Canadian Small Cap Advantage

June 28, 2016

As we have reiterated many times, our investment approach is focused on understanding and valuing a limited number of carefully chosen businesses run by trustworthy managers. But in order to profit from this approach, we need to find companies that we not only like and understand, but that are also mispriced. A group of investors that run a well-respected private equity firm like to drive their corporate strategy agenda by asking: “where do we play and how do we win in that chosen market?” As that question applies to Ewing Morris, our preferred hunting ground is the Canadian small cap market which we believe is structurally prone to mispricing businesses. The S&P/TSX Small Cap Index consists of just 220 companies with a median market cap of $425 million. By comparison the U.S. equivalent, the Russell 2000 Index, consists of almost nine times more companies with a median market cap of $1 billion. For mutual funds and other large funds, the Canadian small cap market is simply too small in which to make meaningful investments. The Canadian market in general is also very narrow in its sector concentration. Energy and materials (i.e. mining), two areas that are generally not of interest to us, together represent 45% of the index. Not only are these sectors large in Canada, but they also regularly require additional capital. As a consequence, they have the potential to generate large fees for investment banks. So it is not surprising that our major banks devote a lot of attention and human resources to these areas, leaving smaller sectors of the economy largely ignored. Since the Canadian market is small and narrow, when talented international investors find themselves in Canada they are usually seeking opportunities in the natural resource sector. We continue to be viewed from abroad as a nation composed of hewers of wood and drawers of water, oil, gas, gold, copper and potash. These factors have created niches of overlooked and underfollowed businesses within the Canadian small cap market. For example, there are only two publicly-traded trucking companies in Canada compared to twenty-five in the U.S. Similarly, there is only one publicly-traded auto dealership in Canada compared to seven in the U.S. In the U.S. you will find brokerages with dedicated research coverage of these industries but in Canada they are too small to justify full-time coverage. With fewer trained eyes analysing these businesses, the odds of mispricing increase. Furthermore, studying the more competitive U.S. market also provides opportunities to see into the future when American patterns are repeated in smaller markets like Canada. Another advantage for thoughtful investors in Canada is the ability to integrate and connect with our relatively small business community. This provides access not only to management but also directors and employees. By fostering relationships with senior business leaders, many of whom are our clients, we gain additional insights that would be difficult to replicate in other markets. The combination of these factors makes Canadian small cap a terrific environment to apply our approach. We currently have 63% of our investments in Canada. Nonetheless, it is important that we retain flexibility in terms of both geography and size.

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