Zeroing in on the mid-cap sweet spot

Canadian investors saw the domestic equity market underperform U.S. stocks badly for five years, something that nobody was able to ignore, even if they tried. But what may have fallen under the radar was the similar underperformance of small caps versus large caps.

Of course, the tides have started to turn in 2016, with the S&P/TSX Composite index up about eight per cent year-to-date, compared to only a two-per-cent gain for the S&P 500.

Meanwhile, small caps have begun to work again, with the S&P/TSX Venture index up around 30 per cent this year.

“Obviously, a lot of that has to do with resources, but when stocks have been down for five years in a row, even a little bit of money coming into the market can cause a bounce,” said Peter Imhof, portfolio manager at AGF Investments. “I think that’s where we’re at because most stocks have been washed out.”

Whereas Imhof made a shift toward more large caps for the AGF Canadian Growth Equity Class in the second quarter of 2015 due to liquidity concerns, he is now much more comfortable with smaller cap names. However, he does have a little more cash in the portfolio than in the recent past, partly because of the nice run-up Canadian equities have had in the past couple of months.

Imhof is seeing value in mid-cap names with good liquidity and higher-thanaverage earnings growth, often found in the $1-billion market cap range.

“Larger cap money managers are looking down to try and find that growth,” he said. “They’re moving to those names that are still sizable enough, such as Boyd Group Income Fund or Kinaxis, without going to the small cap area to get that growth.”

While Imhof manages the fund primarily on a bottomup basis, as opposed to targeting specific sectors, the portfolio’s largest overweight is in technology. That’s where he is finding companies that are growing fairly rapidly and trading at reasonable multiples.

“I’m still underweight the materials sector, even though I still like it,” Imhof said, noting that the Venture index has a weighting of roughly 26 per cent in gold — too much to be prudent.

“Precious metals companies took five years to clean things up, and we’re about two years into that for the energy sector,” he said. “All of them have been cutting costs and learning how to produce at lower costs because they have to.”

Imhof believes many have accomplished this, so when commodity prices come back up on a sustained basis, that will bear fruit in terms of higher margins.

Colombian oil and gas producer Parex Resources Inc. is his largest energy holding in the portfolio, with Imhof noting that the company is able to generate quite a bit of cash flow at current prices. He pointed out that with Brent at US$50, Parex’s cash flow is $160 million.

“They are one of the only companies out there that is still able to grow production and generate cash flow at these prices,” Imhof said. “It recently hit a 52-week high, but there are a lot of catalysts coming up in terms of drilling prospects over the next six months.”

Another portfolio holding that serves as more of a oneoff stock pick is Milestone Apartments REIT, which invests in and operates multifamily, garden-style homes in the U.S., but primarily Texas.

“I’m not really a buyer of REITs, but I looked at this company based on the fundamentals, and Texas is the fastest-growing state in the U.S. due to the influx of people moving there,” Imhof said. “They have a very strong management team, the company continues to grow, and all the metrics look very strong.”

That includes a 6.4-percent rent increase in the past quarter, a payout ratio of only about 56 per cent, and a dividend yield around four per cent.

Milestone also stands to benefit as more investors look toward that $1-billion market cap range, and when REITs become a new GICS sector in the next few months.

Another position in the fund that will be familiar to consumers, but not necessarily to investors, is Skechers USA Inc.

Imhof highlighted the shoe company’s very strong track record of increasing earnings, with EPS rising 70 per cent in the most recent quarter.

He estimates Skechers will earn about US$2.10 per share this year, representing growth of more than 40 per cent, yet the stock trades at a multiple of just 14x to 15x.

“The stock got hit a few quarters ago because there was a lot of inventory left in the channel, so people got spooked,” Imhof said, adding that Skechers’ international sales are seeing growth closer to 100 per cent. “The company said since it is growing by 40 to 50 per cent, they needed that inventory. And in the past two quarters, they beat analysts’ estimates and all the inventory got cleaned up.”