US Equity Strategies

Pembroke’s US equity strategies continued to struggle in the third quarter of 2022. The pressure caused by rising rates and fears of a pending recession have challenged a wide swath of sectors, from secular growth technology to traditional retail. Investor fear gauges in the US have hit extreme lows, reflecting angst surrounding not only central bank activity but also geopolitical tensions, including the Russia-Ukraine war and the ongoing stress between many western nations and China.

At the same time, employment remains robust, with worker shortages persisting in both skilled and unskilled areas. In fact, market participants worry that the only way to put an end to inflation might be to cause a jobs recession in order to take pressure off demand.

In that scenario, falling demand would allow many businesses to right-size their inventories, supply chains would have a chance to recover following the COVID-induced chaos, and consumers would regain some power to ask for lower prices. The outcome would basically be a “typical business cycle”, which has not been seen for decades.

While much of the news is gloomy, the market is forward-looking. Therefore, stock prices have reacted negatively to many of the risks highlighted above and have priced in significant headwinds to revenue and earnings progress. Pembroke remains focused on the multi-year earnings power of its business, which is many cases is unchanged. Further, the investment team is being diligent on balance sheets to ensure that holdings have the financial flexibility to navigate an economic downturn.

When does the market starts to sense that a bottom has been reached and begins to price in an improving outlook? It is difficult, if not impossible, to make that determination. Only hindsight will provide that knowledge.

In the meantime, know that the Pembroke team is taking advantage of the current market conditions to buy strong franchises with long-term growth prospects, is carefully weighing valuations in its portfolios, and is in touch with management at current holdings to assess their outlooks.

US Growth Fund

With strong headwinds affecting the markets, Pembroke’s US growth Fund posted a negative performance in the third quarter of 2022.

Two stocks that made positive contributions to returns of the Fund over the past 12 months

WNS’s (“WNS”) share price rose modestly in the third quarter of 2022 despite the difficult underlying market conditions. The stock is now down 4.4% for the year, which is significantly better than the Russell 2000’s performance. WNS helps its customers reduce their costs by outsourcing back-office business processes to low-cost jurisdictions, such as India. For example, insurance companies use WNS for claims processing and adjudication, and travel companies such as Expedia use WNS to help with bookings. As the economy has reopened following the pandemic, WNS has seen its sales from travel clients and other particularly hard-hit verticals recover significantly. The company typically signs multi-year contracts, which gives it high levels of revenue visibility. Further, building economic concerns are leading many companies to look for ways to lower their cost structures, and WNS is consistently winning new customers and expanding its relationships with existing clients. While the company faces modest revenue headwinds from a falling British pound, its profit margins should benefit from the weakness in the Indian rupee. WNS has a long record of revenue growth, industry-leading profit margins and cash flow, and prudent capital stewardship.

Enphase Energy (“ENPH”) is a leading global developer of home energy solutions managing energy generation, storage, control and communications. ENPH shares rose over 40% in the third quarter, bringing its year-to-date appreciation to over 50%, compared to the -2% and -25% respective declines in the Russell 2000 benchmark (all values in USD). The company’s fundamental performance in 2022 is impressive, with first-half revenue growing almost 60% on the back on strong demand for its industry-leading residential solar products. Importantly, ENPH’s multi-year outlook remains robust as a combination of rising energy costs, government subsidies and consumer preferences, coupled with declining production costs, materially increases the penetration of residential solar deployments. While we remain convicted in ENPH’s opportunity, we recognize that the company’s market capitalization is toward the high end of Pembroke’s historical comfort zone. Over time, we could look to recycle the capital into smaller companies with equally promising outlooks.

Two stocks that made negative contributions to returns of the Fund over the past 12 months

Shares in Dorman Products (“DORM”) retreated in the past three months, despite posting strong fundamental results over the past two years. Dorman is a leading provider of aftermarket components for the automotive industry. The age of cars on the road continues to rise in North America, which means more repairs and ongoing demand for Dorman’s products. The company also acquired Dayton in 2021, thereby making a concerted push into the market for heavy-duty truck components. Management is encouraged by the acquisition’s progress, which combines Dorman’s engineering expertise and speed-to-market with Dayton’s strong brand and distribution capabilities. Based in part on the success of this transaction, Dorman recently announced the purchase of SuperATV, which engineers and sells aftermarket components used in the recreational vehicle market. Dorman plans to markedly ramp the number of parts offered by SuperATV and is excited by the growing install base of these vehicles, which will inevitably need parts and repairs over the coming years. While some investors worry about the risk of a recession and a near-term slowdown in demand in this new segment, it represents less than 15% of Dorman’s total revenue and offers exciting prospects for long-term growth. Dorman management has historically been careful with capital deployment, but clearly sees a multi-year opportunity to grow SuperATV’s revenue and profitability. If the overall economy does slow down or fall into a recession, Dorman’s automotive and heavy truck revenue should prove relatively resilient. Dorman has successfully navigated difficult industry conditions in its history, and there is no current reason to believe it will not continue to grow and generate robust free cash flow over the next few years.

