Canadian Micro-Caps Provide Ample Opportunities by Royce Funds
After visiting close to 30 micro-cap companies in four Canadian cities over the past six months, International Micro-Cap Portfolio Managers Jim Harvey and Dilip Badlani make a case for Canadian micro-caps opportunities and an economic landscape that boasts many of the kind of quality businesses in which we typically seek to invest.
Can you give us a brief history of Royce’s exposure to Canadian companies and talk about your recent trips to Canada?
Jim Harvey: Royce has been investing in Canadian companies for quite some time now. The areas that we have historically been most attracted to in Canada are the Energy and Materials sectors, particularly in energy equipment & services, precious metals, and natural resources companies.
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But Dilip and I have been approaching Canada a little differently—we’re screening the whole Canadian market. In the past six months we’ve visited Toronto, Montreal, Vancouver, and Calgary and met with the management of close to 30 micro-cap companies across a variety of industries, including consumer, industrial, energy services, technology, healthcare, transportation, aerospace, and software companies.
On our last trip we concentrated more on energy because we were in western Canada, which is somewhat unique given the prominence of the energy industry in that region of the country.
Why have you increased your weighting in Canada in Royce International Micro-Cap Fund’s portfolio since taking over management duties in October?
Dilip Badlani: Canada is a big market and benefits from having a huge natural resource base relative to the size of its population. It is the world’s eleventh-largest economy and has among the highest GDP per capita.
The country is easily accessible and the government has implemented policies that invite foreign direct investment (FDI). Calgary, for example, is booming with Chinese investment. Petronas, a state-run Malaysian oil company, has purchased energy assets in Canada.
The goal is to eventually export some of this energy via investment in liquefied natural gas (LNG) to Asia once approvals are put in place.
JH: In Calgary, we met several companies who told us that, in their view, there is essentially zero unemployment in western Canada. It is booming given the large investment in the Energy sector. The labor market is thriving and people are making money, which is spilling over to the rest of the economy.
DB: We have been able to maintain our discipline and find good companies at good valuations with global exposure and unlevered balance sheets.
I think that many investors immediately think of minerals and natural resources when they think of Canada. But we’ve been able to find under-the-radar companies in different industries with minimal analyst coverage that have low trading volumes but strong businesses with room for growth.
As Jim mentioned earlier, we’re trying to cover the entire economy because there are opportunities in every sector. I think that many investors immediately think of minerals and natural resources when they think of Canada.
But we’ve been able to find under-the-radar companies in different industries with minimal analyst coverage that have low trading volumes but strong businesses with room for growth.
If you’re willing to be patient and try to use volatility to your favor, which is what we do here at Royce, these companies will hopefully grow at a pace that’s both faster than the Canadian economy and faster than the pace of global GDP. Ultimately, we believe this can be a recipe for strong returns.
Are there themes to your Canadian investments?
JH: We’re really just carrying the Royce mandate over to other areas of the globe, essentially looking for the same characteristics that we seek in all of our micro-cap holdings both inside and outside the U.S.
Before we visit any part of the world, we run screens to help us determine which companies we’d like to meet. Dilip and I actually do this independently at first in order to best ensure we get a fuller snapshot of any given market. We then synthesize our findings to come up with a list of candidates.
The core metric we focus on is high returns on invested capital (ROIC). We want to see companies that consistently generate returns well beyond their cost of capital.
We also prefer companies that are able to improve returns over time. In addition, Royce has always emphasized investing in companies that have strong balance sheets.
We generally want to see companies that have at least 50% of total assets supported by shareholders’ equity. We also like to see companies that have built in operating leverage.
So we have a preference for micro-caps that are able to grow operating income faster than sales over time.
By profiling companies in this way, we’re typically led to those that are self-funding and well capitalized—companies that don’t need to come to the market to raise capital and companies that are able to fund their own dividends as well as their own growth.
And since many of these companies don’t need to raise capital, they’re not likely to receive attention from most Canadian investment banks, so analysts typically don’t write about them. We feel that this gives us an advantage.
