between 30 and 50 stocks; van Berkom, about 50. No stock is allowed to appreciate to the point where it accounts for more than about 5% or 6% of their respective portfolios.

Van Berkom and his peers cull from the list of hundreds of companies by applying a series of financial tests to assess each prospect's financial strength and health: ratio of stock price to earnings, book value to sales, cash flow to interest expense, and enterprise value to operating earnings. They're looking for stability, but also for bargains. Tattersall says anything valued below 1.5 times the ratio of stock price to book value per share, or seven times the price to cash flow, is "interesting." A 10% to 15% discount to valuations relative to the index "may be fair value, and 30% to 50% is where they're cheap," he says. Stock value discounts last sank to that range in 2002, and were heading there in late 2008.

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