Canadian Equity Strategies

Pembroke’s growth-focused Canadian equity mandates faced a difficult economic and investment environment in the past twelve months. Aggressive monetary and fiscal stimulus deployed during the pandemic coincided with supply chain, labour and geopolitical disruptions to push inflation to measures not witnessed in decades. Central banks ratcheted up interest rates in response, pressuring equity valuations, slowing economic growth and increasing the likelihood of a recession.

This backdrop has been notably challenging for growth-oriented, smaller-cap companies, whose longer-term prospects became more heavily discounted by the market. While valuation multiples have been compressed across the broader equity markets, the phenomenon has been particularly acute for these companies.

However, on a positive note, the returns for the fourth quarter of 2022 and the first quarter 2023 rebounded into positive territory on the hopes of cresting inflationary pressures and a potential end to the cycle of interest rate hikes.

Canadian Growth Fund

Most industry groups represented in the Pembroke Canadian Growth Fund posted losses in the past twelve months, reflecting the prevailing economic environment.

The strategy’s financial, industrial and technology holdings were particularly weak, whereas the consumer-oriented investments showed relative strength. Additionally, the portfolio has limited exposure to the energy and mining sectors, which have been supported by robustness in underlying commodity prices.

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

Shares in Kinaxis (“KXS”) rose in the first quarter of 2023, after the company reported a strong end to 2022 and announced that it expected a revenue growth above 20% in 2023. Kinaxis supplies leading edge supply chain management software to large companies around the world. The company’s flagship product, RapidResponse, allows users to run scenario analyses and uncover potential shortcomings in their supply chains. When a planner in one link of the chain makes a change, everyone who is affected immediately sees the impact. The company’s global technological leadership was also recognized by Gartner, which could impact decision-making at potential customers. Kinaxis is seeing increased demand and a growing pipeline of large deals. While the shares are not cheap on traditional valuation metrics, the company is well financed, cash flow positive and growing quickly. Management also tends to guide conservatively, which makes their strong 2023 initial guidance all-the-more impressive. Finally, Kinaxis’ solutions are sticky, as they become part of their customers’ supply planning toolset, which means the company is building a base of recurring, high-margin revenue.

Shares in Pollard Banknote (“PBL”), a leading supplier of instant scratch tickets and iLottery services to North American lotteries, performed well in the quarter. The company’s inability to pass on inflationary price pressures in its key inputs, namely paper and ink, has weighed on profitability. However, it appears the worst is now behind us. Pollard has been successful in repricing a number of very important contracts, providing visibility into improving profitability starting in the second half of 2023. Should inputs costs decrease from their current elevated levels, a likely scenario in an economic downturn, we see the potential for margins to expand beyond their historical levels. Additionally, its digital lottery business has been posting record results in recent quarters and new jurisdiction wins could sustain earnings growth over the long-term. The stock’s current valuation remains far from demanding for the quality of the business, even after the recent rally. It offers investors the potential for attractive returns, combined with limited downside.

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

Shares in Trisura Group (“TSU”), a specialty insurance provider operating in the surety, risk solutions, corporate insurance and fronting segments in Canada and the U.S., fell during the first quarter due to a one-time write down of reinsurance recoverables in its U.S. fronting business. The write-down was related to an isolated disagreement with one of its reinsurance partners over contractual obligations. It was not due to elevated insurance underwriting losses. While we do believe this was a one-time event, the growth of the U.S. business may see a moderate temporary slowdown. Despite this impact, we still see Trisura producing high-teens annual earnings per share growth in the future. This growth profile paired with a valuation pullback makes TSU an attractive long-term opportunity.

Shares in Tucows (“TC”), a provider of fibre-to-the-home Internet access, domain name registration services and telecommunications software, were weak during the first quarter, facing a challenging environment for companies deploying capital expenditures to build longer term annuities. While the company’s software and domain registrar businesses are generating significant profits and free cash flow, the Internet access division is currently drawing capital as fibre infrastructure is being deployed to service new markets and customers. We believe that fibre-to-the-home will be a key technology in providing broadband Internet access to underserved markets, but we acknowledge that competitive offerings and technologies could pressure returns on investment. Moreover, a tighter financing environment makes funding longer-term asset builds more difficult and expensive. Given these challenges, we have sold our position in the company and redeployed the capital into other opportunities.

