To briefly survey the state of the small cap Canadian equity world, let’s look at the iShares XCS.TO exchange traded fund, which is really the only significant financial product tracking the small cap sector in Canada. A former US-based ETF product tracking the sector, EWCS, has been discontinued for several years.
There’s some suggestion of value here – P/E of 12.5 is reasonable, forward yield of 2.4% is average, but the key issue with Canadian small caps is the lack of sectoral diversification. Here’s what the breakdown looks like:
This is a lot of resource exposure, which is not ideal for anyone looking for wide diversification, low beta, or who doesn’t believe in the Canadian resource sector. The management expense ratio is also pretty high at 0.6% and the track record of the fund is mediocre. So there’s a strong case that if you are interested in small caps, you should pick your own inside Canada.
Why am I generally concentrated in small caps? I strongly believe in the small-cap premium and the liquidity premium, both of which have been well identified in the academic literature, as sources of outperformance. In particular, if I’m going to be picking individual stocks, I do not want to compete with people who are smarter or have more resources. One theory of how to accomplish this is to focus on stocks in which these types of people would not be interested, perhaps because it would be impossible to accumulate a significant position to move the needle for a larger player. As a consequence, my personal holdings are largely concentrated in nano-to-medium Canadian names.
Further, economists and other academics have written at some length about how retail investors are subject to myriad biases and mistakes in their investing. Likely everyone has a friend who tells stories of their gains and conveniently omits their losses. Decisions are made because a security is ‘red’ or ‘green’ without concern for the price and the value.
The moment one starts picking stocks, therefore, it becomes mandatory to keep close track of personal performance and evaluate if the exercise is worth it or whether things need to be changed. In the spirit of such, I’ll use the approximate one-year anniversary of my first posting here to recap my picks, talk about my personal portfolio, and break down what I own.
Here’s what I’ve written about in the last year. All figures Canadian.
1. Versabank (OTC:VRRKF), long, July 17, 2017, daily closing price of $4.79. Called the sell publicly on February 22 for a closing price of $8.18. +71% net over seven months. A++.
I don’t hold Versabank anymore. The model works, but it’s fully valued. More generally, when your CEO suddenly starts raving about cryptocurrency sidelines when they’re running a profitable business with a long growth runway, that’s a bad sign – they don’t have high conviction in the core business.
2. Morguard North American to underperform Morguard (OTC:MRCBF), August 2, 2017, Morguard long February 23, 2017. Morguard has actually underperformed its subsidiary by 8% since publication, with Morguard -4.8% and the subsidiary +3.1% including distributions. Morguard is also down -3% since the second call.
I was right here initially, with Morguard North American underperforming, but it quickly reversed and obviously not a great trade. Could still be a decent investment. Morguard is now my personal largest individually picked position. I think the value metrics are all undeniable. The lending is largely at fixed rates long term, the cash flow is great, and the asset management business is growing. I believe in the Canadian housing market, though.
3. Canadian forestry, hold, August 6, 2017, and May 7, 2018. Held up West Fraser Timber (OTCPK:WFTBF) as the paragon of this industry, which is +33%/+2%, respectively.
Totally blew this. Mea maxima culpa. Missed the forest for the trees – got way too caught up in analyzing the second-order effects of the trade war and ignored the first-order effects of demand for lumber. I still can’t see valuations going higher than they are now, though. I’ll stick with my second hold.
4. Mainstreet Equity (OTC:MEQYF), speculative long, August 23, 2017. +21% since. Loved the value here, just very thinly traded and I wasn’t sure when the stock was actually going to catch some attention. See strong parallels to Morguard here. Decent pick.
5. Emera (OTCPK:EMRAF), long, February 20, 2018. Up 4% with dividends since. I bought this myself a couple days before the article came out and did better – faster to buy than write. Pretty clear oversell to me.
What I Own
I try to eat my own cooking. I own a generic US ETF (11% of portfolio) and a generic emerging markets ETF (10% of portfolio), both in USD. I don’t have time to try and research world stocks and so I very rarely make an explicit non-Canada stock pick, and then only by piggybacking someone else’s research.
My portfolio is mostly denominated in CAD, slightly less than 80%. With both the Fed and the Bank of Canada largely successfully targeting 2% inflation, purchasing power parity suggests the long-term value for the Canadian dollar should probably be stable in the low 80s. Since my income is mostly in Canadian, I add to my portfolio in Canadian, and have not had good opportunity to buy USD in several years. I would generally like to hold more USD, and would do so with CAD appreciation.
Cash (13%) – biggest holding, reflecting my lack of high-quality ideas in the marketplace. Part of this is me selling InterRent (IIP.UN) and Canadian Apartment Properties (OTC:CDPYF) within the last year as they’d gotten expensive.
Morguard (8%) – see above.
Emera (8%) – will be unspectacular. I also have to pay them for my electricity and owning their shares thus has an additional psychic benefit for me. Would not be as large if I had better investment ideas for my existing cash – would prefer to deploy elsewhere.
E L Financial (OTCPK:ELFIF) (7%) – classic value pick. Huge discount to book.
Brookfield Asset Management (BAM) (6%) – like Morguard, I always want to be maximally aligned with principals, and so I own the Brookfield parent over any of the subsidiaries.
Genworth MI Canada (OTCPK:GMICF) (6%) – I believe in the Canadian housing market, and if you believe in the Canadian housing market this prints money.
Gran Colombia Gold (OTCPK:TPRFF) (5%) – shamelessly stolen research, average cost basis of $1.64. Still holding.
Fairfax Financial Holdings (OTCPK:FRFHF) (5%) – fluked into nailing the bottom here at $557, but the company is too complicated for me to write about. Candidate for a sell.
There’s a selection of smaller holdings to fill out the portfolio, but nothing particularly exciting. Many others have written better stuff than I have on these names – hopefully this provokes some good reading.
Disclosure: I am/we are long MRCBF, VRRKF, ELFIF, EMRAF, FRFHF, GMICF, BAM, TPRFF, TTTGF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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