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A darling of Wall Street: Canadian tech stocks

Two years ago, with the market rising and confidence slowly returning to the market, Jason Donville made a big bet. The president and CEO of Toronto's Donville Kent Asset Management plowed 50 percent of his client's assets into the technology sector. But the fund manager didn't buy any shares of LinkedIn, Apple or IBM—he scooped up a bevy of Canadian tech stocks instead.

Names like Constellation Software, Open Text and Enghouse Systems make up most of his Capital Ideas Fund, and while they may not be brand-name technology companies, his gamble still paid off. The fund was up 52 percent in 2013 and was named Morningstar's Best Opportunistic Hedge Fund.

"We made a dramatic bet on this sector," he said. "And it worked."

Pawel Dwulit | Bloomberg | Getty Images

When most investors hear "Canadian tech," thoughts of an imploding BlackBerry come to mind. While the smartphone maker is still the country's most recognizable tech company, it's by no means the only one.

A number of fast-growing, cash flow–generating operations are making a name for themselves on both sides of the border, said Donville, and American investors should start taking notice.

(Read more: Stocks still tops, advisor survey finds)

Small but steady
Canada's tech industry is much different than America's. It doesn't have hot stocks like Twitter or Facebook or legacy names like IBM and Microsoft. It's also far smaller than its U.S. counterpart.

There are only 63 companies listed on the Toronto Stock Exchange and 114 on the smaller-cap TSX Venture Exchange, compared to more than 600 on the NASDAQ alone. Most of the Canadian companies have a market cap of less than $1 billion.

So why would someone from outside the Great White North want to look at this market? It's because many of these stocks are inexpensive and have the ability to generate stellar returns.

Racking up big gains
Over the last 12 months, the S&P/TSX Capped Info Tech index has climbed by 30 percent, while the S&P 500 Info Tech index is up by 24 percent.

There are several reasons for the sector's growth, but a main one is that Canadian investors have begun turning away from the struggling resource sector, which makes up a large part of the country's market, said Patrick Horan, a portfolio manager with Agilith Capital Inc. A lot of funds flowed into other sectors, including technology, said Horan.

That trend will likely continue, and it's the tech sector that will keep benefiting, he said.

A lot of the sector's companies, and especially the larger-cap names, are the types of businesses that any investor would want to own.

They're mostly software operations that collect recurring revenues and have a client base that rarely switches providers. This business model allows them to rake in cash, which many spend on acquisitions.

(Read more: Top trends in mutual fund investing)

Canadian tech's lure
Managers often cite Constellation Software, a $5.3 billion market-cap company, as an example of what investors can find in the Canadian market. It provides what it calls "mission critical software," programs that help transit companies organize bus routes or keep track of inventory for golf shops. It operates in a number of different industries, from real estate and water utilities to agriculture and medical.

About half of its revenue comes from the U.S., with the rest split between Canada and overseas, and it's bought more than 160 businesses since it formed in 1995. In its last quarter it grew revenues by 47 percent year-over-year, while its earnings per share expanded by 10 percent over the same time period.

"It's a bit like those stocks that people enjoy buying in the States," said Donville. "The Johnson & Johnsons or McDonald's—you're getting a global company with diversified earnings."

Other Canadian companies have a similar makeup, even hardware ones such as Avigilon Corp., a Vancouver-based company that develops and sells high-definition video technology.

It has a roster of reliable clients and keeps adding new ones all the time, said Horan. Its revenues are growing 100 percent a year, and that's translated into a 154 percent return over the last 12 months.

(Read more: Five start-ups to watch in 2014)

More upside to come
Many Canadian tech companies are also cheap, in large part because they don't get the attention that companies in the U.S. receive.

Companies are also less liquid than American operations because they're smaller and don't trade as frequently. It's not a problem for individual stock pickers, said Horan, but it means larger mutual funds can't buy into this space, and that keeps valuations low.

On average, Canadian tech stocks are trading at a 20 percent discount on a price-to-earnings basis to American tech companies, said Horan. He thinks Avigilon would be 50 percent more expensive if it were based in the U.S.

While the sector has seen good gains, Keith Lam, a portfolio manager with Red Sky Capital, thinks there's more upside to come.

For one, the Canadian dollar has sunk to 90 cents U.S. A number of companies receive the majority of their revenues in greenbacks, so they benefit from a lower domestic currency.

The sector is also growing. Last year there were 31 IPOs on the TSX and TSX Venture Exchange, far more than the industry has seen in years, said Chris Dulny, a partner and national leader of PricewaterhouseCoopers Canada's technology practice.

He thinks we'll see even more companies, including Shopify and HootSuite, a popular social media–management program, come to market in the next two or three years.

"These aren't just great Canadian companies; they're strong global companies," he said.


Buy Canadian
If you do want to own some Canadian tech names, look for companies with clean balance sheets that generate a lot of cash, said Lam.

Little debt is especially important for Canadian tech businesses, because many can't grow as organically as American ones can. They need to boost revenues through acquisitions.

"You want the company to be able to take advantage of the strategic opportunities that present themselves," he said.

For Donville, net profit margin is a crucial metric. The more profitable the business, the more money it has to buy other companies or pay dividends. Better profits are also a sign that the company is more competitive than its peers, he said.

Other metrics, such as attractive price-to-earnings and enterprise value-to-EBITDA ratios and high returns on equity are important, too, he added.

While no expert is suggesting that Americans ditch all of their tech stocks to buy Canadian, it can make sense to add few Northern names, said Donville.

Despite his fund's strong returns, he's not selling any holdings. To him, the sector is looking as attractive as ever.

"I put my money where my mouth is, and we're still holding on to these stocks," he said. "We see things continuing."

—By Bryan Borzykowski, Special to CNBC.com

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