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• Commentary

July 2010

The small-cap market retreated in the second quarter, with the BMO Small Cap Index falling 5.7%. After a year of strong gains, small-cap stocks gave up some ground as investors curbed their appetite for risk.

The Small-Cap Equity Fund fell 4.2% in the quarter and was up 12.8% for the year ending June 30th. Since its inception in February ‘07, the fund has lost 0.4% per year, modestly ahead of the market’s decline of 3.7%.

As a reminder, the manager’s (Wutherich & Company) focus is on smaller companies that are established leaders in their field, have strong balance sheets and experienced management teams that have a lot of skin in the game.

The fund’s assets continue to be tightly concentrated in a diverse collection of businesses that produce tangible products and offer in-demand services. This is a feature that sets it apart from the small-cap market as a whole, which consists of many exploration-phase resource companies and other early-stage businesses that are yet to reach profitability.

Along with looking noticeably different than the index, another distinctive feature of the fund is the illiquidity of several of its holdings. Over half of the fund’s holdings have a market capitalization of less than $300 million. These are businesses that are under-followed and have modest trading volumes. While this can lead to big swings in their share prices, the manager isn’t discouraged by short-term volatility as long as the underlying business is not broken. Investing in illiquid securities requires patience, but is a strategy that has proven to produce market-beating returns over time.

On the topic of price swings, Vecima Networks, Medical Facilities and Shoppers Drug Mart experienced the largest share price declines in the quarter, while MacDonald Dettwiler gained ground. Although Shoppers was dealt a blow by the Ontario government (with respect to generic drug revenues), there were no glaring operating issues with any of the fund’s holdings.

A new addition to the portfolio, Alaris Royalty Corp. (see Stock Snapshot), is a good example of what sets the fund apart from larger offerings. Alaris has a market cap of roughly $120 million and would not be on the radar screen of most managers due to its small size and relative illiquidity. Along with having a unique and attractive business model, Wil Wutherich likes the company’s management team and the fact that it has attracted interest from prominent private investors.

Balancing the portfolio’s ‘petite’ holdings are medium-sized businesses such as MacDonald Dettwiler, Stantec, and Pacific Rubiales Energy (the other new addition in the quarter). These stocks have market caps exceeding $1 billion and make up roughly 30% of the fund.

Pacific Rubiales is typical of what the manager looks for in an energy company. The firm is a sizeable producer of oil in Columbia (producing nearly 20% of the country’s oil) and has a strong growth profile based on what they currently have in the ground. The company is very profitable and has a strong track record of execution.

With the addition of Pacific Rubiales, two of the fund’s three energy holdings operate outside Canada (although they are all Canadian based). This provides valuable emerging market exposure and complements some of the fund’s smaller companies that focus more on the domestic market.