The shares of TTEC Holdings (“TTEC”) fell sharply during the third quarter, following disappointing guidance for the rest of 2022. TTEC is a leading provider of outsourced customer care solutions and tools to a broad array of clients, from all levels of government to the financial sector. TTEC experienced significant growth during the pandemic, as the company worked on special projects for “e-governments” and benefited from the rapid growth of e-commerce in the service and retail industries. As the pandemic abated, TTEC successfully replaced most of the COVID-related business with new clients. However, economic uncertainty has caused the sales cycle for new clients to become elongated, which resulted in the change in guidance. The shares have almost fully retraced their COVID-related gains, despite the earnings more than doubling between 2019 and 2022, even with the post-pandemic fall off in 2022. The valuation has now fallen to very reasonable levels for a business with a very strong backlog growth and high free cash flow.

Concentrated Fund

Over the last year, the Pembroke Concentrated Fund (“PCF”) has declined in absolute terms along with the market, as a combination of inflation, interest rate, recession and geopolitical fears have pressured financial assets globally. The most recent quarter provided a reprieve, with the Fund posting gains of almost 5% (PCF A-Class units in CAD). On a relative basis, PCF outperformed its benchmark, the Russell 2000 Index (“R2000”), for the second quarter in a row. However, it is trailing the Russell over the prior 12-month period.

Two stocks that made positive contributions to returns of the Fund over the past 12 months

WNS’s (“WNS”) share price rose modestly in the third quarter of 2022 despite the difficult underlying market conditions. The stock is now down 4.4% for the year, which is significantly better than the Russell 2000’s performance. WNS helps its customers reduce their costs by outsourcing back-office business processes to low-cost jurisdictions, such as India. For example, insurance companies use WNS for claims processing and adjudication, and travel companies such as Expedia use WNS to help with bookings. As the economy has reopened following the pandemic, WNS has seen its sales from travel clients and other particularly hard-hit verticals recover significantly. The company typically signs multi-year contracts, which gives it high levels of revenue visibility. Further, building economic concerns are leading many companies to look for ways to lower their cost structures, and WNS is consistently winning new customers and expanding its relationships with existing clients. While the company faces modest revenue headwinds from a falling British pound, its profit margins should benefit from the weakness in the Indian rupee. WNS has a long record of revenue growth, industry-leading profit margins and cash flow, and prudent capital stewardship.

Shares in Paycom Software (“PAYC”) gained 18% in the third quarter of 2022, bringing the year-to-date performance to -21%. Paycom is a leading vendor of payroll and human capital management software solutions for US business customers. Since Pembroke initially invested in 2017, the company’s innovative product set and superior technology foundation have allowed it to gain market shares and disrupt incumbents, such as ADP and Paychex. More recently, in the third quarter, the company’s strong execution in a difficult environment has led to a significant outperformance in comparison to the broader market and its software peers. Paycom combines many of the elements of a true Pembroke stock: an enormous market opportunity, a sustainable competitive advantage, a rapid growth, a profitable business model, and an aligned and entrepreneurial management team. For these reasons and others, Paycom remains a core position in Pembroke’s US growth mandates.

Two stocks that made negative contributions to returns of the Fund over the past 12 months

Trex Company (“TREX”), a long-time Pembroke holding, and a manufacturer of composite decking products, posted strong results during the last quarter, but gave cautious indications for the remainder of 2022. During the first half of the year, the Company continued to benefit from strong demand for its products, helped by consumers embracing outdoor living and a switch in buying behaviour from wood to composite decks. Trex’s stock has continued to decline along with other housing-related stocks. Also hurting the stock was the Company’s announcement that its customers were proactively reducing inventory ahead of reduced consumer demand. With a debt-free balance sheet, we are confident that Trex will weather the upcoming economic storm and emerge as an even stronger player in the industry.

Shares in Gentherm (“THRM”) have come under pressure as investors worry that rising interest rates and a slowing economy will bite into demand for new cars. Gentherm is the leading provider of heated and cooled seats for the automotive industry. It has leveraged its technology and customer relationships to launch heated steering wheels and climate-controlled cup holders as well. Even more importantly, Gentherm is uniquely positioned in its industry to benefit from the shift to electric vehicles, as its current and future products offer an efficient and highly customizable way to heat and cool passengers. The company recently acquired a German business which offers comfort solutions, such as massage chairs, to automotive customers. The acquisition should help further establish Gentherm’s brand and capabilities with several large car manufacturers that were previously only small customers. Gentherm’s management is committed to running the business profitably and with a strong balance sheet. While a near-term decline in automotive demand is possible, the sector has also been undersupplied since the onset of the pandemic. Regardless of the next year’s outlook, the company’s multi-year prospects remain exciting. Furthermore, they are backed up by hundreds of millions of dollars of new contracts being awarded on a quarterly basis as well as a growing interest in its highly integrated, industry-leading climate solution for cars of the future.

 

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