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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. 31, it was showing a one-year loss of 4.12% and a 10-year average annual compound rate of return of 3.74%. 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. (TSX: BYD). It was recommended at $5.50 in 2010 by contributing editor Ryan Irvine. The stock closed Feb. 20 at $306.76 for a cumulative gain of 5,477%! If you bought 100 shares at the time of the original recommendation, an investment of $550, it would be worth $30,123 today.
Ryan’s company, B.C.-based KeyStone Financial, specializes in findinig little-known small-cap stocks and has recommended many other winners over the years. XPEL Inc. (NSD: XPEL), recommended in the Internet Wealth Builder at $3.32, closed on Feb. 20 at $55.60, up 1,574%. The best-performing stock on the Toronto Stock Exchange over the past five years, little-known Hammond Power (TSX: HPS.A), was recommended at $8.60. It closed Feb. 20 at $108.03, up 1,156%, not including dividends.
Ryan advises that the best way to invest in small caps is to create a broader portfolio of 20-25 stocks that includes 5-10 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 (TSX: XCS) 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%.
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% that year. But in 2023, it gained an unimpressive 4.31%. Over the long term, it’s been a mediocre performer with an average annual gain since inception of 1.84%.
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 (TSX: ZSML). 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% in 2022 but bounced back with a gain of just over 13% last year. It has a low MER of 0.23%.
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 American small- and mid-cap stocks.
BlackRock U.S. operates the iShares Russell 2000 ETF (NYSE: IWM). It’s a huge fund, with about $64 billion in assets under management and a low MER of 0.19%. It’s coming off an excellent year with a gain of 16.8% in 2023. The 10-year average annual compound rate of return is 7.12%.
The portfolio focuses on industrials (16.98%), financials (16.84%), healthcare (15.73%), and information technology (13.44%). Energy and materials combined make up slightly more than 11% 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. Before investing in any security check with you advisor to ensure it meets your portfolio objectives and risk tolerance level.
Gordon Pape is one of Canada’s best-known personal finance commentators and investment experts. He is the publisher of The Internet Wealth Builder and The Income Investor newsletters, which are available through the Building Wealth website.
Follow Gordon Pape on X at X.com/GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney.
Notes and Disclaimer
Content © 2024 by Gordon Pape Enterprises. All rights reserved. Reprinted with permission. The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting, or tax advice. Always seek advice from your own financial advisor before making investment decisions.
Image: iStock.com/phongphan5922
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