Shifting Sands – Thoughts on 2021

Equity markets around the globe climbed the proverbial “wall of worry” in the fourth quarter of 2021. Faced with the COVID-19 Omicron variant wreaking havoc, fears of rising interest rates and their impact on asset valuations, and ongoing geopolitical tensions between China and the US, investors focused their attention on the prospect of strong economic growth. Employment remains robust, the Omicron variant appears to be highly contagious but also less deadly, and there are signs that supply chain challenges have peaked.

As always, rational cases for and against owning equities over the short-term can be made. Certainly, the market is looking toward an improving picture based on the sectors that drove much of 2021’s returns, including energy, industrials, and financials. In other words, economically sensitive businesses saw their stocks perform better, in general, than companies operating in secular growth industries such as software-as-a-service.

2020’s winners were growth companies that were able to perform regardless of the macroeconomic backdrop. Conversely, 2021’s winners rose from attractive valuations and benefited from reopening tailwinds.

A number of the firm’s holdings in high-growth companies, notably in the software sector, struggled to make headway over the past year. High-growth businesses that can prosper even during difficult economic periods are enticing, but they often attract valuations commensurate with their growth. If these businesses continue to execute against their significant market opportunities, they offer meaningful long-term upside, but their high valuations warrant prudent portfolio weighting.

Fortunately, Pembroke invests in both secular and cyclical growth companies. Cyclical businesses are prone to short-term revenue growth and profit volatility, but they too can gain market share and deploy capital effectively, thereby producing “higher high” and “higher low” profits and rewarding investors who focus on the long term.

Pembroke’s patience with these more cyclical businesses during the uncertainty of 2020 helped propel portfolio gains in 2021. What gave the investment team confidence to hold these companies over the past two years? Generally, their strong balance sheets, sustainable competitive advantages, and impressive long-term earnings power.

Temporary pressures can emerge during challenging economic cycles, but businesses with solid balance sheets, and compelling offerings can look past these dips and execute against their long-term objectives.

Pembroke’s balanced approach to growth stock investing, cultivated since 1968, helped deliver strong returns in 2021 even though “secular growth” was generally out of favour versus “value” and “pro-cyclical” strategies. The uncertain outlook for the economy, interest rates, as well as the effects of COVID-19 call for ongoing industry diversification, valuation discipline, and balance sheet strength, while staying invested in businesses positioned to increase their per-share earnings over the next four to five years.