Pembroke’s Canadian equity portfolios endured a challenging economic and investment environment in 2022. The higher interest rate environment has had a negative impact on valuation multiples in equity markets, and this phenomenon has been particularly acute for the growth-oriented companies whose longer-term prospects became more heavily discounted by the market. Uncertainty as to the corporate earnings outlook in 2023 has also been a headwind to performance.
On a positive note, fourth quarter returns rebounded following the difficult first three quarters of 2022, as markets anticipated a potential cresting of inflation measures.
Canadian Growth Fund
From an industry group standpoint, Pembroke’s Canadian Growth Fund has significant weightings in the technology and industrial sectors, which underperformed in the prevailing economic environment. Additionally, the portfolio has limited exposure to the energy and mining sectors, which have performed relatively well, corresponding with strong underlying commodity prices. Finally, the Fund’s financial holdings feature specialty lenders, insurance underwriters, and asset managers, which tend to trail the performance of large, diversified banks in times of economic turmoil.
Two stocks that made positive contributions to returns of the Fund over the past 12 months
The shares of Guardian Capital (“GCG”) rallied strongly in the fourth quarter of 2022, as investors responded to better than expected third-quarter earnings and a very significant strategic action. In the fourth quarter of 2022, Guardian announced the sale of its IDC Worldsource division, one of Canada’s leading life insurance brokerage and wealth advisor networks to Desjardins for $750 million. The net proceeds will be $600 million to Guardian. This puts the company in a very strong capital position to either effect share buybacks or acquisitions. The shares remain deeply undervalued at trough levels in the stock market.
Magnet Forensics (“MAGT”), a leading digital forensics investigation platform serving both law enforcement and private enterprise customers globally, saw its share price rise over 140% since the June 2022 lows. The reasons are primarily two-fold. Firstly, MAGT was too cheap: it declined with the rest of Canadian small cap tech earlier this year. Sector-wide pessimism was so extreme that MAGT, a company growing its revenues over 40% year-over-year with 20–40% free cash flow margins historically (unlike most SaaS companies today) and operating in a duopoly with high barriers to entry, saw its share price-cut almost in half in the first six months of 2022 and traded at approximately 20 times its free cash flow. We took advantage of this unwarranted pessimism by increasing our ownership of the company in June. Secondly, despite supposed macro headwinds, MAGT continues to consistently outperform at an operational level, with annual recurring revenue growing 50% in the most recent quarter, and operating leverage kicking in after a short period of research and development as well as sales and marketing investment. Moreover, new product launches driving the land-and-expand strategy continue to be successful. The combination of a cheap valuation (relative to its quality and growth prospects), and strong quarterly performance acting as a catalyst, turbocharged the stock’s performance in the second half of 2022. During January of 2023, MAGT was acquired at a premium by Thoma Bravo, so the holding will also make a significant contribution to first quarter performance.
Two stocks that made negative contributions to returns of the Fund over the past 12 months
Shares in MDA (“MDA”), a space technology and service provider addressing commercial and government customers, were weak in the fourth quarter. The company has been successful at winning new business, which has rapidly grown its backlog. It has also delivered better than expected margins on existing projects. Nevertheless, MDA shares have retreated as valuation multiples afforded to space technology companies have contracted, with concerns regarding supply chain disruptions and a more difficult financing environment facing end customers weighing on sentiment. Longer-term prospects remain compelling, as the commercialization of space continues to accelerate, with declining launch costs and geopolitical tensions heightening the intensity of competition in a new “space race”.
Shares in Tecsys (“TCS”), a provider of supply chain software, services and solutions for the healthcare, retail, and complex distribution sectors, declined in the fourth quarter. While the company made encouraging fundamental progress throughout 2022 by posting revenue growth fuelled by accelerating software-as-a-service adoption, investments to grow its sales force weighed on near-term profitability. We believe these investments will bear fruit in the form of growth in long-term recurring revenues, as the pandemic and subsequent supply chain challenges have highlighted the critical nature of supply chain infrastructure, and the shortcomings of legacy systems. Tecsys is poised to capitalize as an emerging leader in these modernization efforts.
