We aren’t hearing much about small-cap stocks these days. It’s not that anything disastrous has happened. But, as a group, Canadian small-cap stocks haven’t gone anywhere. They’ve simply been marking time.
Look at the S&P/TSX SmallCap Index. As of Jan. 18, it was showing a one-year loss of 4.93 per cent and a 10-year average annual compound rate of return of 0.86 per cent. No one would get excited over that.
There are several reasons for this weak showing.
For starters, about half the index consists of mining and energy stocks, two notoriously volatile sectors. Second, small companies often rely on loans to ramp up the business. With interest rates rising through most of the past two years, that has made borrowing more expensive, putting pressure on bottom lines. Then there’s the risk factor. Small companies are perceived as being more prone to losses or even going out of business than well-established large-cap companies, especially in uncertain times. And, finally, analyst coverage of small caps is thin. There’s not a lot of information out there.
None of this is to say that small-cap stocks can’t be big winners.
The top-performing stock in the history of my Internet Wealth Builder newsletter is Boyd Group Services Inc. (BYD-T). It was recommended at $5.50 in 2010 by contributing editor Ryan Irvine. The stock closed Friday at $287.79 for a cumulative gain of 5,132 per cent! If you bought 100 shares at the time of the original recommendation, an investment of $550, it would be worth $28,226 today.
Ryan’s company, B.C.-based KeyStone Financial, specializes in finding little-known small-cap stocks and has recommended many other winners over the years. XPEL Inc. (XPEL-Q), recommended in the Internet Wealth Builder at $3.32, closed Friday at $52.01, up 1,467 per cent. The best-performing stock on the Toronto Stock Exchange over the past five years, little-known Hammond Power Solutions Inc. (HPS.A-T), was recommended at $8.60. It closed Friday at $93.21, up 983 per cent, not including dividends.
Ryan advises that the best way to invest in small caps is to create a broader portfolio of 20 to 25 stocks that includes five to 10 carefully selected small caps. They should focus on profitability, growth, a strong balance sheet and quality management. Of these, a couple will likely significantly underperform, a few will produce average returns, a couple will outperform, and, hopefully, one or two will be big winners that will more than offset your losers. It only takes one Boyd Group!
If you want to go a different route, there are some ETFs to consider. The iShares S&P/TSX SmallCap Index ETF (XCS-T) tracks the performance of the index of the same name, net of expenses. It was launched in May, 2007, and has $133-million in assets under management. The MER is 0.6 per cent.
The fund generated double-digit returns every year from 2019 to 2021 and outperformed the TSX Composite in 2022, even though it lost 9.22 per cent that year. But in 2023, it gained an unimpressive 4.31 per cent. Over the long term, it’s been a mediocre performer with an average annual gain since inception of 1.84 per cent.
I prefer funds that invest in U.S. small caps because the asset mix is more diversified. Material and energy are minor players; these funds focus more on financials, industrials, consumer discretionary and information technology stocks.
A Canadian-based fund to consider is the BMO S&P US Small Cap Index ETF (ZSML-T). It’s a relatively new fund, launched in February, 2020, but it’s almost as big as XCS, with $114-million in assets under management.
This ETF posted a loss of 10.51 per cent in 2022 but bounced back with a gain of just over 13 per cent last year. It has a low MER of 0.23 per cent.
The benchmark measure of U.S. small-cap stocks is the Russell 2000 index. It’s relatively new, started in 1984 by Frank Russell, and has become the most widely cited measurement of U.S. small- and mid-cap stocks.
BlackRock U.S. operates the iShares Russell 2000 ETF (IWM-N). It’s a huge fund, with about US$62.3-billion in assets under management and a low MER of 0.19 per cent. It’s coming off an excellent year, with a gain of 16.8 per cent in 2023. The 10-year average annual compound rate of return is 7.12 per cent.
The portfolio focuses on industrials (16.98 per cent), financials (16.84 per cent), health care (15.73 per cent) and information technology (13.44 per cent). Energy and materials combined make up slightly more than 11 per cent of the assets. The stocks in this portfolio will generally have a greater market capitalization than their Canadian equivalents.
I think the U.S. market offers better balance, more diversification and greater profit potential than the Canadian small-cap sector, so my choice among the mentioned ETFs is IWM.
Gordon Pape is the editor and publisher of the Internet Wealth Builder and Income Investor newsletters.
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Gordon Pape