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Canada’s Smaller Stocks May Lose Edge Over Biggest Companies

Canada’s smallest companies will trail the rest of the market after rallies in metals and fuel prices pushed valuations close to a record high, according to the country’s best-performing investors in so-called small caps.

Ralph Lindenblatt, co-manager of the Bissett Microcap Fund, said the shares will return about 5 percent annually during the next five to 10 years after more than doubling in 2009 and 2010. Allan Jacobs of Sprott Inc. said he has let cash accumulate in his Sprott Small Cap Equity Fund as bargains became harder to find. They beat all other Canadian mutual funds specializing in small caps last year, returning 60 percent and 50 percent, respectively, according to Bloomberg data.

The S&P/TSX Venture Composite Index and S&P/TSX SmallCap Index have risen about twice as much as the S&P/TSX 60 index of Canada’s largest stocks during the bull market that began in 2009 as the economic recovery spurred investment in riskier assets, and oil, silver and copper more than doubled. The SmallCap Index’s enterprise value, which measures the value of equity and debt, rose to almost 13 times earnings before interest, taxes, depreciation and amortization in April, within 0.3 percent of the post-2001 high reached on Dec. 30.

“We’re up 200 percent from market lows,” Lindenblatt said, referring to the Venture Composite Index of companies on Canada’s junior stock exchange. “It’s not surprising small caps are going to pull back or at least give up leadership to large caps. If you look at the valuation for small caps today, we’re at the point where we have to expect much lower returns.”

More Commodities

Small caps have benefited from a greater concentration of commodity producers. Energy and raw-materials companies make up 55 percent of the SmallCap index, compared with 47 percent of the S&P/TSX 60, according to data compiled by Bloomberg.

Larger companies will do better, said Chris Conkey, chief investment officer for global equities at Manulife Asset Management. The S&P/TSX Composite Index, which adds the S&P/TSX 60 index of stocks with an average market capitalization of C$21.4 billion ($21.9 billion) to the S&P/TSX Completion Index of medium-sized companies, will return 7.5 percent to 8.5 percent a year for the next three to five years, said Conkey, who oversees about $60 billion at the unit of Toronto-based Manulife Financial Corp.

The Venture Composite Index, in which companies have an average market value of C$100 million, has fallen 8.2 percent since Dec. 31, and the SmallCap Index, with an average market value of C$860 million, has advanced 0.4 percent. The S&P/TSX 60, which comprises 60 of Canada’s highest-valued and most-heavily traded stocks, has gained 2.8 percent.

Size Limit

This month, the SmallCap Index, which is limited to companies with market values from C$100 million to C$1.5 billion at the time of S&P’s annual review, has declined more than twice as much as the large-cap index, driven by losses in precious metals.

“When people get risk averse, they don’t want to have stocks that don’t trade millions of dollars every day, and they go to the safety of cash or bigger-sized companies,” Jacobs said. “Micro caps could easily underperform.”

Today, the SmallCap Index increased 0.8 percent and the S&P/TSX 60 0.1 percent as the U.S. dollar declined and fuels and metals rallied.

Cash Increase

Because stocks have risen so much, Jacobs has let cash in the Sprott fund increase to about 13 percent from 3 percent on Dec. 31. He has had to look beyond his usual focus in the Canadian natural-resources industry to find stocks for his C$221 million fund.

Jacobs, 52, added Indianapolis-based shoe-store chain Finish Line Inc. The company’s net income increased 93 percent in the fiscal year that ended in February, while cash rose 28 percent. Finish Line trades at 17.6 times profit from the past year, 52 percent less than the ratio of the Russell 2000 Index of smaller U.S. stocks.

The fund invested in Richmond, British Columbia-based aerospace and defense contractor MacDonald, Dettwiler & Associates Ltd. last month. It has a “very reasonable valuation given its earnings, large cash position and superior historical performance,” he said. The shares have gained 5.5 percent since Jacobs bought them.

The C$169 million Bissett Microcap Fund has also avoided the raw-materials industry. While materials companies make up 35 percent of the S&P/TSX SmallCap Index by market value, they accounted for 3.5 percent of the fund on March 31.

Best Opportunities

“The easy money has been made there, and it’s time for us to move on,” said Lindenblatt, 42, a Calgary-based money manager for Franklin Templeton Investments. “The best opportunities are often not in the hot sector, but in areas of the market where others aren’t looking.”

Technology, consumer and industrial companies are bigger bargains, according to Lindenblatt and the fund’s other co-manager, Richard J. Fortin.

In March and April, the fund bought shares of Glacier Media Inc., which publishes 120 newspapers and trade publications in Canada. The managers said the company’s establishment of a semiannual dividend indicates cash flow will increase. Lindenblatt and Fortin also invested in Woodstock, Ontario-based trucking company Contrans Group Inc., saying its share price does not reflect its future earnings growth.

The Bissett fund, which has holdings with an average market value of C$225 million, was led last year by Fortress Paper Ltd., which tripled after announcing plans in March 2010 to buy a Quebec mill and convert it to the production of a raw material used to make rayon.

Oilfield Services

Lindenblatt’s fund also gained on investments in oilfield-services providers. Three of the fund’s four biggest holdings -- Horizon North Logistics Inc., Pure Energy Services Ltd. and Technicoil Corp. -- all rallied at least 80 percent last year.

Jacobs’ fund, which he manages with the help of strategist Peter Imhof, returned 50 percent last year largely because raw material and energy companies accounted for 68 percent of its value at year end.

Jacobs’ concentration in resources reflects a firm-wide focus. Besides Sprott’s asset-management arm, which counts stakes in dozens of small-cap materials and energy companies among its about C$8.5 billion in assets, Sprott Inc. manages a resources-industry private-equity firm, a lender to resources companies and a wind-energy developer.

“We meet 30 companies a week and I see maybe 15 or 20 of those,” Jacobs said in an interview at Sprott’s Toronto headquarters. “If I see none to buy out of those 15 to 20 and the other 10 that my colleagues see, I get pretty worried about the market.”

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