Although Canadian small caps are typically written off as a domestic play heavily tilted towards commodities, this market presents many opportunities to invest in a universe of high-quality Canadian names with significant global exposure and solid growth potential. With these stocks currently trading at low valuations, now is a historically attractive and rare entry point for active, long-term investors.
Today, many Canadian small caps offer high global growth potential
Even if, on the surface, more than 50% of the S&P/TSX Canadian Small Cap Index is composed of energy and materials companies, there are many high-quality Canadian companies outside the highly volatile commodities space, offering investors a treasure trove of hidden gems with considerable global exposure and tremendous growth potential.
Keep in mind that the recent outperformance of commodities is more the exception than the rule. Because this sector is prone to huge macro-induced price swings, it is one of the most volatile in the market. Macro conditions can shift very quickly, changing the trajectory of the commodities market, from years of upswings to decades of downturns.
The recent performance of the commodity sector is an exception since, as illustrated below, the TSX Small Cap Materials and Energy sectors have seen negative compound annual returns of -0.82% and -8.01%, respectively, over the past decade.
TSX Small Cap Materials and Energy Sectors
Source: Scotiabank GBM Portfolio Strategy, Bloomberg.
In the Canadian small cap universe, there are many industry-leading companies with compelling global growth stories to consider as an alternative. ATS Automation (ATA on the TSX), Altus Group (AIF on the TSX) and Colliers (CIGI on the TSX) are a few examples.
ATS is a global industry-leading automation solutions provider for many industrial end markets. It has evolved into a truly global small-cap company over the past decade—with most of its revenue now from North America, Europe and Asia. Coupled with this fact, ATS has a proven management team, a solid worldwide growth strategy, high secular growth potential and a strong balance sheet.
Altus provides the global commercial real estate industry with vital actionable intelligence solutions. The company is trusted by most of the world’s largest commercial real estate (CRE) leaders, for its CRE valuations, performance and risk management. Through its high-growth Analytics division and its market leading Property Tax practice, Altus has a long runway of global growth ahead.
Colliers is a leading diversified professional services and investment management company, with operations in 63 countries. The company provides a wide range of services to the commercial real estate sector, including consulting, representation, asset management and more. Colliers plans to more than double their profitability by the end of 2025 and augment its internal growth via smart acquisitions and expand its services.
Now’s a historically attractive and rare entry point for Canadian small caps
Today’s difficult macro environment for the current Canadian small cap market offers attractively priced opportunities. The recent broad market sell-off, like any dramatic market downturn, has wrongly put low- to high-quality names in the same bucket, punishing all of them indiscriminately in the short term.
The result? High-quality Canadian small caps are now trading at ridiculously low valuations, providing seasoned stock-pickers with a once-in-a-decade opportunity to invest in the best names.
TSX SmallCap Forward P/E Ratio
Source: Scotiabank GBM Portfolio Strategy, Bloomberg.
A case in point: Richelieu Hardware (RCH on the TSX), a leading North American distributor, importer and manufacturer of specialty hardware, was hit hard by the recent market sell-off in the consumer discretionary sector, even though it is a well-managed growth company with a leading market share.
Today, Richelieu is trading at 13.0x NTM earnings and has the financial strength to accelerate its acquisition growth as other players exit the market. Additionally, with interest rates moving higher and mortgaged homeowners more likely to renovate rather than move, this company should continue to see strong growth tailwinds and deliver outsized returns for some time.
Although a recession would undoubtedly put pressure on the short-term profitability of Richelieu and other high-quality small-cap names in today’s economic climate, many should outperform their peers, capitalizing on their strong balance sheets to make value-enhancing acquisitions and, in turn, increasing their market share.
Richelieu Hardware is just one example. With the valuations of Canadian small-cap stocks relative to large caps stocks at two-decade low, Canadian investors have an historically low and rare entry point into this market.
Canada: Small Cap Fwd. P/E ratio Relative to Large Caps
This huge valuation gap creates a unique opportunity to profit from market inefficiencies, which can provide compelling investment setups for active managers with long-term time horizons.
Finding high-quality, mispriced companies requires in-depth research
Of course, finding high-quality, well-managed, yet mispriced companies in any market requires an investment process built on an in-depth knowledge of the complexities and ever-changing factors that impact any potential investment.
When the broader stock market significantly overreacts or underreacts, seasoned investors turn to both quantitative and qualitative research to profit from high-quality, attractively valued investment opportunities, particularly financial data, quantitative metrics, risk models and other analytical tools.
In the small-cap world, where stock information is in short supply, active investors tend to rely much more on qualitative research, particularly management interviews, company visits, competitive analysis and growth modeling, to stack the odds in their favour. And when the market makes extreme moves in either direction, this in-depth research carries even more weight.
To identify financially strong, resilient Canadian small-cap companies that can benefit from the current economic climate, today’s investors adopt the time arbitrage approach, which calls for a medium- to long-term focus, not the short-term focus of the market.
Generally, these are high-quality companies that benefit from solid organic growth tailwinds and strong financials, including a high return on equity, high return on capital and strong free cash flow generation—plus the ability to grow by acquisition and compound capital at solid double-digit rates.
Capitalizing on their strong balance sheets to make value-enhancing acquisitions and increase their market share, the names in VBA’s Canadian small-cap portfolio are currently trading at a valuation that discounts most or all the looming recession, offering decent downside protection from today’s levels and extremely attractive medium- to long-term return prospects.
Key metrics for the Canadian small-cap portfolio
| Number
of Holdings | ROE | 5yr Expected
EPS Growth | P/E NY | EV/EBITDA NY | Discount to DCF |
|---|
| 39 | 16.2% | 20.5% | 16.9x | 9.7x | 14.9% |
Source: Scotiabank GBM Port folio Strategy, Refinitiv.
Now is a once-in-a-decade opportunity to add more Canadian small caps to your portfolio
Canadian small caps are, more than ever, a beautiful success story in the making and, despite what many market pundits may believe, it has a cast of leading characters that makes this market more than a “Commodities play.”
For active investors, there are many Canadian small-cap companies with high global growth exposure and historically low valuations that should outperform their peers. With expert stock selection, a Canadian small-cap portfolio composed of these compelling names can offer decent downside protection from current levels and extremely attractive medium- to long-term return prospects.
That makes now a once-in-a-decade opportunity to go beyond Canadian “commodities plays” and profit a universe of otherwise hidden, high-quality, attractively priced Canadian gems with considerable significant global exposure and strong solid growth potential.
