Top Canadian Fund Since Crisis Sees Safety in Blue-Chip Small Caps

(Bloomberg) -- With Canadian small cap stocks falling almost twice as much as the broader index this year, you might expect managers of these funds to start getting the jitters.

Not so for Jeff Mo, the manager of the Mawer New Canada Fund, the top-performing Canadian fund -- with more than C$1 billion ($740 million) in assets -- since the 2008-2009 financial crisis. So far, the fund is doing relatively well amid the recent turbulence, and in Mo’s estimation, its portfolio of what he calls “blue-chip small cap” companies should hold up well on what could be a rocky road ahead.

“My experience in 2008 is that the fundamentals of the companies we invest in did quite well there -- their peak-to-trough drop in earnings was not that severe,” Mo, 32, said in an interview at Mawer Investment Management’s headquarters in Calgary. “That’s probably due to what we call the blue-chip, small cap effect. They have strong niches, but it just so happens that they dominate smaller niches.”

That strategy has helped the fund, which is closed to new investors, return 385 percent since the S&P/TSX Composite Index bottomed out on March 9, 2009. That compares with a 149 percent return for the TSX index, including dividends, and 117 percent for the TSX small cap index.

Top Canadian Fund Since Crisis Sees Safety in Blue-Chip Small Caps

Here are Mo’s other thoughts on investing and the markets in the year ahead:

End of a Run?

While Mawer doesn’t try to time the market, Mo says the recent downturn in equities may last for a while. Canada’s main benchmark is down 13 percent on the year.

“After nine years of a bull run, there’s room for investor psychology to correct. I would say there are signs that the economy, the fundamentals could also be slowing. But I would also say at Mawer, we are also seeing potential reasons for the economic expansion to continue. Overall though, we agree with the pundits that we are probably nearing the end of an economic cycle.”

Among Mo’s reasons for confidence in the economy are continued strong job gains in Canada, widespread global economic growth and robust fundamentals in the companies his fund is invested in.

“That said, right now, the stock market is moving very differently than the fundamentals of the companies underlying it. That can end only in one of two ways: Either the fundamentals eventually come and match the market’s pessimism, or the stock market goes back to being in line with company fundamentals.”

Investing Philosophy

Mawer takes a bottom-up approach to investing, meaning they are generally sector-agnostic and start with an analysis of a company’s business, managers and track record.

The key financial criteria Mo and his team look for is a return on invested capital that exceeds the cost of capital, which he says is “definitionally the only way to create wealth.”

The fund’s current top holding, with 5.8 percent of its assets, is MTY Food Group Inc., a Montreal-based quick-service restaurant franchiser founded by Stanley Ma, who Mo calls “The King of the Food Court.” The company, which owns brands ranging from Manchu Wok and Mucho Burrito to Jugo Juice and Extreme Pita, has about 5,500 locations. The shares are up more than sevenfold since the market’s 2009 bottom.

“They have shown that they have a competitive advantage when buying and integrating new fast food brands,” Mo said.

Top Canadian Fund Since Crisis Sees Safety in Blue-Chip Small Caps

That roll-up strategy is a common characteristic of some of the fund’s other top holdings, including Enghouse Systems Ltd., a Markham, Ontario-based provider of software for mapping and contact centers, and Boyd Group Income Fund, a Winnipeg, Manitoba-based owner of a variety of collision-repair shop brands.

“They’re very disciplined in what they paid for their acquisitions,” Mo said of Boyd. “They have their competitive advantage in scale, and every time they buy a new collision repair shop, they can bring to that collision repair shop better paint- and auto-part-purchasing scale, and, most importantly, preferred access to the direct-repair programs at major insurance companies in the U.S.”

Sectors to Watch

Despite Mawer’s sector agnosticism, Mo says the firm has found certain industries with better returns on invested capital.

“Software has been where we’ve found lots of companies with really high returns on invested capital, probably due to the scalability of that business model. You write the code once and you can sell it to anybody.”

Financial services companies also tend to perform well, he said.

“Bank CEOs tend to understand there’s a cost to their capital, because they have to tell the regulators what it is, and so they tend to have a larger focus on earning a return above the cost of capital.”

Likewise, other industries such as energy pose greater risks. Though Mawer is based in Canada’s energy hub, Mo’s fund contains only 7.8 percent energy stocks, compared with a 17 percent weighting for those companies in the TSX small cap index.

“Resource extraction is a tough industry. You invest all of your capital up front, then you often don’t know exactly what the quantity you will produce is, nor do you know the prices. And so because of that, it’s very difficult to ascertain whether a company truly has the ability to earn a return on capital. Our observation is that in that type of uncertain environment, management teams tend to be overconfident on their assets.”

As for Canada’s hot new industry, the fund has evaluated some marijuana stocks but hasn’t made any investments because it can’t find a company that has demonstrated a competitive advantage and because the “exuberance” of that market has inflated valuations.

“We definitely expect that some winners will come out of dozens and dozens of publicly traded companies today,” Mo said. “I would say that none of them have obvious competitive advantages right now, and it’s too unpredictable to know who will.”

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