US Equity Strategies

Pembroke’s US equity portfolios rose in the fourth quarter of 2021, capping off a robust 2021. Further, the firm’s US portfolios outperformed the Russell 2000 in the past three months, finishing the year significantly ahead of their primary benchmark. It is worth noting that in a year which favoured more cyclically oriented companies versus secular growth businesses, Pembroke’s approach to growth investing helped it outperform the Russell 2000 Growth index by over 20%.

Performance in the fourth quarter was marked by strong stock selection in important sectors for Pembroke, including industrials, consumer discretionary and healthcare. Performance was negatively impacted by holdings in the information technology sector, which struggled in the face of high valuations. Despite these headwinds, Pembroke’s exposure to the information technology sector contributed positive absolute returns over the course of 2021.

Two stocks made significant additive contributions to returns of the Fund in the fourth quarter

Trex Company (“TREX”), a long-time Pembroke holding and manufacturer of composite decking products, had positive developments during the quarter, bringing its stock price to higher levels. The company announced the addition of a third production site, less than a year after the completion of a 70% capacity expansion project.  Trex management wishes to stay ahead of demand and accelerate share gains after operating in a capacity-constrained environment in the last 18 months.  Trex also announced strong quarterly results driven by high demand for its products.  Both announcements reinforce our confidence in the factors driving consumer demand, namely continued interest in outdoor living

, conversion from wood to composite decks, and market share gains from the company’s strong brand and low-cost manufacturing capability.

Shares in A. O. Smith (“AOS”) returned over 40% in the fourth quarter as a combination of solid third-quarter earnings results and better-than-expected forward guidance dispelled fears that the company’s China exposure might derail its growth story.  Some investors were concerned that excessive financial leverage in the Chinese construction industry would impact AOS’s residential water heater sales, leading to a 17% decline in the stock in September.  Our due diligence indicated this fear was misplaced, and that new water heater sales growth was sustainable.  More importantly, we remain focused on the long-term potential for this high-quality industrial business.  In addition to high margins, high returns on capital, and multi-year growth, AOS is benefiting from the pricing power that its brand, technology, and consolidated market dynamics provide to stay ahead of raw material inflation.

Two stocks posted declines that weighed on performance in the fourth quarter

Shares in Sprout Social (“SPT”) declined 26% in the quarter, despite significantly exceeding quarterly sales and earnings expectations.  The company continues to make solid fundamental progress in its quest to become the system-of-record for enterprise social media management software, a goal we believe is attainable.  We attribute the decline in the shares to two interrelated factors.  First, as near-term inflation data has climbed, interest rate expectations have also climbed.  Rising interest rates tend to hurt fast-growing companies whose cash flow generation is expected in future years, as the implicit discount rates to those cash flows increase.  Second, investors have rotated capital away from growth technology and from the last year’s best-performing stocks, two categories both applicable to SPT.  Despite the Q4 selloff, SPT still gained approximately 100% in 2021. We expect the company to grow at a rate of at least 25% for at least the next several years. Its highly profitable software margin structure (more than 75% gross margins) offers the potential for robust free cash flow generation at scale.  Management owns close to 20% of the business and has executed brilliantly thus far.

Shares in Castle Biosciences (“CSTL”), a market leader in diagnostic testing for dermatological cancers, underperformed in the fourth quarter of 2021 along with the broader diagnostics and life sciences sectors. While the company continues to make fundamental progress with the successful commercialization of its flagship DecisionDx-Melanoma test, lower traffic at dermatology clinics as a result of the pandemic, and the doubling of its sales force last year, led to lower-than-expected salesforce productivity. We believe this to be a transitory issue as newly trained sales representatives take two to three quarters to reach normal productivity levels. Additionally, two new tests launched in 2021 have the potential to generate upside to revenue expectations as they target the same doctors. Finally, the company acquired Cernostics, an early-stage diagnostic company focused on the gastrointestinal market. While the acquisition expands Castle’s addressable market, thereby offering greater visibility into the sustainability of organic growth in the longer term, the lack of meaningful near-term revenue pushes out the company’s turn to profitability. A strong financial position with over $300M in net cash limits the company’s need to access capital markets and de-risks our investment thesis, allowing us to remain patient as Castle executes on its long-term strategy.

 

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