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Gordon Pape
Gordon Pape

The Truth About Canadian Small Caps

It is hard to find good companies among Canadian small caps.

Contributing editor Ryan Irvine is back this week with some startling insights into Canadian small cap stocks and updates on four of his recommendations. Ryan is the CEO of KeyStone Financial (www.KeyStocks.com) and is one of the country's top experts in small cap stocks. He is based in the Vancouver area.

Ryan Irvine writes:

At KeyStone, we just completed research on our annual 65-page Cash Rich, Profitable Small-Cap Stock Special Report. It is a long name for a long report that starts by checking over the financial statements and reading the annual reports of 3,000 Canadian publicly traded companies over a three-month period. Aside from alienating your friends and family, you do come across some interesting nuggets in the process. Here are some of them.

1. There are a lot of really poor investment choices in the Canadian markets. Although we have done this exercise twice a year for the past 15 years, it is still actually a bit shocking to rediscover this. Almost 75% of the stocks we review with market capitalizations of under $1 billion are not consistently profitable and over half never earn a dime. Many are essentially money pits, set up to enrich the financial industry and entrenched management while destroying shareholder capital.

2. Several Canadian resource stocks can be bought for less than their cash value. Be careful though; they are priced this way for a reason! Our search turned up around 20 junior exploration stocks whose shares can be had for less than they are worth on paper. More than anything else, this tells you about the long-term depression in the junior resource sector. Each of these stocks is a TSX-Venture listed junior resource company - and we use the term "company" loosely. The fact they are trading under cash value is reflection of how poorly the management of these junior resource stocks look after shareholder wealth. Essentially, the pricing tells you that the market expects these management teams to quickly burn through the cash on hand in a manner that will not increase shareholder value. It is hard to argue with this if you look at the TSX-Venture Exchange over the past five years, which has lost 75% of its value. These shell companies are "value traps". Avoid them at all ! cost.

3. Around 60 stocks (or 2% of over 3,000) made the grade for our report. About half of these small-caps had over 20% of their market caps in cash and zero debt. These companies have operating businesses, are generating cash flow, and, therefore, are of great interest to us. The trick is to determine whether they are growing, will continue to grow, and if they are trading at reasonable prices, thus making them investment worthy.

4. A lack of true "organic growth". In a number of the companies reviewed we observed acquisition related growth and productivity or cost cutting growth which filtered to the bottom line. But grass roots expansion of existing products or services in the form of same store sales, for example, was tough to come by. This points to limited growth in the economy generally and pockets of negative growth. Alberta based companies in particular stood out with energy prices being the major culprit. We believe a combination of organic and acquisition related growth is key for long-term sustainable share price gains.

5. Due partly to the lack of organic growth, we witnessed a great deal of financial engineering to create "growth stocks". The result was poorly constructed investments. Canadian banks and brokerages have historically made their dollars financing the mining and energy sectors. Over the past five years, mining revenues have ground to a halt and energy related financings almost completely dried up in 2014-2015. Bay Street is nothing if not clever, however. In an effort to generate more investment banking dollars, a number of "roll-up" or growth-by-acquisition companies were created, notably in the healthcare, pharmaceutical, infrastructure, and gaming sectors.

Unfortunately, most of these companies have been built hastily with the goal of enriching management (salaries tied to more acquisitions) and Bay Street promoters, who clip off millions with each new financing to buy top-line growth. These management teams issue countless shares to buy new companies, reporting higher revenues with a promise of unending growth, only to hit a wall when it is revealed that "per share growth" is non-existent.

We have seen it play out with large caps like Valeant and small caps like the highly promoted Patient Home Monitoring. Both initially had strong share price gains as revenues grew but the unsustainability of the model was proven as shares in each company have crashed this past year. In the end, the greater size of the companies did not lead to higher per share profits.

Growth via acquisition can be successful. We have seen it executed beautifully and for great profits by companies such as Enghouse Systems (TSX: ESL) and Boyd Group Income Fund (TSX: BYD.UN), the latter of which is updated below. But it is a difficult strategy and must be executed with patience. We believe capital used to execute this type of strategy should at least partially come from internally generated cash flow rather via large share issuances designed to chase huge near-term gains.

