If small cap stocks are more risky than large caps, Saxon Small Cap Fund is the exception to the rule. Noteworthy is the manager’s bear market performance in the wake of the tech-bubble, when his small-cap peers were languishing. “To be truthful,” comments Bob Tattersall, fund manager since its 1985 inception, the reason is “difficult” to identify, “largely because we keep doing the same things.”
What they “keep doing” is in fact bottom-up, value-oriented investing. Sector weightings are “serendipitous” as a result, explains Tattersall. They employ a variety of measures of value; price-to-book was the key measure at inception, he recalls, but they are relying much more these days on standard measures of cash flow. Their value style translates into overweight in industrials, underweight in technology—and no gold stocks. The key, he concludes, is not so much what they own as what they don’t own.
Where are they finding value today? Interestingly enough, in the oil patch. This is a sector, says co-manager Scott Carscallen, “where we’ve been finding more interesting value opportunities, I’d say, over the past year.” Traditionally, he explains, the sector has been “very expensive”; but now juniors are coming under pressure and presenting investment opportunities. The juniors are feeling it on two fronts: they are heavily exposed to plummeting natural-gas prices; and they are feeling the pinch of cost inflation in the oil patch.
Carscallen notes that some are now missing production targets. If it’s just bad weather or the lack of drilling rigs, he says, then there is a great opportunity. Some names that were previously expensive, based on a discounted cash flow analysis (supplied by third-party oil-patch analysts), present real value.
Carscallen warns, however, about the growing cyclical build-up of debts among these apparent bargains. Time and again, he says, these companies will go on an acquisition spree or overspend on internal cap-ex. “I want to see a clean balance sheet,” he insists. When the cycle turns, he cautions, “their cash flow comes under pressure, and that creates liquidity problems.”
There are still great juniors, he hastens to add, with good track records and production and/or reserves. Gentry Resources Ltd., the Calgary-based junior, is one in the sector that Carscallen really likes. He thinks the real story’s been mostly timing issues: the lack of infrastructure, the weather, and so on. They’ve been moving away from the lower-quality heavy oil, more costly to refine and transport, and he doesn’t think this has been reflected in the share price.
Another area in which they are finding value is the “busted-up, beaten-up” income trusts. Looking back over two decades, Tattersall considers the most important change in the small-cap market to be the advent and legitimization of the income trusts. “We think that there’s lots of opportunity here,” laughs Tattersall: “lots of ‘busted,’ beaten-up businesses.”
Co-manager Scott Carscallen has been, seredipitously, a student of income trusts for the past seven years. Originally, he explains, they were cool to the trusts: “too rich for our liking” at IPO, the pay-out ratios were too high, and there was too much debt. Subsequently, struggling trusts have been pushed over the edge by the “perfect storm,” as he puts it: tight margins due to rising costs, especially fuel, and the rising currency.
When struggling trusts have suspended distributions, he continues, share prices has fallen, in some cases, by more than half. Is the situation temporary or spiraling out of control? Cash flow is the key, answers Carscallen. “If you’re going to play the busted-up trusts, you’ve got to be able to get a feel for whether or not they’re going to be able to manage the balance sheet properly.”
The upside is still finite, Tattersall chimes in: with the restoration of distributions the trust will only return to its original level. This “restrained” upside guides their maximum allocation at roughly 10-15 percent. That said, some good established businesses have popped: take, for example, Connors Brothers Income Fund, the Nova Scotia-based fish processor.
Clearwater Seafoods , is another interesting example. They suspended distributions in 2005 as costs and forex pushed them into deep waters. After nine months, however, in early August 2006, they resumed distributions and were rewarded for it. While the fund realized the expected upside here, Carscallen still considers it a hold at its current valuation.
One might think a small-cap portfolio would entail greater risk. Not necessarily so, counters Tattersall. He estimates that the portfolio’s beta, the statistical measure of assumed market risk, is roughly equal to the overall TSX Composite, not the more volatile small cap indexes. He says this has been achieved by concentrating on low price-to-book, which implies low beta.
Tattersall says that small caps were significantly undervalued vis-à-vis large caps stocks in the spring of 2000, by roughly half. That discount has narrowed to 10-15 percent, he estimates. Years ago, he reminisces, it was like shooting fish in a barrel. Now, small cap is “no longer a no-brainer.” The value hunter is finding it much tougher to find bargains.