Betting smaller is better

Some large caps have become expensive so small caps can be better value

Manager: Leslie Lundquist, Bissett Investment Management Fund: Bissett Canadian High Dividend Fund

Description: Canadian equity fund with a high dividend yield mandate and focus on capital gains

Performance: 1- year - 1%, 3- year + 20.8%. 5- year + 7.9% ( compounded annually as of Dec. 31, 2011)

MER: 2.48% Leslie Lundquist and Les Stelmach, portfolio managers of the Bissett Canadian High Dividend Fund, have a target dividend yield for the portfolio that is 2.5 times that of the S& P/ TSX composite index.

At the end of 2011, the fund’s yield stood at 6.6%. While this is slightly below the managers’ target due to tax- loss selling near the end of 2011 and trimming back exposure to names that performed well, they continue to find companies that meet their criteria.

“If you want noticeably higher yields than the TSX, you have to go into smaller cap names,” Lundquist says. “By and large most of those names are former income trusts.”

In 2011, investors keyed in on large cap names that provided stability, certainty and dividend yield. That translated into a relatively strong year for traditional blue chip companies and a very strong year for telecoms in particular. Similarly, Canadian pipeline and infrastructure companies such as Inter Pipeline Fund, Pembina Pipeline Corp. and Keyera Corp. have been popular among investors.

While these remain solid businesses, Lunquist says they have gotten expensive. As a result, the managers are finding much better value in smaller cap names.

“Many of them do have an element of economic cyclicality or sensitivity,” Lundquist says, highlighting names like Vicwest Inc. and Phoenix Energy Services Corp.

The energy sector makes up roughly a third of the portfolio. Two- thirds of that is in energy producers, with the other third in pipelines ( generally large caps) and service companies ( smaller names).

“There is no question that these smaller companies will be more economically sensitive, but we think they have a very attractive outlook given the really strong oil and gas drilling activity levels in Western Canada,” Lundquist says. “When we look at the results some of these companies are putting out, then compare it to the prices they are trading at, we really think they have been overlooked or investors are very concerned that they are too risky.”

The financial sector makes up roughly 30% of the fund, with banking holdings including CIBC and Bank of Montreal. While the managers like Canadian banks, they are maintaining a relatively small position in the group given higher yields available elsewhere.

Instead, they are favouring certain Canadian REITS, which make up more than 10% of the portfolio. The sector has run up in value, but in some cases valuation levels are still reasonable, and their yields are too attractive to pass up.

The managers focus on companies with yields that are supported by strong cash flow, reasonable debt levels, and reasonable payout ratios.

“Companies with stable businesses can typically handle higher debt levels, as opposed to those that are more economically sensitive,” Lundquist says. “We will accept higher payout ratios if the business is steady even in more difficult times.”

They also focus on valuation metrics such as cash flow multiples and DCF ( discounted cash flow) analysis.