This strategy takes time. Both Enghouse and Boyd built their growth stories over 10 years, not in 10 months. We encourage companies we invest in long-term to focus on generating cash flow internally to fund a solid percentage of their acquisitions. Growth from cash flow is non-dilutive and it can be very accretive to existing shareholders if executed properly.


Boyd Group Income Fund (TSX: BYD.UN)(BFGIF)

Originally recommended on Aug. 30/10 (#20131) at C$5.50, US$5.20. Closed Thursday at C$71.05, US$54.01.

Background: Boyd's business is very simple: they fix automobiles. Recession or not, most people find it essential to keep operational their method of getting from point A to point B. Boyd is the largest operator of non-franchised collision repair centres in North America in terms of number of locations and it is one of the largest in terms of sales. The company currently operates locations in five Canadian provinces under the trade name Boyd Autobody & Glass, as well as in 19 U.S. states.

Stock performance: For IWB readers, our original Buy recommendation dates back to late August 2010 at $5.50. The shares have been in a steady upward trend ever since, with recent gains boosted by the company's exposure to the strong U.S. dollar. This past week, shares in Boyd jumped $7.23 in one day and moved over $71 following the release of the company's strong fourth quarter and year-end 2015 financial results.

Recent developments: Highlights from the 2015 financial results included the following:

  • Sales increased by 39.1% to $1.2 billion from $844.1 million in 2014, including same-store sales increases of 5.6%.
  • Adjusted EBITDA increased 47.4% to $101.7 million, compared with $69 million in 2014.
  • Adjusted net earnings increased to $40.5 million compared with $30 million in 2014.

Subsequent to the end of the quarter, the company added 11 locations, including a five location multi-service operator and two locations in British Columbia. Boyd also acquired the glass repair assets of Ryan's Auto Glass in Cincinnati, Ohio.

Dividend: The stock pays a monthly dividend of $0.042 per share (about $0.50 a year).

Conclusion: Once again, we were very pleased with the company's 2015 results, which marked new all-time highs in terms of revenues, adjusted EBITDA, and adjusted earnings. Boyd also surpassed 300 locations in the United States, expanded its U.S. presence to 19 states (from 17), exceeded $1 billion in revenue, and crossed $1 billion in market capitalization.

Boyd will continue to pursue accretive growth through a combination of organic growth (same store sales growth) as well as acquisitions and new store development in 2016. Acquisitions will include both single and multiple locations. Combined, management expects this strategy to generate growth sufficient to double the size of Boyd's current business over the next five years, implying an average annual growth rate of 15%. The company has about $400 million in capital at its disposal to execute its strategy and is thus well positioned to take advantage of large acquisition opportunities, should they arise. This could accelerate the time frame to double the size of its business. In today's limited growth market, we will take that.

Action now: Boyd is not cheap on a traditional valuations basis, trading in the range of 23 times 2016 expected adjusted earnings, but given the fact EBITDA is expected to grow at over 15% long term, it remains attractive. As such, we maintain our long-term Buy rating on the stock for investors with an investment horizon of greater than one year.

Exco Technologies Limited (TSX: XTC)(EXCOF)

Originally recommended on Feb. 27/12 (#21208) at C$4.25, US$4.22. Closed Thursday at C$15.45, US$11.88 (March 9).

Background: Exco Technologies is a global supplier of innovative technologies servicing the die-cast, extrusion and automotive industries. Through its 18 strategic locations in 10 countries, it employs 5,081 people and services a broad customer base.

Stock performance: This stock was recommended in February 2012 as a Buy at $4.25. In our most recent update in December, with the shares at $17.13, we reiterated our near-term Hold and long-term Buy ratings. Since then, we have seen a bit of a retreat in the price.

Recent developments: Consolidated sales for the first quarter of fiscal 2016 (to Dec. 31) were $130.9 million compared to $119.9 million in the same quarter last year, an increase of $11 million, or 9%. The Automotive Solutions segment reported sales of $77.7 million in the quarter, an increase of $5.2 million, or 7%, over last year. The Casting and Extrusion segment reported sales of $53.2 million, an increase of $5.8 million, or 12%.

Consolidated net income for the quarter was $11.8 million ($0.28 per share, fully diluted) compared to $9.6 million ($0.23 per share) in the same quarter last year, an increase of 23%. Earnings were impacted by a higher effective consolidated income tax rate of 31% in the current quarter compared to 26.8% last year.

