Southern exposure in the North: when Canadian small-caps expand into the U.S.
A commonly held idea with respect to smaller companies is that with less resources and sophistication, they will tend to have a mostly domestic business. While that can be the case, it is possible for smaller companies to punch above their weight in a foreign market. In our Canadian small cap portfolio, there have been many wealth-creating companies that were able to successfully expand and compete in the United States. Six of the portfolio’s top ten holdings derive the majority of their revenues from our southerly neighbours, and 40% of the weighted average revenue of the portfolio comes from the States. That is perhaps more southern exposure in a Canadian strategy than one might expect, but we would argue that’s a good thing.
Since Canada is a much smaller market, international outfits are rarely interested in launching an operation here. This reality provides Canadian-based businesses an opportunity to refine their expertise, learn how to compete effectively, and gain adequate scale relatively unnoticed before going beyond the border (although not all take it). First, they become big in their domestic niches. Richelieu Hardware is a good example of a company that illustrates the benefits of having scale. Currently, it dominates Canada with over a 50% market share in selling renovation hardware. Having scale means it can offer a greater selection of hinges, drawer slides, and knobs to its customers. What’s more, it can create value by bringing that vast selection to any new acquisition—the company only has a single digit market share in the U.S. but is actively looking to expand through acquisitions.
Richelieu also highlights how, from an exposure standpoint, the U.S. offers Canadian companies a much larger runway for growth. Once the Canadian market has mostly been exhausted, looking to the U.S. is a natural extension in many of these companies’ growth strategies. A good illustration of this is Boyd Group, based in Winnipeg. With over 500 shops, it is one of the largest collision repair shop chains in North America, and, with more than 30,000 shops in the overall market, it has a massive growth runway when considering the consolidating potential of this fragmented market.
Of course, expanding south presents challenges. Competition is fierce in the very diverse and entrepreneurial U.S. market. The failure of iconic Canadian companies such as Tim Horton’s and Canadian Tire to expand south is a good reminder not all business models can make it. Better competitive advantages and management teams are required, as well as prudent capital allocation to build on already existing competitive footholds. We find, however, that this challenge bodes well with our investment philosophy—we actively seek companies that can withstand higher competition. Stantec, a historically strong engineering consulting franchise in Western Canada that focuses on environmental, water/wastewater, and other niches, has grown by acquiring U.S. businesses that operate in the same industries. For example, they recently acquired MWH, a water/wastewater specialist company, which gives them both a strong U.S. and international base. In other words, they are continuing to build on the niches they are already good at.
Canadian small cap companies that expand effectively into the U.S. are more robust than if they were to operate within the confines of just the smaller Canadian market. For one, they must be able to withstand the intense competition in the States, and from a diversification standpoint, they allow us to mitigate NAFTA risks and potentially benefit from the new U.S. tax bill. Moreover, their growth runways are significantly longer than if they were to just operate domestically.
In short, some more southerly exposure for us northerners may be a very good thing.