Published in the Financial Post, January 29, 2015 – by David Pett

The strengthening U.S. Dollar is starting to take a toll on the profits and stock prices of many large multinational companies south of the border, but the strong greenback may end up being an important catalyst for beleaguered shares in the country’s small-cap companies.

“Look at what happened with Caterpillar, Microsoft, Dupont and other large caps this week. They are all blaming FX for missing earnings and lowering guidance,” said Peter Barlas, a portfolio manager at K.J. Harrison & Partners Inc., a wealth management firm in Toronto.

“I think small caps have a bit of an advantage right now. The majority of their sales are domestic, and that is a big benefit.”

U.S. small caps in 2014 had one of their worst years in some time. The Russell 2000 gained less than 5% and trailed its large-cap cousin by the widest margin since 1998.

It was just the 10th time since 1926 that small caps provided only single-digit positive gains for investors.

“It was a particularly tough year for active strategies across all size segments, as most fund managers lagged behind their indexes, but more so in the mid caps in which managers set all-time lows,” said Steven deSanctis, small-cap strategist at Bank of America Merrill Lynch, in a note to clients.

Mr. de Sanctis expects another lacklustre year for small-cap indexes, but thinks there are a number of positives that should keep returns in the black.

For one thing, he’s confident that the U.S. economy will grow at a better clip than many of its global peers, a scenario that tends to bolster small caps more than it does large caps.

Furthermore, he expects small caps to benefit disproportionately from the U.S.housing recovery and from potentially higher interest rates later this year.

“With stronger economic growth and the need for the Fed to raise rates in 2015, small tends to perform well when interest rates move higher and the Fed first starts to increase the Fed funds rate,” he said.

Mr. Barlas admits it has been a tough go for small-cap managers such as himself, but the KJH Opportunities Fund he manages outperformed the Russell 2000 in 2014 and he sees plenty of opportunities to better the benchmark this year.

His focus is primarily on U.S. companies that should benefit from falling unemployment, rising consumer confidence and the knock-on effects of cheaper oil prices. “To me, the U.S. is the crown jewel.” Mr. Barlas said. “It’s harder to do the due diligence and the research, but it’s worth it. You have to be looking there.”

In particular, he likes companies that are market leaders and dominate players in their respective industries such as KAR Auction Services Inc. and Halyard Health Inc., a maker of surgical gowns, masks and gloves that was spun off by Kimberly-Clark Corp. last year.

“It comes down to the quality of businesses that you own,” he said. “Just because they are small doesn’t mean they have to be high risk.”

Mr. Barlas also sees select opportunities in Canada, but is staying clear of the junior resource plays that make up a large share of the small-cap universe in the country.

“There’s a lot of junk,” he said. “Whether it African potash mines or Argentinian oil and gas companies, to me, those are lottery tickets, they are stories, but they are not real companies, so we avoid them.”


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