On the Money

 

Petites capitalisations, grand potentiel?

22 avril 2021

Vishal Patel, vice-président et gestionnaire de portefeuille, parle de la progression des petites et moyennes entreprises au cours de la dernière année ainsi que de leurs perspectives de croissance pour les prochains mois.

PARTICIPANTS

Mark Brisley
Managing Director and Head of Dynamic Funds

Vishal Patel
Vice President & Portfolio Manager

PRESENTATION

Mark Brisley: You are tuning in to On the Money with Dynamic Funds, a podcast series that delivers access to some of the industry's most experienced active managers and thought leaders. We're sitting down to ask them the pertinent questions to find out their insights on the market environment and navigating the investment landscape. Welcome. Thanks for joining us at On the Money.

I'm your host, Mark Brisley. It's a timely and topical discussion for this podcast today, as we've seen shares of small and mid-cap companies on a roll during the last 12 months. Large part of this rally has been attributed to the more recent economic recovery over the past few months, which many market and economic outlook signal will directly benefit small and mid-sized companies as they stand to benefit from investor confidence. Despite arguably peaking in March of this year, particularly referring to small caps, there seems to be a lot more room to run in this space.

Small caps are in a unique position and proved in 2020, the ability to adapt to market uncertainty. My guest for the discussion today is Vice President Portfolio Manager, Vishal Patel here at Dynamic Funds. Throughout his more than 15 years of industry experience, he's covered a broad range of companies across multiple industries. Vishal is a growth-oriented manager who employs deep fundamental analysis to select best-in-class sustainable growth companies. Today, we're going to focus particularly on the Canadian small-cap space and companies and the Dynamic Power Small Cap Fund, which Vishal runs. Vishal, it's great to have you with us once again today.

Vishal Patel: Thanks for having me.

Mark Brisley: Let's start off with, is this in your opinion, a particularly good time to add small caps to a portfolio, or should investors really consider always having a small-cap component in a well-diversified portfolio?

Vishal Patel: That's a good question. The way I would frame it is I think that you should always have a little bit of small-cap in your portfolio, but right now, you should maybe have a little bit even more. The reason that I'm saying that is that I believe that we're in the early part of an economic cycle. When you're in the early part of an economic cycle, you want to participate in small-cap companies and the growth that some of these small-cap companies provide, but as we move through the mid-cycle, late-cycle, and then another recession, I think that small caps also provide a very strong diversification benefit.

The reason right now, why I think it's extremely timely to say, be overweight small-cap versus just having a neutral position is I'm seeing a lot of new innovative companies come to the marketplace. There's a lot of M&A activity. There's a lot of private equity interests. There's a lot of consolidation happening. The smaller companies are buying mom and pops. The larger companies are buying small companies, private equity companies are taking small companies private. It's a very active market. There's a lot of activity. There's a lot of opportunity and there's a lot of retail interest,

Mark Brisley: Pretty incredible rally for North American small caps in particular last year during the height of the pandemic, but probably more so even towards the end when we started to see the recovery unfold. Is the relative performance of this space tied to the reopening of the economy, or even related potentially to the pace of vaccine rollout in Canada?

Vishal Patel: That's a tricky question, but the way I believe I can answer that, it goes back to earlier when I said early cycle, mid-cycle, late-cycle. If you think that vaccine rollout and economic cycle kickstarted from that. We're at the beginning of the cycle, small caps will do well. This idea that a rising tide lifts all boats. In this initial phase, you did see a lot of small-cap interests, you saw small caps do extremely well, but as we enter this mid-cycle, and then late-cycle, I believe our small caps will do well, but you have to be more selective.

There's this Warren Buffett quote, "You only find out who's swimming naked when the tide goes out." I'm not saying the tide is going to go out right now, but longer term, if you focus on the right companies and small caps, I think you'll do extremely well, but you're absolutely right. Since November 1, and vaccine, you've seen a lift-off in the small caps, but not all small caps are going to do well just because they're small caps. I think you're going to see more differentiation within the small-cap universe as we move from early cycle to mid-cycle.

