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What are we looking for?

Canadian small cap stocks that could be heading for outsized returns.

As optimism returns to equity markets, small companies often take the lead and outpace the large and stable stocks that are favoured when the outlook is more murky. That's been the trend so far this year, and if investors continue to regain their appetite for risk, small may indeed be beautiful for your portfolio.

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This is part two of screening for these stocks through a model portfolio created by Validea Canada that is based on the strategies of Motley Fool website founders David and Tom Gardner. (The Globe and Mail has a distribution agreement with, a premium Canadian stock screen service). Last time, we took a look at the top 10 U.S. stocks.

More on our screen

The Validea model filters companies using a lengthy list of criteria, many of which we highlighted in last week's Number Cruncher. A high emphasis is placed on finding stocks with an earnings growth rate that is greater than the stock's price-to-earnings ratio. Also note that these stocks are already high performers, with most outperforming 80 per cent or more of the market for the past year. (The exact number is shown in the table as "relative strength.") Stocks are assigned a fail or pass based on each criteria and are assigned a strategy score; the closer to 100, the better.

Of the 14 model portfolios Validea has produced, this small cap screen has produced the greatest returns for both Canadian and U.S. stocks. The Canadian version of this screen doesn't have the track record of its U.S. equivalent, but since its inception in 2010, it has boasted returns of 23.6 per cent, versus 7.6 per cent for the S&P/TSX composite index .

Justin Carbonneau, vice-president of Validea, attributes the model's strong performance to its strict criteria and its focus on small caps and growth-style companies.

"Investors are paying up for growth, and the Fool's strategy, as we've interpreted it, has done a good job at picking up small to mid-size firms that are flying mostly under the radar with strong past and present growth characteristics and relative price momentum," he said. "These are the types of stocks investors are willing to pay a premium for in what many are considering a slow growth economic environment."

What we found

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Some familiar names in finance made the list: Great-West Lifeco Inc. and Canaccord Financial Inc. . We wouldn't traditionally refer to these as small caps in Canada, but they still made the screen given its requirement that daily dollar volumes had to be less than $25-million.

Juicy dividends also aren't usually associated with small caps. Yet six of the 10 have yields above 2.0 per cent, including a couple of real estate investment trusts.

As always, treat these screens as a starting place for further analysis before making investment decisions.

Note from table

* Canmarc REIT was delisted March 5 after outstanding shares were acquired by Cominar REIT.

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About the Author
Investment Editor

Darcy Keith is The Globe and Mail's Investment Editor. He has been a business journalist since 1992 and joined the Report on Business in 2010 from Yahoo! Canada, where he was the senior editor of finance. More

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