China’s Cheaper in Toronto

03/18/2010 12:01 pm EST


Ryan Irvine


Ryan Irvine, editor of the KeyStone Small-Cap Stock Report, is finding a few bargains in a pricey market—including some geared to the Chinese boom.

Q. Are Canadian small caps leading the Toronto market like small caps in New York?

A. As more and more investors get more comfortable with the fact that there is a recovery in the economy, you’re seeing risky assets bid up at a higher rate. In an up market, small caps typically outperform, and you’re seeing that right now.

Q. How are valuations stacking up against the larger caps?

A. In Toronto, we’ve come up just under 60% from the March lows. We’re still down 20% from our highs. Anecdotally, we have had more Sell [recommendations] in the last six months than we’ve had in a two-year period.

The Standard & Poor’s TSX Index is at about 27x trailing earnings; typically when you’re coming out of a recession, you’re looking at 15x earnings. So, we could see a pullback. But we still can find some companies that are trading at eight to ten times earnings and growing 20% to 30%.

Q. But overall you don’t think there is much up side left.

A. We’ve been trapped in a range for the last six months, and we’re at about 35x trailing earnings on the small caps.

Q. That sounds really, really expensive. Is it?

A. For me, the broader market at 27x trailing earnings is even more expensive than the small caps at 35x. [And since] the broader market is trading at very rich valuations, we don’t see one sector that’s offering good value.

For Canadian-listed companies that operate in China, you can find some reasonable valuations. Shanghai is trading at about 35x forward-looking earnings; we would rather buy a company here at eight to ten times earnings that is benefiting from the domestic growth we see in China. You can find those companies, [though] it is getting harder.

Q. Is that a growing trend, Chinese companies listing in Toronto?

A. Yes, the TSX is really pushing towards that market. It’s a market that people want to participate in because of companies like Sino-Forest (Toronto: TRE). We bought this company back in 2002 at about C$1.15; the stock trades above C$20 today. When you see returns such as that, it really starts to get investors looking. It’s not just Sino-Forest; there’s Migao (Toronto: MGO) and a number of other companies that have done really well over the last eight to ten years.

Q. How confident are you in their financials?

A. If this is the one stock that you’re going to put in you portfolio, then you’re crazy. You need a diversified portfolio of small caps. But I wouldn’t ignore that segment of the market, because when you’re seeing GDP growth this year of 10% to 12% in China, and 1% to 3% in Canada and the US, to not be a participant in that growth is going to injure your portfolio long-term.

Q. We recently featured your recommendation of Zungui Haixi (Toronto: ZUN.V).

A. A very interesting company, [it] has a tremendous balance sheet, tremendous cash position on the books. They just listed. I don’t expect a big jump for this company [in the] near term, but I believe they have C$58 million in the bank; that’s a dollar per share in cash, and the stock trades at about C$3.00 right now. In 2008 they did C$111 million in revenue, up from C$75 [million] in 2007; they earned 30 cents per share, up from 19 cents per share.

It’s trading at about seven times earnings right now, and that’s without stripping out the cash. There’s a massive urban migration within China, and many households finally have the disposable income to purchase their products. If they can continue to gain market share, or just hold market share, the GDP growth alone is going to power this company.

Q. Aside from Chinese companies, which Canadian small caps look attractive to you now?

A. One we like that operates in a pretty basic business within Canada is The Cash Store (Toronto: CSF). We recommended it in June at C$7.12; it’s at about C$13 now, but valuations are reasonable [and] growth is there. They trade at about ten times earnings, and we expect them to grow at about 20% to 25% over the next four to five years.

Right now they have 475 branches, [but] we expect that to increase to about 700 by 2012, which builds in some growth. It’s an area of the market that’s underserved. This company also bought back about 20% of its shares in the seven-dollar range, a very astute purchase, so you’ve got some built in earnings-per-share growth there. It also has about a 20% interest in The Cash Store Australia Holdings (Toronto: AUC.V), which is basically the same business model if you go back about eight years.

Q. One more?

A. Orvana Minerals (Toronto: ORV) has a great balance sheet. They had a mine in eastern Bolivia, which is a geopolitical nightmare in the best of times, but they were able to generate over C$100 million in cash flow from this mine, which they have now depleted, and they purchased a near-stage project for C$50 million in cash in Spain. They [still] have C$58 million of cash in the bank, which is about 50 cents a share; you’re buying them at a buck right now, so about 50% of their value is cash. We look a year to three out, and you participate in the move in gold, plus you have significant growth at a reasonable price.

Q. Thank you.

—Igor Greenwald

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