DB: Through the financial crisis of 2008, the Canadian financial system went largely unscathed. Canada has a strong regulatory environment and historically people there have a propensity to save money and maintain conservative balance sheets.
This conservatism has prevented the massive volatility seen in other markets. Things just seem to be moving along slowly and steadily in Canada. Some investors might think it’s boring, but to us it sets a backdrop for long-term growth.
I’m hoping that two years from now, when we look at Canada, there will be very few companies meeting our investment criteria in our investment universe that we don’t know something about.
Canada, when compared to some of the other countries around the world, is not one of the “hot” economies, so to speak. To Jim’s point, I don’t think Canada is front and center in anybody’s mind. We believe this helps enable us to find companies with good valuations.
JH: More recently, a kicker for the economy has been a weakening in the Canadian dollar. There are a lot of exporters in Canada that benefit from this trend after close to a decade of strength.
DB: In general, our Canadian holdings have a strong amount of stewardship from their employees, who care about the stock and what’s right for the company in the long term. They also have a large degree of insider ownership, which helps to align our interests.
JH: Almost all of the Canadian management teams that we’ve met with over the past six months have been open, friendly, and easy to deal with. They value corporate governance and they like to pay dividends. They tend to reach out and follow up in a timely manner. They’re on top of things in terms of earnings releases and transparency.
What are some examples of Canadian companies that you currently like?
DB: We own some high-quality businesses in Canada that are global leaders in their industries. Since our most recent trip was to western Canada, let’s start with an energy company.
We own Total Energy Services, an energy services company based in Calgary, Alberta that has three business lines: contract drilling, transportation services, and the sale, rental, and servicing of new and used equipment for oil and gas processing and gas compression. It’s a very well-run company with prudent capital allocation.
We’ve known this management team for some time and have always felt they do a good job in determining when to grow and when to cut back, which is crucial to us because in this type of business it’s important to not get over levered; oil and gas prices are cyclical by nature.
JH: In the case of Total Energy, it was nice to be in Canada and get confirmation from analysts as well as other management teams that our thesis, which is that the company is especially good at allocating capital, looks accurate. We heard confirmations of that repeatedly.
DB: MTY Food Group is a good example of how Canada has benefited from its open-door immigration policies. The company was started by Chinese immigrants from Hong Kong and is now one of the largest restaurant franchisers within Canada.
We like the company because of its cost-focused business model. In the world of casual dining, where margins can be thin, it’s imperative that you have a good grip on costs because brands can go in and out of favor. But if you keep your cost structure low you can be profitable. MTY Food Group is also growing into the U.S. market.
JH: AirBoss is a company we saw when we visited Toronto. It’s an industrial company—one of the top companies in the world in rubber compounding. It also offers automotive products in the U.S. market. It’s a true mini-conglomerate.
One of the things we like about AirBoss is that management has already paid back more in dividends than it has issued in share capital. We also like that the founding shareholders still own their original stock. Management has a long-term vision to make the company much bigger than it was when it started.
Another company we met in Toronto was Contrans, which is one of the largest trucking companies in Canada. Contrans is well run, has large insider ownership, and a history of paying dividends.
DB: One of International Micro-Cap’s largest holdings is Magellan Aerospace. Based in Ontario, this company serves the civil aerospace and defense market. Management runs the business with a long-term focus, similar to how we invest. Its balance sheet is unlevered and it is growing at a solid rate and also recently increased its dividend.
Is there anything else you’d like to add?
DB: I’m hoping that two years from now, when we look at Canada, there will be very few companies meeting our investment criteria in our investment universe that we don’t know something about.
JH: It’s been great getting to really know these micro-caps companies and sort of reboot our effort within Canada. We’re hoping to continue to build on this momentum.
DB: Since last August we really ramped up our international micro-caps efforts, and now we’re making targeted trips to meet with micro-cap companies around the world. Our goal is to know as much as we can about this mostly overlooked segment of the market.
JH: The exciting thing is that not a lot of people in the industry are going around the world meeting with micro-cap companies, which makes us all the more enthusiastic about our efforts.