Mark Brisley: Vishal, before we go any further, I think it would be beneficial to our listeners, probably some of them are wondering, define the small-cap space for me, in terms of what does that mean when we're describing a company? Then as a second part of that question, how is the Canadian small-cap universe changed over the last several years?

Vishal Patel: When we think about the definition of small-cap, and specifically, the small-cap mandates that I would focus on, the weighted average market cap would be less than $4.5 billion. It's really a small mid-cap universe, when you think about the Canadian marketplace, the indexes, whether it's a TSX SmallCap Index or the TSX MidCap Index would be companies that would be considered as part of that. The definition that we're looking at is weighted average market cap of less than $4.5 billion.

In terms of the universe and how it's changed, overall, the small-cap index in Canada would be over-indexed to energy and materials. Those sectors would represent a large portion, close to 30% of the universe in Canada. That universe is changing and that's one of the reasons why we're pretty excited about the investment potential going forward, is that there's a broadening out in terms of the sector exposure. You're seeing the introduction of companies in the healthcare space, in the technology space, in the industrial space. There's a little bit more depth and breadth to the Canadian small-cap universe going forward.

Mark Brisley: That's a great definitioning and great overview. I wanted to ask you, then when you start thinking about adding a small-cap company to your portfolios, in particular the Small Cap Fund, what are some of the investment characteristics that you're looking for when making those selections?

Vishal Patel: When we think about our investment process, whether it's large-cap or small-cap, it remains the same. It's a four-step process. It really starts with doing our qualitative work, our quantitative work, our valuation work, and then portfolio construction, but specifically, when you're focusing on small-cap, a big part of it is management and investing with management. Mark, if you recall, we did a podcast and we talked about the benefits of co-investing with founder-led businesses, entrepreneurs. I think the small-cap universe allows for more of that. This idea of investing in people, investing in businesses, business leaders, and next-generation entrepreneurs is one of the big things that we're looking at, but I think the small-cap space offers additional potential because of the universe of entrepreneurs that we're seeing in the Canadian marketplace.

Mark Brisley: Yes, that's a great reference to your previous spot on our show here, and I would encourage anyone who didn't get a chance to listen to that, to, in addition to this one, go back and listen to that one as well on founder-led businesses, it was excellent. My next question is really a three-part question for you, so I'll apologize in advance for the complexity. First of all, what areas within small-cap are you actually excited about, that you believe have good potential? What are some of your favorite ideas or themes in your fund today, and maybe a couple of the names that you're excited about?

Vishal Patel: Let's just start with the two big areas in where I see the biggest potential going forward. It's really this idea of financial services and building products. We can talk about housing. I think housing is doing extremely well. We all have this idea. We read it in the newspaper every day. House prices are doing extremely well. People are buying homes, they're renovating homes, they're building homes, they're adding decks. This idea of building products for home and home renovation, I think remains a good long-term area to invest in.

The second area where I'm seeing potential is financial services. Small-cap financial services have the ability to scale. There's a large and growing opportunity. Some of these financial services businesses are also not just domestically focused, but they can benefit from some of the growth in the United States. I would say the two biggest areas for us of focus and where I see opportunity is building products and financial services.

This other idea of unique individual names and how we're thinking about the future, so going back to this financial services idea, a unique individual name, I'll use. I'll give you a story here actually, is Trisura. Trisura would be the largest holding in the fund, but how we got to Trisura goes back to this whole idea of entrepreneur, founder-led business, being early.

This is the story of Brookfield. If you look at Brookfield and you ask Bruce Flatt, why has Brookfield done well? He'll tell you the reason is George Myhal and low interest rates. George Myhal retired from Brookfield, he's got a family office, but he's the chairman of this company called Trisura. Trisura was a spinoff from Brookfield, nobody knew about it. We took the time to get to know the management team. It goes back to co-investing with great managers and entrepreneurs. David Clare is the CEO of that company. He's George's protégé. We got to know this management team before anyone was covering the company in the Canadian marketplace.

