Small-cap stocks can offer investors a unique pathway to diversification. We recently sat down with Steve Arpin, Managing Director of Canadian Equities and Bill Otton, Vice President of Canadian Equities to discuss the differences between large- and small-cap investing, ESG integration in a small-cap portfolio, and applying the Beutel Goodman investment process.
The recording took place on September 17, 2021. The following transcript has been edited for clarity.
MATT PADANYI: Thanks for listening in on our fireside chat today. My name is Matt Padanyi, I’m the Content and Communications Manager at Beutel Goodman. I’ll be speaking with Steve Arpin, Managing Director of Canadian Equities, and Bill Otton, Vice President of Canadian Equities here at Beutel. Steve and Bill comanage the BG small-cap [strategy]. They’ve worked together for over 20 years, so they’ve got a bit of experience.
Major markets around the world have been reaching all-time highs in the recovery from the COVID crash, but investor attention typically is focused on the big and recognizable names. Yet, it’s the small companies that form the backbone of an economy and are often where some of the best investment opportunities may lie. Steve, Bill, thanks for taking the time to talk small caps with me today.
Steve, I’m just going to jump right in directly to you. This is not something that has a black and white definition for a lot of investors, but obviously there are definitions out there. And as a professional, you follow one yourself.
STEVE ARPIN: Thanks, Matt. That’s an interesting question because the definition of small cap has changed over time. Certainly, it’s changed for us, along with other investment managers. Currently, we use the MSCI World Small Cap [Index] definition, which is the bottom 15% capitalization of the S&P/TSX [Composite Index], less the bottom 1%. And the size of that definition essentially floats with the value of the TSX.
Currently, the cut-off is approximately $8.5 billion. And for our purposes, practically, companies below $100 million of market float are under sized, and that’s reflective of the size of our portfolio. It’s a challenge for us to get a weight into the portfolio while owning less than 10% of the market float of a company.
I’d like to emphasize that we only own TSX-listed stocks. We don’t own [TSX] Venture companies. The advantage of the TSX is [that] these companies have stronger disclosure and capital requirements. And we would characterize our portfolio as a high-quality, value small-mid cap.
SA: I think investors need to recognize that small-cap stocks are inherently more volatile, but that’s actually something we’re trying to take advantage of. Short-term volatility shouldn’t be confused with permanent capital loss. So, our goal is to get exposure to smaller companies with significant business opportunities at significantly discounted valuations. And really, that’s the key to generating a premium return over time. We don’t view volatility as synonymous with risk, and we offset it with business quality.
SA: Yeah, I think that’s accurate. The small-cap premium does exist, although I would say that it is lower than it was historically. In other words, I think that small-cap companies are better researched than they were, say 20 [or] 30 years ago. But over time, a well-managed Canadian small-cap fund can provide a significant added return, as smaller companies do tend to trade at valuation discounts and often have larger opportunities to grow their business.
The key really is to own a high-quality portfolio and managing risk. And the way that we manage risk is on a company-by-company basis. We’re focusing on buying businesses at a substantial discount to our estimate of their intrinsic value. And the other key is focusing on businesses with strong free cash flow generation.
MP: Alright, that’s great, Steve. Thanks. Bill, I want to bring you into the conversation. I don’t want you to feel lonely out there.
BILL OTTON: Yeah. So Matt, I would say in general, broad investment themes in small cap can lag relative to large cap initially, as investors focus on better known and more liquid large-cap names for exposure to any investment theme. And then, as the larger-cap names become more fully valued, you’ll see a rotation into the smaller-cap names.
For us, getting early exposure to smaller companies with significant business opportunities at discounted valuations is really key in achieving superior long-term investment results. An important difference for us at BG is having an appropriate time frame. We use a longer investment time horizon of about four years in small cap, which reflects our experience that business value and smaller companies may take longer to be reflected in the market.
MP: Okay. So typically, I think when a lot of perhaps more novice investors think about small-cap stocks, their minds always kind of go directly to thinking of less liquidity. You could put me in that bucket that I kind of always connected the two: smaller-cap stocks and lower liquidity.