Dividend Growth Fund
The Pembroke dividend Growth Fund is a Pooled fund. This is a prospectus-exempt product that is only available to investors who meet the definition of an “accredited investor” under securities legislation. This strategy also forms a significant component of the Canadian Balanced Fund.
The Pembroke Dividend Growth Fund posted modest absolute losses in the past twelve months, reflecting the challenging macroeconomic backdrop for equity markets. While the Fund’s holdings made solid fundamental progress in terms of earnings growth, cash flow generation, and dividend distributions, market headwinds still led to negative returns.
The Fund’s performance outpaced both larger cap and smaller cap benchmarks for the year. Most industry groups were in negative territory in the past twelve months, reflecting the difficult prevailing environment, though energy, materials, and industrial holdings managed to post gains. The Fund’s approach of balancing trade-offs between growth, value, and dividends, provided reasonable ballast for investors in a turbulent market.
Two stocks that made positive contributions to returns of the Fund over the past 12 months
The shares of Guardian Capital (“GCG”) rallied strongly in the fourth quarter of 2022, as investors responded to better than expected third-quarter earnings and a very significant strategic action. In the fourth quarter of 2022, Guardian announced the sale of its IDC Worldsource division, one of Canada’s leading life insurance brokerage and wealth advisor networks to Desjardins for $750 million. The net proceeds will be $600 million to Guardian. This puts the company in a very strong capital position to either effect share buybacks or acquisitions. The shares remain deeply undervalued at trough levels in the stock market.
Shares in Hammond Power (“HPS”), a leading manufacturer of dry-type transformers supplying the North American markets, performed well in the fourth quarter. Investors reacted positively to financial results highlighted by very strong revenue growth, impressive gross margin expansion, and healthy levels of both bookings and backlog. The company is benefiting from a robust demand backdrop boosted by accelerating trends towards the electrification of the economy. It appears to be winning market share without sacrificing profitability. While shares have appreciated markedly in the past two years, they remain attractively valued in light of Hammond’s longer-term growth prospects and its well-funded dividend.
Two stocks that made negative contributions to returns of the Fund over the past 12 months
The shares of Stingray (“RAY.A”) declined in the fourth quarter of 2022, as investors reacted to somewhat disappointing results. The shares were also weak because of negative investor sentiment surrounding all advertising-related equities, including disappointing results from a direct competitor. There was also concern about the high level of leverage at Stingray, although this situation should improve materially over the next two years. Despite promising growth initiatives in in-store advertising and streaming, investor sentiment continues to be weighed down by the company’s exposure to traditional broadcasting and cable distribution of its content.
Tricon Residential (“TCN”) owns and manages a portfolio of single-family rental homes, both on a wholly owned basis and in joint ventures where third-party investors provide capital. The homes are located throughout the US in the “Sun Belt” states. These are states which are benefiting from a net migration of Americans coming from coastal states and buoying the demand for housing units. This dynamic is reflected in the rental rate increases these markets have experienced in the past few years. Given the nature of the business model, that is financing a capital-intensive purchase of a home with debt, Tricon is very sensitive to the interest rate environment. While the vast majority of Tricon’s debt is at a fixed rate, the higher rate environment does compress incremental returns. As a result, management has taken a significant step back from their home acquisition strategy to allow for some better clarity as to where the markets will settle (including the securitization market and capitalization rates on real estate transactions). This has dampened investors’ enthusiasm and lowered the multiple ascribed to the stock. We do not believe the new rate environment has changed the prudence with which management deploys capital and the long-term thesis for the company remains intact.
Canadian All-Cap Fund
The Pembroke Canadian All Cap Fund finished the year on a strong note on both an absolute and relative basis. Nevertheless, full-year results were down, slightly trailing the benchmark due to a difficult first half of the year that was marked by the strong performance of value stocks in general, and energy securities in particular. As a growth fund investing in high-quality names, the Fund did not have exposure to these cyclical themes.
