After languishing for several years prior to the broader market downturn in late 2008, it seems like Canada’s small/mid-cap segment is on the move again. For the year ended December 31, 2009, Canadian focused small/mid-cap equity funds’ average yield of 43.0% ranked fifth among all fund categories; in December 2009 alone they ranked third with a 5.1% return, outperforming even the erstwhile high-flying precious metal and natural resource fund categories.

And, this trend is likely to continue in 2010, according to Christian Cyr, Montreal-based portfolio manager for the National Bank Small Capitalization Fund, which mustered a stellar 69.0% return for calendar 2009 and a very respectable average annual compound return of 10.6% for the ten-year period through 2009.

“From 2004 until March of 2009 when the market began its recovery, Canadian small/mid-caps underperformed large-caps,” says Cyr. “That was not the case in the U.S. or globally. “Everybody has been impressed with how well they rebounded last year, but Canadian small/mid-caps are still undervalued in 2010, and still cheaper than their counterparts elsewhere.”

“Canadian small/mid-cap valuations are still not that stretched and, given that small and mid-cap companies are usually the first to grow following a big downturn, maybe the big surprises will be in this segment going forward,” Cyr adds. “These companies have survived the recession, as well as the impact of the loonie rising from around 60 cents [U.S.] to a dollar, so they could do pretty well this year.”

This view is echoed by Michael Waring of Galileo Equity Management Inc., portfolio manager of the Galileo Small/Mid Cap Fund, another top performer with a FundGrade rating of A: “As a category, small/mid caps have come back to life after a somewhat disappointing few years.

“One reason for this resurgence, we believe, is that at this point small/mid caps are the only segment of the market that can offer demonstrable growth,” Waring adds. “And coming out of a recession, many investors are looking for growth opportunities. Since the global economic recovery is still in its infancy, we believe there is more out performance to come from this segment of the market.”

As for how these managers intend to make the most out of future prospects, both are bottom-up investors, looking for all the traditional indicators of corporate success – solid financials, good management, growth prospects, etc.. “We look for good companies, and any sectoral deviation in our portfolio is a result of that,” says Cyr.

Adds Waring: “We tend to run more concentrated portfolios than many other small/mid cap managers. If we have done the due diligence on a stock and like it, we want it to be a significant weighting in the portfolio.”

Beyond that, Waring is always on the lookout for fresh prospects with high growth potential. “An essential part of Galileo's process is to identify new emerging ideas early before they are well known,” he says. “A limited portion of the Galileo Small/Mid Cap Fund is held in names that are not widely recognized. This sector of the market tends to be highly inefficient, but it offers significant potential rewards.”

For his part, Cyr is focused on takeover prospects. “Most small/mid-caps are suppliers to bigger companies, and these large companies can try to grow their revenues either organically or through [mergers and acquisitions].

“Today the big companies have plenty of cash after the cost-cutting of 2009,” Cyr adds. “It’s often cheaper to grow revenues through M&As, especially if it costs a lot of money to set up production facilities on their own, so we’re keeping our eyes open for acquisition targets.”

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