BO: As Steve mentioned, we run a small-mid cap portfolio with strong general liquidity. As Steve mentioned, we’ve got our market cap constraints are somewhere between $100 million and about $8.5 billion. So, that’s quite a large range, and it provides us with lots of opportunities and lots of liquidity. But we’re not concerned about owning less-liquid stocks if the company meets our investment criteria, particularly sustainable free cash flow generation, strong balance sheet and our 100% prospective return over our four-year investment time horizon.
So, we’re not afraid to go into the $100 million, $200 million market-float companies if they’re attractive to us from the perspective of their balance sheet, the cash flow generation and the return. And generally, as long-term investors, we build our portfolio on a company-by-company basis, and we’re trying to acquire our positions well before the average investor.
MP: Okay, that makes perfect sense. That’s great. Thank you. I’ve got one more that I’m going to throw you right now, Bill. I think a lot of people – and this is kind of similar to my last question – perhaps [many people are] not necessarily understanding the small cap world relative to the large cap world. I think a lot of people and again, myself included, kind of think of small caps as being growth stocks. It’s a growth area. But of course, Beutel Goodman is a value investor. You already mentioned that you take a value approach.
BO: Well, Matt, there’s really no difference between small cap and large cap in terms of value investing. In both cases, we buy what we believe are undervalued businesses that are sustainable free cash flow generators with strong financial positions.
In effect, we want our companies to grow their businesses and free cash flow, but we need to buy them at a substantial discount to our assessment of what they’re really worth. The key to value investing is really not overpaying today for the future growth of a company and thereby protecting capital if forecast growth rates fall short of expectations.
SA: So, Matt, I’d say that the most important difference is that smaller companies tend to be more monoline businesses. They tend not to be as diversified. And the fact that they’re small also means that they have less access to different forms of capital.
So, for example, the bank lines [of credit] that they would get might be more expensive and more limited. They may not be able to access the corporate debt market because they don’t have an investment rating. They may not be able to access high yield, or they may access it at a higher price, and they may or may not have access to convertible bonds.
It’s kind of a combination of the facts that they’re both a monoline business and, from a debt perspective, that the cost of the debt is likely to be a little bit more expensive, and there may not be as much support there for the company as there would be for a larger business. So, because they’re monoline, this may also mean that the businesses may be less resilient from a free cash flow standpoint. And this is where it really depends on the quality of the business and the assets.
This is why it’s really critical to make sure that small-cap companies are well funded and conservatively managed. Outside of these risks, we characterize the analysis as similar to large cap, and what we do is we demand higher returns and we accept a longer time frame which reflects these business and financial risks.
MP: Okay, thank you. I want to keep talking about the process – the Beutel Goodman process. In the vast majority of Beutel Goodman strategies, there is a discipline [around a] one-third sales process. But for the small-cap fund, it’s a one-quarter sales process.
SA: So, Matt, you’ve described that accurately. In small cap, our discipline is to buy businesses with 100% potential return over a four-year period versus our large-cap portfolio, which requires a 50% return over three years. And the reason for that is we demand higher returns. If you think about that in a compounded basis, we’re demanding a low-20% compounded rate versus the mid-teens for large cap.
This reflects small caps’ growth potential, but also it’s risk. Small-cap companies can be very undervalued, and they ultimately may be worth many times what we pay for them because of the growth potential and the revaluation potential as their market cap increases.
As a result, we exercise a sell discipline that allows us to retain more of a position in a company when we hit the target price, but still forces us to redeploy the capital into more undervalued companies. Ultimately, at the end of the day, [for] the investors in our portfolio, their capital protection comes from us owning businesses at a discount. So, the sell discipline is important, but it reflects the differences between large cap and small cap investing.
MP: Alright, that makes perfect sense. Bill, I want to bring you back and keep following down this path in terms of discussing the process and growth. And as Steve mentioned, [there is a] higher growth potential for small caps.
BO: Yeah, really. Matt, the only real trigger for us to liquidate a position from the small-cap portfolio due to its size would be when it reaches the S&P/TSX 60. So, if a company is included in the S&P/TSX 60 Index, it has to be sold from the small-cap portfolio. That’s the only real constraint we have on the upside. If a company we buy at, say a $100 million market cap, grows and grows and grows and breaches the $8.5 billion that Steve talked about as our threshold for defining what small cap is, we can continue to hold that until we feel it’s fully valued. And we may be trimming it along the way, but we’re re-evaluating it as we go along, and we can continue holding that until it reaches the S&P/TSX 60 Index and then we are obligated to sell.
