Tech, finance sectors help Mawer wallop small-cap benchmark

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The odds of beating the Canadian small-cap market in recent years would have been dramatically increased by investing heavily in technology and financial stocks, while avoiding the mining sector.

Martin Ferguson did just that. As co-manager of the Mawer New Canada small-cap fund, he has trounced his benchmark by tapping into both Canada's burgeoning tech sector and a pool of niche financial names.

Doing so has allowed him to largely sidestep the resource slowdown, which has made Canadian small-cap investing in general a middling pursuit in recent years.

"Canada, thankfully, is a very entrepreneurial country," Mr. Ferguson said.

Along with co-manager Jeff Mo, the pair shared the honour of domestic-equity fund manager of the year at the 2014 Morningstar Canadian Investment Awards in Toronto on Wednesday evening.

Mr. Ferguson was the recipient of the same award in 2011. This year, the New Canada fund, which has been closed to new investors since 2005, was also named the best Canadian small/mid-cap equity fund.

Returns on the New Canada fund seem to warrant recognition. In 2013, the fund posted a return net of fees of 49.4 per cent, compared with a 7.7-per-cent gain by the fund's benchmark – the BMO Small Cap Index – according to Mawer figures.

This year, up to the end of October, the fund has returned a further 16.3 per cent, while the benchmark rose by just 0.6 per cent.

Sector weightings have a lot to do with that outperformance.

As of the end of the third quarter, the New Canada fund had a 26.3-per-cent weighting in financials, compared to the benchmark's 15.7 per cent.

Information technology holdings, meanwhile, accounted for 14.5 per cent of the fund versus 5.3 per cent in the index. And materials stocks made up just a 10.9-per-cent weighting, compared to 25.7 per cent for the benchmark.

Those weightings, however, are not really the result of explicit sector calls. Mr. Ferguson, citing Mawer's bottom-up approach to the markets, evaluates potential investments based on potential return on invested capital.

"Nothing gets into the portfolio unless it makes sense from a bottom-up point of view," he said. "We try to create portfolios that are resilient under all macroeconomic scenarios."

He seeks to identify companies with sustainable competitive advantages, competent management and track records of smart capital allocation.

If a company meets those conditions, he looks at valuation based on 15-year cash flows.

It's that process, rather than a broad macro assessment or sector analysis, that led Mr. Ferguson to load up on tech and financials.

"Starting probably 10 years ago, we started seeing value in small-cap technology side, especially on the software stocks," he said.

The fund's single biggest holding is Constellation Software, which through an aggressive acquisition campaign, has grown in share price by more than 1,800 per cent since it began trading in 2006, when Mr. Ferguson first acquired Constellation's stock.

His other top tech picks include Descartes Systems Group Inc., and Solium Capital Inc., a Calgary-based company that provides software to help companies manage their stock-based incentive programs.

New Canada fund's heavy weighting in financials, meanwhile, primarily targets alternative lenders, including Home Capital Group Inc. and Equitable Group Inc.

On the materials side, Mr. Ferguson maintains limited exposure compared to his benchmark, while taking a pass on the entire gold-mining sector.

"Gold companies tend to trade on different parameters than what we're looking at," he said.

Since the Canadian small-cap space is dominated by junior mining and energy companies, even more so than the broader market, limiting resource positions has certainly helped boost returns, Mr. Ferguson said.

But he has remained heavily invested in energy services stocks. "They make very high return on invested capital," he said. "They can make money and create wealth throughout a cycle."

His top energy services stocks are Canadian Energy Services & Technology Corp., ShawCor Ltd., and Secure Energy Services Inc.