Here's a P&C insurance company that we believe is going to continue to grow, not just domestically, but in the US. I think that there's a lot of these kinds of opportunities, but you got to be early. You got to identify them, you got to spend time with management, and I think that they have a long runway for growth. The idea, if you can actually find a small company that's going to become a large company, I think there's a lot of value to be added there.

Mark Brisley: That's an interesting point, and a question that comes up a lot is if you see a company that starts out as small or a midsize company that can become a large company. I wanted to know if you had an example of a company that you have actually owned where that has happened or been the case.

Vishal Patel: Yes. Mark, there is recent examples and there's examples in the past. The two biggest examples in the past would be Dollarama and Couche-Tard. Dollarama and Couche-Tard started off with a couple of stores and they are where they are now. They would be considered TSX 60 constituents, but we're seeing new business and new business formation in Canada. A more recent example of a company that started off as a small/mid-cap and now is actually large-cap company, it's a Montreal-based payments company called Nuvei.

They've got a market cap of around $12 billion now. This is interesting because we get to know the company, we get to know the management team once they're smaller, so we've done our homework. Once they graduate, they can be included in the larger funds. It's this natural progression. It sort of makes sense. It's interesting to see because we've already done our homework. If you owned it when it was small, of course, you want to own it when it gets bigger as long as the growth potential is still there.

Mark Brisley: Vishal, when many investors hear the term "small-cap," they often get concerned or associate that with volatility. How do you mitigate risk when you're investing in small caps?

Vishal Patel: The way you should think about risk is really permanent loss of capital. If you're taking this longer-term business ownership philosophy towards small-cap, think about it as private equity and private equity ownership. That's one way that you mitigate risk. The second way that you mitigate risk is really diversification. We talked about the index being over-indexed to energy and materials.

I think if you take a more diversified approach, have a little more technology, industrials, healthcare, that's the second way that you can manage risk. You will have day-to-day volatility, but I think you've got to focus on the long term, and you've got to think about permanent loss of capital and liquidity of these companies. I would say that the best way you can actually manage risk is by having different sector exposures.

Mark Brisley: Beyond small caps, you do, as a portfolio manager here at Dynamic, you manage larger-cap Canadian equity and US balanced funds. How does being a small-cap manager play a role or help you with those larger mandates?

Vishal Patel: I spent a lot of time thinking about this, and I would actually say that being a small-cap manager makes me a better large-cap manager and being a large-cap manager makes me a better small-cap manager. I'll give you two little tidbits here, or stories. Earlier, I just mentioned this idea of Trisura, Trisura being a P&C insurance business, but if I wanted to understand Trisura, understand the P&C insurance space and understand the surety market, when you look at our large-cap funds, you'll notice that we own a company called Intact.

Intact is the largest P&C insurance company. I could pick up the phone and call up Charles and ask him about the surety business and he'll explain to me what that business is. He knows the small-cap universe of Trisura. In a way, I could ask David, "What's going on with Charles?" and Charles, "What's going on with David?" because of P&C insurance business, whether it's a small P&C insurance business or a large P&C insurance business, has some similar characteristics.

The second thing I would say, an example I could give, we talked about building products in housing and how we see tremendous opportunity there going forward. The large-cap funds would have exposure to home building, housing, housing products, so if you take a company like Home Depot, Home Depot would be a very large buyer of lumber, would be a very large buyer of products from Richelieu Hardware. You'll notice Richelieu Hardware is one of our top 10 holdings. This idea of channel checks, checking with the customer, understanding what's going on in the value chain, I think is important. I wouldn't be able to do that unless I had both large-cap and small-cap mandates.

Mark Brisley: It's really interesting that anytime you Google small-cap or look in the news media for a small-cap story, that you often get a reference to the small-cap indices. A question that I've had often by investors is the index a good or a bad representation of the type of companies and opportunities that you can actually invest in and in particular, in small caps?

