(Bloomberg) -- Canadian small-cap stocks – unloved and often ignored – have caught a wave, thanks to cooling inflation and a surge in deal activity.
A benchmark index of smaller Toronto-listed stocks has returned 12.3% this year in Canadian dollar terms, including dividends, outperforming larger domestic firms and the MSCI World Small Cap Index, and some portfolio managers say the trend is poised to continue.
It’s partly about the economy and the odds of a soft landing. The global growth outlook is healthy enough to keep oil above $75 a barrel, yet inflation is cooling, offering hope that the Federal Reserve will cut rates soon. Those factors help the S&P/TSX Small Cap Index, with is laden with oil and gas, gold and silver companies. Materials and energy stocks constitute about 54% of the gauge.
Meanwhile, dealmaking has boosted stocks like steelmaker Stelco Holdings Inc., one of biggest names in the index, and Heroux-Devtek Inc., a maker of aviation equipment. Both just received takeover bids at sizable premiums.
Jordan Zinberg, chief executive officer of Toronto-based Bedford Park Capital Corp., said there are still many opportunities in small caps outside of commodities plays. Overall, he says, they still look cheap — trading at a substantial discount to larger stocks based on the price-to-equity ratio, adjusted for non-cash and one-off charges.
“A lot of the large cap multiples are stretched,” Zinberg said by phone. “If investors are looking for growth, they’re moving down cap.”
Sentiment Shift
Before this year Canadian small caps were on a terrible run, on a relative basis. They’ve underperformed the large-cap TSX 60 Index in 11 of the past 13 calendar years — just as the Russell 2000 has often been eclipsed by the S&P 500 in recent years.
The Russell gauge, which includes US stocks up to about $12 billion in market capitalization, is on its way to its best monthly performance of the year, gaining 8.6% in July, as of Thursday’s close. A sentiment shift has also fueled outperformance of the UK’s FTSE 250 Index this month compared with the better-known FTSE 100.
A report from Atrium Research in May noted that Canada’s small- and mid-cap equities were much cheaper than their US and international peers due to a dearth of liquidity and institutional capital.
To be sure, a hard landing for the US economy — a recession — would crush many smaller commodity stocks. “The small cap index will not do well in that scenario,” said Zinberg. “But I don’t think that matters because I think there are so many other fantastic companies that are available in the Canadian small- and mid-cap space.”
Some strategists see the rotation to small caps holding up in other markets as well. Julian Emanuel, senior managing director of equities at Evercore ISI, argued that “small caps have been abandoned” and are cheap compared with historical valuations.
“The drama of July’s outperformance in small caps is really almost breathtaking,” Emanuel said on Bloomberg Television this week. As Fed policy becomes more accommodative, he said, the theme for small caps “is outperformance, and it’s there and we think it’s durable.”
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