Recent acquisition: On Feb. 16, Exco announced that it has signed a conditional purchase agreement to acquire a group of private companies (known only as the Target for now). The companies are organized under the laws of Mexico and Michigan. A wholly owned U.S. subsidiary of Exco intends to acquire all of the shares of the Target.

Founded in the 1990s, the Target is a leading tier 2 supplier of interior trim components to a diversified group of North American automotive customers. Additional details, including the name of the Target, will be released after closing, until which time they remain subject to a confidentiality agreement.

The transaction will not require significant integration or restructuring charges and is expected to be immediately accretive to Exco's earnings per share. The Target generated revenue of approximately C$115 million (equivalent) in 2015.

Dividend: We are happy to report that for the fourth consecutive year in our coverage, Exco increased its quarterly dividend, this time by 17% to $0.07 per common share. The next payment will be on March 30 to shareholders of record on March 16.

Conclusion: To start 2016, the market had not expected top line growth would again be in the 25%-30% plus range that the company has posted in recent years, so expectations were tempered. However, management is targeting the company's sales run rate to be close to $700 million by the end of 2017 from the range of $500 million following the company's Target acquisition. That amounts to growth in the range of 40% over the next two years, which will handsomely exceed the market rate. This figure could increase with another potential acquisition.

Given the strong end to 2015 and solid productivity gains we witnessed in the latest quarter, and despite significant short-term losses at ALC and one-time factory upgrades, we expect Exco is positioned to earn between $1.35-$1.45 per share on an adjusted earnings basis in 2016, with upside depending on the integration of the Target acquisition. At present, the stock trades at a reasonable 11.3 times expected 2016 earnings and remains attractive given the long-term positive track record.

Action now: While the company's industry is cyclical, given the growth element added from the new acquisitions with no shareholder dilution, we believe the current environment appears positive for the next 12-24 months. Buy.

Hammond Power Solutions Inc. (TSX: HPS.A)(HMDPF)

Originally recommended on Jan. 28/13 (#21304) at C$8.60, US$8.58. Closed Thursday at C$6.46, US$4.72.

Background: Hammond Power is a North American leader in the design and manufacture of dry-type custom electrical engineered magnetics, electrical dry-type, and cast resin transformers. Leading edge engineering capabilities, high quality products, and responsive service to customers' needs have all served to establish HPS as a technical and innovative leader in the electrical and electronic industries.

Stock performance: This stock was originally recommended in January 2013 at $8.60. The shares briefly topped $9 in July 2014 but since then the stock has been a laggard in our portfolio, closing this past week at $6.46.

Recent developments: Sales for the quarter ended Dec. 31were $80.74 million, an increase of 25.1% from the comparative quarter last year. Full year sales in 2015 were $274.6 million as compared to $247.8 million in 2014, an increase of 10.9%. U.S. sales grew 29.3% and were $50.7 million for fourth quarter of 2015 compared to $39.2 million in the fourth quarter of 2014.

The 2015 financial results were impacted by the new Department of Energy regulations that became effective Jan. 1, 2016. This new legislation resulted in abnormally strong fourth quarter sales demand, as there was a cost advantage to U.S. customers to increase their inventory levels in 2015. This favourably impacted the company's fourth quarter 2015 sales by approximately $7 million and will have a negative effect on the first quarter sales of 2016, as customer demand will soften until their inventory levels normalize.

Dividend: The stock pays a quarterly dividend of $0.06 per share ($0.24 annually).

Conclusion: While 2015 was positive overall for Hammond Power, the strong fourth quarter results will not continue into the first quarter of 2016 as customers pre-bought inventory.

Action now: We are not yet recommending buying new positions in the stock and maintain our Hold rating.

About the author:

Gordon Pape
Gordon Pape is the best-selling author/co-author of many acclaimed investment books, including the recently-published Sleep-Easy Investing (Viking Canada ). He is also publisher and editor of five investment newsletters, including the Internet Wealth Builder, Mutual Funds Update, The Income Investor, and The Canada Report, which was created specifically for U.S. residents interested in investing in Canada . He is a columnist for several magazines and websites and a frequently quoted media source. He has been a featured speaker at numerous events including the World Money Show in Orlando . His websites can be found at www.BuildingWealth.ca and www.TheCanadaReport.com.

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