Looking ahead into the new year, we are encouraged by the strong balance sheets across all our holdings and their attractive valuations. We remain confident that many of our portfolio companies will take advantage of a weaker economic environment to take market share from their competitors and carry out strategic acquisitions, ultimately emerging as stronger businesses in the longer term.
Two stocks that made positive contributions to returns of the Fund over the past 12 months
Shares in Fairfax Financial (“FFH”), a holding company with property and casualty insurance as well as reinsurance companies worldwide, performed remarkably well in 2022, despite headwinds from challenging capital markets and catastrophe losses. The headwinds were more than offset by tailwinds from stronger profitability in the core underwriting business, and higher yields and income from the investment portfolio. Fairfax is well positioned to continue to benefit from a firming insurance market, as well as higher investment yields. This should drive stronger top-line growth, underwriting profitability and investment results going forward, leading to substantial earnings and book value growth. Divestitures in the past year give the holding company more dry powder to deploy capital, providing additional potential upside to earnings. FFH still trades at a steep discount valuation relative to peers, despite the recent performance in the stock, and we see room for further multiple expansion on top of growing earnings and book value, setting up a potential “double play” for returns.
Shares in Finning International (“FTT”), an industrial equipment dealer specializing in selling, renting, and servicing Caterpillar products in Western Canada, South America and the United Kingdom, showed strength in the fourth quarter as the company delivered well-received financial results. These results featured solid revenue growth, margin expansion and healthy backlog levels. Finning has benefited from robust spending activity in its infrastructure and mining end markets, while successfully navigating supply chain challenges with minimal disruption to operations. The company’s strong operating performance has resulted in significant free cash flow generation, which backstops a conservative dividend and opportunistic share buybacks. Finning’s shares remain attractively valued even following its recent rally on both relative and absolute measures. We believe the company is well positioned to deliver market share gains and margin expansion. It also has the financial capacity to opportunistically acquire additional dealership territories as they become available.
Two stocks that made negative contributions to returns of the Fund over the past 12 months
Telus International (“TIXT”), which provides consulting and digitization services to growing companies around the world, saw its stock perform poorly following the company’s decision to acquire high-growth competitor WillowTree. While the strategic rationale for the transaction was sound, the return on capital math was challenging, and Telus’s debt ballooned to three times earnings before interest, taxes, depreciation, and amortization (EBITDA). Pembroke made the difficult decision to sell Telus, despite the company’s exposure to strong end markets and its history of revenue growth and robust free cash flow. Respect for shareholder capital is critical to wealth creation, and Pembroke’s investment team could not get comfortable with the price paid for WillowTree.
CCL Industries (“CCL.B”) stock declined during the fourth quarter, on the back of slightly disappointing third-quarter results. Sales and earnings per share were up 14% and 12%, respectively, but fell shy of analyst expectations due to margin pressure in the Company’s Avery and Innovia divisions. We believe the weakness incurred in the third quarter will prove to be temporary as input costs have started to decline. Through broad product and geographic diversification, and the company’s industry-leading position, CCL is a best-in-class packaging company. A large portion of its sales originates from the economically stable consumer packaging and healthcare sectors. As such, revenues and earnings should prove to be resilient during a tougher economic environment. The company’s balance sheet is in good shape and should support strategic acquisitions going forward.
Other Articles Of Interest
Disclaimer
This report is for the purpose of providing some insight into Pembroke and the Pembroke funds. Past performance is not indicative of future returns. Any securities listed herein, are for informational purposes only and are not intended and should not be construed as investment advice nor is it a recommendation to buy or sell any particular security. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Pembroke seeks to ensure that the content of this document is correct and up to date but does not guarantee that the content is accurate and complete and does not assume any responsibility for this. Pembroke is not responsible for decisions or actions taken or made on the basis of information contained in this document.