This has happened on occasion. One example of this would be CCL Industries. So, we’ve owned CCL for much longer than our four-year time horizon, just because management did such an excellent job of continually growing the company. We sold that position when CCL entered the S&P/TSX 60 Index not too long ago.
Subsequently, CCL was reviewed and added to our large-cap portfolio during a period of weakness for the stock. And this indicates the synergies that we have between the small- and large-cap portfolios, where small cap can identify the quality companies that may eventually become attractive for investment in our large-cap portfolio.
MP: Alright, that makes perfect sense. I’m going to keep pushing you down this road because now you’ve mentioned an example. So now I want to talk more about that.
BO: The first thing to understand is that we don’t focus our portfolios based on a sectorial approach. We’re very much bottom-up stock pickers. So, our stock selection is driven by where we see value in the market on an individual company basis. Each position is an active investment and it’s got to hold its own place in our small-cap portfolio based on its own merits. So really, the sector weightings within our small-cap portfolio are the result of our bottom-up stock selection process.
I would say, more recently, the results of this bottom-up approach have seen a significant weighting in industrial companies build within the portfolio, such as ATS Automation, which is a provider of automation equipment services for industrial processes. We’ve also made significant investments in consumer discretionary businesses, such as Aritzia, which is a women’s clothing retailer, which is now well established in Canada and has an excellent opportunity to grow its store base in the US, as well as it has a very successful online retail offering. As a result of our bottom-up stock selection process, the BG small-cap portfolio is currently significantly overweight industrials, consumer discretionary, and financials, relative to the S&P/TSX SmallCap Index, and significantly underweight energy, materials, and healthcare.
MP: That’s interesting. I don’t think I would have guessed that if I had the chance. Steve, I’m going to come back to you. And so, for some context for our listeners, the BG Canadian Equity Fund also has a small-cap portion to it. And of course, Steve and Bill have a significant role in that.
SA: Sure, Matt. The small-cap weight as a percentage of the large-cap portfolio has fluctuated over the last 15 years between 7% and about 15% of the aggregate Canadian equity portfolio. Currently, given the size of assets that we run in Canadian Equities, we would view small-cap weights as likely confined to below 10% of the Canadian equity portfolio, and that reflects the portfolio size. So, I don’t think you’re going to see our small-cap weight up as high as 15%.
Now, the way that we decide whether we’re going to increase the amount of small-cap allocation in the aggregate portfolio basically varies on the opportunity that we see to add return through small-cap companies and the attractiveness of the valuations versus large cap. I’d note that the weight in the small-cap [portfolio] has not varied substantially over the past number of years other than the relative performance of small-cap Canada versus large-cap Canada.
MP: Okay, we are running short on time, so I’m going to I’m going to ask one final question. I’m going to pose it to you, Steve, and this is a question that I will never let anybody get away with because I think it’s very important to investors.
SA: We think that ESG is essentially the same for small cap as large cap. In other words, our approach doesn’t really vary across the portfolios. The main difference, and this will probably be rectified over the next number of years, would just be the quality of information that’s available to us because large-cap companies have more reporting resources around ESG. On the other hand, a lot of smaller-cap companies, being monoline businesses and sometimes simpler; that might make up for that.
But really, our focus is on sustainable free cash flow generation. And really that’s resulted in a less resource-oriented portfolio. And that’s really helped the ESG quality of our portfolio versus the market. So, I think if you look at Beutel Goodman portfolios, both on the large-cap and small-cap sides, our ESG scoring [would be] excellent.
MP: Alright. Thank you for that. Honestly, I think we could spend hours talking about this. It’s been a huge learning opportunity for me, and I hope for those that listened in as well. But that is all the time that we’ve got. So, thanks to both of you for sharing your thoughts today.
SA: Absolutely. It’s been a pleasure. And thanks very much.
BO: Yeah. Thanks, Matt. My pleasure.
MP: And to those listening in, please feel free to reach out to your relationship manager to provide any feedback or any additional questions that you may have. Thanks again. Have a great day.
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