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Small-cap blues: Why Canada's Venture bourse is in the dumps

As a potential top stock pick, CanaDream Corp. ticks all the boxes. It has a couple of decades of corporate history, a respected management team, a culture of innovation, good growth prospects, a strong record of profitability and a bargain-basement valuation.

But the RV rental and sales company based in Rocky View, Alta., has one key flaw – it is a small-cap stock trading on the TSX Venture exchange, which is just about enough to ensure it goes ignored.

"People should have been all over that stock," said Darrin Hopkins, director and co-head of the public venture capital division of Richardson GMP. "Had they been highly liquid, and had they got a good valuation in the public market, then I don't think they would have been a target. It was a sitting duck."

A few weeks ago, CanaDream entered into a deal to be acquired by an Australian-based company. By mid-July, it should cease trading on the Venture. The stock, which has a market capitalization of $36-million, will be missed by the few who were paying attention, Mr. Hopkins said.

Across North America, the roster of publicly traded stocks is in systematic decline. The number of initial public offerings in Canada and the United States has steadily dropped over the last several years, while the ranks of existing public companies are being thinned by a wave of mergers and acquisitions.

Nowhere are those trends more prevalent than in the small-cap space, and on the Venture exchange in particular.

The numbers are grim. There are almost 40 per cent fewer Venture listings than there were 15 years ago. Trading volume last year was down by more than 80 per cent from five years ago. And there was just one corporate IPO on the Venture 2016.

Trading activity and equity financings on the Venture have picked up in recent months. But that is more a reflection of commodity prices stabilizing, said Ian Russell, president of the Investment Industry Association of Canada. "There have been some cyclical improvements, but structurally, nothing has really changed."

Under new leadership, the Venture is in the midst of a "revitalization" it says will diversify beyond natural resources and tap into new pools of capital. But with Canadian investors, analysts, and brokerages having turned their backs on small-cap stocks, Mr. Hopkins said the question remains as to whether the Venture can be fixed.

"We have one of the best venture platforms in the world. And I think we've squandered it," he said. "I think that it's too late to get back to where they once were."

The Venture was born in 1999 as a merger of the Vancouver and Alberta stock exchanges, and primarily became a platform for junior resource plays. It also became an incubator for future Canadian corporate champions.

More than 600 companies have graduated from the Venture to the Toronto Stock Exchange over the years, with graduates accounting for one in five current members of the S&P/TSX composite index. Familiar large- and mid-cap stocks that got their start on the Venture include the $12-billion market cap miner Wheaton Precious Metals Corp., AltaGas Ltd., Element Fleet Management Corp., as well as half-a-dozen of the composite's biggest REITs.

The Venture came to set itself apart from other comparable exchanges around the world, or the U.S. over-the-counter market, with better investor protections and stricter regulations, Mr. Russell said.

And the Venture's instruments for raising capital, like the capital pool company (CPC), are "unparalleled," Mr. Russell said. The CPC program makes it relatively easy to get listed through a shell company that can then make a "qualifying transaction" within two years.

Where the Venture fell short was in failing to attract foreign capital, Mr. Hopkins said.

"The TSX has spent very little time over the past 20 years trying to make any inroads with the SEC in order to open that market up."

Brady Fletcher, who took over as head of the Venture last fall after working in the Vancouver start-up community, said he is now spending time doing just that.

"Helping to knock down those barriers is one of our top priorities," he said. "It's easy for a Canadian to invest in a U.S.-listed entity. It's much more difficult for U.S. retail investors to invest in a Canadian one."

That effort should have been under way long ago, Mr. Hopkins said. Domestic sources of capital for small-cap stocks have been steadily declining for years.

Several forces have combined to fuel a growing investor preference for larger stocks. Heightened awareness around fees, combined with poor performance by stock pickers in recent years, has seen vast sums of money flow out of active strategies and into index investing, which generally involves large-cap exposure. The proliferation of exchange-traded funds has facilitated the explosion in passive investing.

Additionally, minuscule bond yields have encouraged equity investors to prioritize dividends, which are primarily generated by large, stable companies.

"The Canadian ecosystem that used to nurture these companies as they came up has been hollowed out," said Tony Pullen, a veteran investment banker focused on Canadian biotech. "The ETF phenomenon doesn't trickle down to this world."

Additionally, Canada's big banks have come to dominate the wealth management business as dozens of boutique brokerages have been swallowed up or shut down.

"It was the independent brokerage firms that were the lifeblood of the TSX Venture exchange," Mr. Hopkins said.

For venture-stage companies themselves, an alternative to going public has emerged in the form of a burgeoning private capital industry, allowing companies to spend what can be difficult early years out of the public spotlight.

"Private equity has done a phenomenal job over the last decade of making it really appealing to stay private," Mr. Fletcher said. "They scared people off the idea of being public."

And while the cost, time, and scrutiny of being a public company can be weighty, Mr. Fletcher said he's out to change the perception of the Venture to a platform that is more flexible and entrepreneur-friendly.

After all, private venture capital investment comes with its own baggage, Mr. Fletcher said. "They [the venture-capital firms] put people on your board, and if they decide they're not a fan of yours, you're fired." A 2008 Harvard Business Review article claimed that four of five entrepreneurs of privately funded companies are ultimately forced to step down.

Another of Mr. Fletcher's priorities is convincing non-resource companies to list on the Venture, particularly technology start-ups, he said.

With about 70 per cent of the Venture based in resource sectors, it was profoundly vulnerable to a downturn in commodity prices.

From its early 2011 peak, the TSX Venture composite index fell by more than 80 per cent over the following five years as metals and energy prices plunged. Trading volume fell by about the same amount. And the number of graduates from the Venture to the TSX fell to just five companies last year. There were 72 graduates in 2007.

By most measures, Canada has moved beyond the commodity bust. The national economy is close to making a full recovery – a feat already accomplished by the TSX – while even Alberta is emerging from its recession.

But the small-cap space in Canada is still grappling with the fallout. The Venture composite index is still 70 per cent below its 2011 peak, even after a big move from the bottom of the commodity crash. (The underperformance of small-cap stocks is a theme in the Canadian markets, even beyond the Venture's woes. The S&P/TSX small-cap index, which includes more established firms such as Russel Metals Inc. and Laurentian Bank of Canada, has produced annual compound returns of less than 5 per cent over the past five years, compared to more than 10 per cent for the large-cap S&P/TSX 60.)

Coming off of such a low base, the improvement in the Venture's raw numbers so far this year have barely registered on the front lines of the business, Mr. Hopkins said.

"It's the worst I've ever seen it, or close to it."

The industry trends that have stricken the Venture – broker consolidation, and index investing – seem unlikely to reverse, at least any time soon, Mr. Hopkins said. But it is not too late to open up the small-cap market to new sources of capital from other jurisdictions, he said.

"The exchange must recognize that and go out and make it easier and friendlier for capital to find the small-cap market."

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