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Building profits in a tough market for small cap stocks

It won’t be easy making money with small caps in the months ahead, says this advisory, but there are some constructive gains to be made.

This is not actually going to be shocking news. In today’s market (let alone yesterday’s total flameout on the TSX), it will not be easy to make money in small cap stocks. The ranks of those migrating to blue chip stocks and other safe investments are liable to swell by the day.

Of course if everybody gave up on small cap stocks, a lot of growing companies would be left gasping for air. Fortunately, there are always investors prepared to take the risks in exchange for the rewards. And there are always market letters willing to show them the way.

One advisory that is prepared to take Canadian investors down this rather thorny path is KeyStone’s Small-Cap Stock Report. The research specialists who send the publication out from Richmond, B.C. have identified several areas of growth in a lurching economy, and they have a select group of Buys to propose.

There’s no point in rehashing what’s wrong in the market, the story has become depressingly familiar. Let’s see instead where some good news is holding its ground. We’ll find it on Canada’s highways and byways.

Pockets of strength

There will be “Pockets of Strength” in the market, say the editors of this advisory.

One area in particular stands out.

“One segment of the market we will be keeping a focused eye on over the course of 2008 is the infrastructure and construction market,” they write. “In fact, there are a number of compelling reasons to believe that Canada is in the midst of a continuing infrastructure and construction boom.”

They turn to a report from Raymond James Equity Research that offers six reasons to believe in this boom. One you can see for yourself: after years of neglect, the country’s roads, bridges, schools, airports and other structures “have reached the breaking point and are in urgent need of repair, expansion and upgrade.”

Second, and very fortuitously, Canada’s federal and provincial governments are in good shape financially and can afford to make the necessary investments. Third, governments have found new and effective ways to finance these projects.

Trade flows, green power and the oil sands

Fourth, “there is a committed effort to strengthen Canada’s infrastructure to improve international trade flows and capitalize on opportunities related to globalization.” Fifth, environmental pressures are forcing governments to invest in “green” infrastructure — wind power, water purification and the like.

Finally, the enormous activity in the oil sands is having a “profound direct and indirect impact on the country’s infrastructure and construction markets.” As in, they can’t put stuff up fast enough in Fort McMurray.

The KeyStone researchers add two points of their own: the cost of capital is more affordable with interest rates remaining low. Plus our strong Canadian dollar “has Canadians feeling better on a world stage and has increased our buying power to the point where large scale projects suddenly appear to be ‘on sale’.”

OK, that’s the why. Now for the who.

Ready for big projects

To cash in on the infrastructure boom, the editors call not on some relative newcomer, but on one of the oldest steel fabrication companies in western Canada.

Empire Industries Ltd. (TSX/V-EIL) can trace its roots back to 1910. Although it has undergone many transformations over the years, it has strong brand recognition in the building industry. It began trading on the TSX Venture exchange in the summer of 2006 after a reverse takeover. Since then, it has taken over five other companies itself.

Now it is ready to compete for larger projects and realize better margins on its contracts. There is limited capacity in western Canada to fulfill larger and more complex projects. Empire, fortified with its recent purchase of Tornado Technologies Inc., has the requisite capacity, with some 420,000 sq. ft. of plant space and a staff of more than 800.

Empire’s products — structural steel, modules and plate steel — are used in tanks, vessels, bridges, pipes and oilfield production equipment, to name a few prominent applications.

The company has recorded seven consecutive profitable quarters. Its revenue increase in the third quarter of fiscal 2007 was a robust 64 per cent improvement over the same period the year before. Based on per cent of sales, third-quarter profits were up 15 per cent in 2006 and 19 per cent in 2007.

The stock has flown under the radar while the first round of the construction boom left Empire shares behind. Its size, lack of liquidity (management held almost 50 per cent of the shares before the most recent acquisition) and a lack of market awareness for the stock did not help, say the editors. But its time may be at hand. “We believe that its valuations relative to its peers should begin to make it a more compelling story.”

The stock was first recommended at $0.43, stood at $0.47 when this report was published last week and closed yesterday at $0.45.

Name recognition

The editors helpfully suggest a stock for those who are looking for a large cap entry in the infrastructure and engineering sweepstakes, and it’s one with solid name recognition: SNC Lavalin Group Inc. (TSX-SNC). “Valuations for the stock are currently at a premium,” they explain, “but it is an industry leader, with a management group that has delivered consistent results over a long-term horizon.”

Back among the smaller fry, the KeyStone editors also like Global Railway Industries Ltd. (TSX-GBI). They made the stock a top Buy a year ago and it performed well in 2007.

“While not a pure play on the infrastructure market, it provides good exposure to the North American railroads and commuter systems markets which, after years of neglect, are in need of an overhaul.” Global is an integrated rail products and services provider — it supplies everything from hydraulically powered rail gear for service vehicles to event recorders to the doors for rail cars.

The company’s wholly owned subsidiary, CAD Railway Industries Ltd., has been awarded a 5-year $101.5 million contract to remanufacture a fleet of 53 VIA Rail locomotives. “We view this as a landmark contract for the company,” say the editors, “and continue to have a long term Buy rating on the stock.”

From roads, bridges and railways we go to another form of transport. The invisible kind.

Phone cards and lottery terminals

It behooves small cap researchers to delve deep into the technology business. It takes a practiced eye to discover those who have the ability to separate themselves from what is still a very large field of would-bes.

The KeyStone editors have a candidate that has done rather well in just over two years. Sangoma Technologies Corp. (TSX/V-STC) makes hardware and software that supports voice and non-voice data transport.

The demand for its services is growing, and the market for PC-based voice and telephony cards is maturing as larger volumes are produced. Sangoma is gained a footing as a leader in the field and has some impressive contracts to its name. It recently won the right to install its PC-based hardware in lottery terminals throughout Quebec on a contract with Loto-Quebec Corporation.

The editors are impressed with the company’s financial results in the face of the rising Canadian dollar. In the first quarter of fiscal 2008 (ended September 30, 2007), revenues rose 82 per cent over the year before. After tax net income was up 22 per cent. This included foreign exchange losses. “We continue to like the company’s growth and relative valutions and rank the company as a Buy,” conclude the editors.

Sangoma was originally recommended by the advisory in December 2005, at $0.33. It subsequently rose above a dollar, trading at $1.10 when the report was published. The market has since pushed it down, and it opened today at $0.97.

Nobody’s pretending that small cap stocks are a safe haven in markets like these. But as long as there are pockets of strength in the economy, there will be gains to be pocketed in the market. For the stout of heart, the next reward is always worth the risk.