Vishal Patel: I think we touched on this earlier, but I would say that the Canadian small-cap universe has a lot more exposure to energy. Energy is an area where we are a little bit more cautious. It's substantially overweight or over-indexed, close to 20% in the materials space, but I do see opportunity in the materials space. We talked about this idea of building products, but there's also unique gold companies in Canada. Vancouver is very well known for this idea of materials. I think Canada is very known for materials. Overall, I would say the Index has a lot of names.

The Index, I think has 235 names when I checked yesterday, so you're not going to be able to own all 235 names of what the Index provides, I think you have to be selective. I think that there's selective businesses to own longer-term. This goes back to my comment earlier, as we move from this early cycle to mid-cycle, if all small caps did so well since this recovery since the vaccine, what's going to work in the next phase of this cycle and what's going to work longer-term is what you need to ask yourself. That's why I think that there's going to be more differentiation going forward in the small-cap space.

Mark Brisley: Given the diversity of mandates that you actually do run, which cross from small and mid right up to large, when you take a look at the market right now, is there anything that's concerning you?

Vishal Patel: In terms of concerning me, I would say that there's a couple of areas that are concerning this idea of the SPACs and there's a lot of IPOs. I'm not against IPOs, we're benefiting in the funds from some of this new business, new board business formation.

I think it's healthy, I think we're in a bull market, there is a party going on, but I am advising prudence. What I mean by that is you don't need to go to the party and do keg stands, you don't need to have tequila shots. It's okay to go maybe have two drinks, maybe three drinks, participate in this party, participate in this bull market, but not everything is going to work out. I think you have to do your homework.

If there's one big key takeaway today, more than anything else, you have to do your homework, you have to go out, you have to read 10-Ks, you've got to read 10-Qs, you got to meet the management teams, spend times on conference calls, read the original documents. You can't just read a tweet or read a Reddit post. You've got to actually take the time and read the perspectives, especially if you're looking at IPOs.

Mark Brisley: Yes, and there's so much news, so much easy access to information these days. It's hard to ignore what we've seen happen out there with the Reddit and WallStreetBets issues that went on. The lure of Bitcoin, SPACs, all these things that you're hearing on the marketplace. What's some of your advice or investors that are listening to this podcast on how you navigate these markets today and how important is patience?

Vishal Patel: Patience is really important, and I think having that temperament and being able to manage through volatility. We could just go back what happened in March of last year. I think a lot of people freaked out, didn't stick to their plan. This idea of financial advice, I think Dynamic Funds, Invest with Advice. I do believe in the tagline and I am a product of this firm, so I do believe in Invest with Advice.

I do think there's a strong role to play in terms of a financial advisor. It's an important role. I would say that it's a bigger role now because we just talked about all this activity. I think activity is good. I think it's healthy. I think there's opportunity, but I would say you've got to do your homework. I would say, seek out an advisor, go back and forth, talk with the advisor.

I've used a couple of quotes today, but I would say, "The people with the experience end up with the money and the people with the money end up with the experience." What I'm getting at here is, if you can work with a financial advisor, I think it would be recommended because there is this idea of speculative excess which we're seeing there is. When we think about small caps specifically, it is prone to some stock speculation. If you can get help, get some advice, work with somebody with experience, I'm recommending that.

Mark Brisley: Well, the last 12 months have certainly provided a lot of experiences for a lot of people around the world. As it pertains to the markets and investing and creating portfolios, your insights are definitely appreciated today. In particular, on a space that's garnered a fair amount of attention in the last little while. I appreciate your time very much for this, Vishal.

For our listeners that didn't get a chance to listen to our first podcast with Vishal, he is a Lead Portfolio Manager of the Dynamic Power Canadian Growth Fund​​, the Dynamic Power Balanced Fund, Dynamic Power Small Cap Fund, which we've talked about today, as well as the Dynamic U.S. Balanced Class. As always, if you would like to learn more about any of the topics that we discussed here today or any of the offerings at Dynamic, please do reference us at dynamic.ca. Of course, as always, we believe in seeking out the advice of a qualified financial advisor. I want to thank all of you for joining us in this edition of, On The Money. We wish you continued good health and safety.

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