Investment Commentary and Outlook

So far, 2022 has been a trying year for investors as rising interest rates, inflation, a war, and challenging politics have negatively impacted equities as well as bonds. The current period serves as a reminder that diversification, like so much else in financial markets, provides long-term benefits without always delivering the desired results over the near term. Broad indices, such as the S&P 500 and the MSCI World, are down more than 15% year-to-date, and bond indices are down by over 10%.

The Canadian stock market fared better at –9.9% during the first half of 2022, primarily due to its high exposure to commodities, namely energy. Pembroke seeks investments in companies offering secular growth opportunities. As a result, our portfolios have greater representation in sectors such as Technology, Consumer, Health care and Industrials, as opposed to other, more cyclical groups, including the commodity sectors.

Earlier in the year, investors worried about inflation and rising interest rates. Now, the likelihood of a recession is rising, and may have negative implications for future company earnings. It is reasonable to be concerned that higher inflation, interest rates, and commodity prices will take a toll on discretionary and corporate spending. Evidence of an economic slowdown is building, with cracks starting to appear in some of the macroeconomic data, particularly with respect to consumer confidence and indebtedness.

Pembroke invests in growth companies. We look for well-financed businesses with compelling competitive advantages in industries where the total addressable market is growing quickly. A rising tide, after all, lifts all boats. However, in recent months, rising rates have compressed the valuations of growth companies. Like always, when the pendulum swings, it can swing too far. Even companies with strong fundamentals and compelling midterm to long-term growth opportunities have experienced significant share price declines.

At Pembroke, we recognize that the one-year to two-year outlook is murkier than before, but that should not alter the five-year to ten-year outlook. Certainly, inflation, rising rates and a possible recession will affect the viability of weak companies. For survivors, there will be little impact beyond pushing earnings growth out for 12 to 18 months.

We accept that inflation, rising rates, and a recession pose real challenges to the earnings power of a subset of companies. We take into consideration all available new information as we want to avoid companies that may need capital from external sources, especially when it is scarce and expensive.

We are also continuously monitoring our companies for hints that they are passing on cost inflation to customers without destroying demand, and that their balance sheets are not deteriorating. Where we see evidence that business models are not as resilient as expected or a worsening of the financial position, we typically sell the shares.

When investors are faced with near-term uncertainty, they are prone to becoming increasingly short-sighted, focusing on easy-to-identify risks and near-term results. For those with a long-term perspective, market dislocations can create opportunities.

Pembroke’s approach when faced with situations like the current one is to stick to our knitting. In the Pembroke Global Balanced and Global Equity funds, we systemically rebalance to the target allocation of the underlying strategies. While both equity and bond markets have declined, equities have fallen further and, as a result, we are adding to the equity position. As growth equities have declined more than other stocks, we are also bringing the active growth allocation back in line with the target.

In our Canadian and US Growth strategies, we continue to evaluate companies based on their growth opportunities, operating strength, balance sheets and valuations. We also look for management teams that are well aligned with shareholders through significant ownership of shares.

While markets have fallen this year, the decline means some known risks are being priced into equities, which in turn means that some of the potential risk has actually come out of the stock market.

• Russia has already invaded Ukraine,
• investors understand that central banks are steadfast in their desire to defeat high inflation,
• and a pending recession is already on the mind of many.

Certainly, some risks are still out there, including the possible recession. Other risks, as always, are unknown, but the same can be said for many opportunities that will present themselves.

As a result, a lot of valuation risk has come out of growth stocks. Are we at the bottom? We do not profess to know, but our analysis suggests that if our companies can hit their long-term goals, today’s share prices seem attractive.

Other Articles Of Interest