The Hidden Diamond in Small Cap Investing: Canadian Micro Cap

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1 The Hidden Diamond in Small Cap Investing: Canadian Micro Cap Allan Hutton, CFA In an era when Canadian Pension Funds are moving to take advantage of opportunities in Global Equities, Emerging Markets, Real Estate, Infrastructure, Private Equity, etc., opportunities abound to invest in the smallest publicly traded Canadian companies. Micro cap equity (market capitalization < $250 million) is an often overlooked asset class for institutional investors. While the total market capitalization is small, a little known fact about the total Canadian small cap universe is that over 60% of the investable stocks are Micro Cap, in other words the opportunity set is quite large. Exhibit 1 Investable Small Cap Universe Dec 2013 Total Small Cap Coverage includes all small cap stocks with market capitalization less than or equal to $2 Billion. Investable Small Cap Universe includes stocks within Total Small Cap Coverage with market cap greater than $25 million. All data presented is from Hillsdale s proprietary database unless indicated otherwise. This database consolidates information from over 30 data suppliers to support Hillsdale s research, portfolio management and reporting activities. Furthermore, compared to large cap companies, analyst coverage in the space is much more limited. Given that potential alpha scales in relation to informational asymmetry, the lack of analyst coverage in the Micro Cap universe should allow a skilled, disciplined investor the opportunity to add significant value. Limited analyst coverage is likely to persist as the marginal cost to cover these names for typical research firms cannot be justified. January

2 Exhibit 2 Analyst Coverage by Market Capitalization December 2013 Management, Capital IQ: Logarithmic average of number of analysts by market capitalization The return potential of Micro Cap names must not be ignored. While many would focus on using the TSX Venture Exchange as a proxy, it is limited to only TSX Venture listed companies, making it a poor choice. An active Micro Cap strategy will be comprised of many stocks that are composite listed. As such, we created a market of Micro Cap stocks using companies between $25 and $250 million (regardless of listing exchange), cap weighted and liquidity screened to appropriately represent historical returns available in a passive strategy. Over the last 10 years, this Micro Cap market has outperformed the TSX Composite, the TSX Small Cap, and the TSX Venture Composite as per exhibit 3. Exhibit 3 Growth of a Dollar 10 Years Ending December 31, 2012 Management. January

3 Over the 10 years ending December 31, 2012, the annualized rate of return for Micro Cap was 7.3% compared to 6.3% for the TSX Composite. Outperforming over the longer term is only one component. The benefits of diversification are also apparent, as adding Micro Cap to a portfolio of Canadian equities allows for an improved return to risk ratio. Once again, over the 10 year period ending 2012, the optimal allocation to Micro Cap in a Canadian equity portfolio was 15%. Exhibit 4 Return to Risk, Portfolio Combinations December 31, 2013 Micro Cap stocks represent a broad cross section of small entrepreneurial businesses, with flat organizational structures, spanning all sectors, and many trading at compelling valuations. Reflecting the entrepreneurial nature of these Micro Cap businesses, management ownership averages approximately 14%, jumping to over 18% if we exclude the Materials sector. This compares favorably with the TSX 60 where a mere 3% of the market cap is owned by management/insiders. The need for active management is quite important as on the surface, in the Micro Cap space, there may be some companies that appear speculative in nature. If one looks beyond these companies, there are many focused or niche players with strong growth opportunities. These enterprises have characteristics that are extremely appealing and compare favorably to many private equity investments. As publicly traded securities, Micro Cap investments have a great deal of transparency, with daily market based valuations and regulatory oversight that comes with a market listing. With these public listing benefits, investor time and resource commitment is significantly less than a private equity allocation. Furthermore, there is no concern with regards to an exit strategy, uncalled capital, or the J-Curve tendency. January

4 The characteristics of Micro Cap are compared to Private Equity in Exhibit 5. From our perspective, these characteristics suggest that in many ways an allocation to Micro Cap is comparable to a Private Equity allocation, with a few additional benefits. Exhibit 5 Micro Cap vs. Private Equity Comparison With a large opportunity set and a systematic investment process in place to weed out the more speculative companies, it is possible to create and maintain a portfolio with compelling valuations and growth. With the additional benefit of supporting entrepreneurial Canadian enterprises, Micro Cap investing offers an opportunity to capitalize on valuations and prospective returns superior to those in the less transparent and higher cost arena of Private Equity. Exhibit 6 Private Equity Characteristics of an Active Micro Cap Strategy September 2013 January

5 ABOUT HILLSDALE INSTITUTIONAL INVESTMENT SERVICES TEAM is one of Canada's premier independent investment boutiques, specialists in a unique array of traditional, enhanced equity and alternative investment strategies for both institutional and individual investors. Founded in 1996, Hillsdale has developed a proprietary investment approach which focuses on superior alpha within a rigorous real-time risk management process. HEAD OFFICE 100 Wellington Street West TD West Tower, Suite 2100 TD Centre, P.O. Box 228 Toronto, ON M5K 1J3 Phone: Fax: Harry Marmer, CFA, MBA Executive Vice President Institutional Investment Services hmarmer@hillsdaleinv.com Johnny Quigley Vice President (Quebec) Institutional Investment Services jquigley@hillsdaleinv.com Allan Hutton, CFA, MA Vice President Consultant Services ahutton@hillsdaleinv.com FIRM CONTACT Chris Guthrie, CFA President, CEO & Founder cguthrie@hillsdaleinv.com January