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 flat returns over the past twelve months, in the context of a challenging macroeconomic environment for equity markets. Valuation multiples compressed due to the higher interest rates, and investors also began to discount the possibility of a recession by revising corporate earnings expectations downwards. The Fund’s holdings nonetheless navigated the challenging environment well, generating free cash flow and funding dividend distributions despite clear headwinds.

The Fund’s performance outpaced both larger and smaller cap benchmarks in the past twelve months, and industry group performance was scattered. Industrial holdings performed well due to company-specific factors, while natural resources holdings outperformed in a robust commodity price environment. Most of the other industry groups were in negative territory, following the prevailing winds on equity markets.

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

Shares in Hammond Power Solutions (“HPS”), a leading manufacturer of dry-type transformers supplying the North American markets, performed well in the quarter as the company delivered strong financial results. These results featured impressive topline growth, robust backlog growth and margin expansion. The company is the beneficiary of secular trends towards increasing electrification of the economy, which will help reduce emissions in the global effort to reduce greenhouse gas emissions. Moreover, Hammond has been growing its market share despite supply chain and inflationary challenges in the past year. While the company’s shares have been stalwart performers in the past two years, we believe that they remain inexpensive in light of the growth prospects that lie ahead.

Shares of Watsco Inc. (“WSO”), the largest independent U.S. distributor of air conditioning, heating, and refrigeration (HVAC) equipment, gained 29% in the first quarter of 2023. Watsco’s solid performance was a function of several factors. First, the company posted strong fourth-quarter earnings and provided a favourable qualitative outlook. Second, sentiment for residential housing names improved following a challenging 2022, as interest rates potentially peaked and demand proved healthier than expected. Finally, WSO is benefiting from a regulatory change in 2023, as the U.S. government raised the minimum efficiency standards for all HVAC equipment sales. Historically, this has led to higher pricing and margins for the industry, all else equal. Importantly, our optimism for WSO extends well beyond 2023. The company remains one of the highest quality industrial growth businesses in our portfolio, led by an aligned management team with an excellent track record of compounding returns over many years.

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

Shares in Evertz Technologies (“ET”), a global provider of solutions that deliver content and broadcast equipment to televisions, on-demand services, streaming services and mobile devices, were weak in the first quarter as financial results lagged expectations. Demand has been uneven from broadcasting customers, though longer-term trends driving appetite for video content remains intact. Moreover, the broadcasting industry’s transition to more software-driven solutions from legacy hardware-centric architecture should lead to an improving margin profile. In the meantime, Evertz enjoys a conservatively financed balance sheet and delivers a well-funded regular dividend that has been augmented with special distributions over time.

Shares in Information Services Corporation (“ISV”), a leading provider of registry and information management services for public data and records, declined modestly in value in the first quarter in the context of general macroeconomic concerns pertaining to the Canadian housing market. While the company’s land registry operations in Saskatchewan remain highly profitable, volumes have fallen from pandemic-driven peaks in the past few quarters. Regardless, the company is delivering growth by harvesting the cash flow from land registry operations and making acquisitions into other registry and technology service businesses. We believe that ISV is well positioned to continue driving both organic and inorganic growth, while maintaining an attractive dividend that is conservatively financed by free cash flow generation.

Canadian All-Cap Fund

The Pembroke Canadian All-Cap Fund started the year on a strong note on both an absolute and relative basis, comfortably beating its benchmark. Technology stocks performed best in the first quarter, helping performance given the Fund’s sizable exposure to the sector. Additionally, the Fund’s limited exposure to the energy and banking sectors, which partially reversed their 2022 gains, was a tailwind.

While fundamental performance continues to be strong, decade-low valuations in our more economically sensitive holdings, combined with solid balance sheets and a focus on profitability, provide downside protection from a potentially weaker economic environment.

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

Shares in Kinaxis (“KXS”) rose in the first quarter of 2023, after the company reported a strong end to 2022 and announced that it expected a revenue growth above 20% in 2023. Kinaxis supplies leading edge supply chain management software to large companies around the world. The company’s flagship product, RapidResponse, allows users to run scenario analyses and uncover potential shortcomings in their supply chains. When a planner in one link of the chain makes a change, everyone who is affected immediately sees the impact. The company’s global technological leadership was also recognized by Gartner, which could impact decision-making at potential customers. Kinaxis is seeing increased demand and a growing pipeline of large deals. While the shares are not cheap on traditional valuation metrics, the company is well financed, cash flow positive and growing quickly. Management also tends to guide conservatively, which makes their strong 2023 initial guidance all-the-more impressive. Finally, Kinaxis’ solutions are sticky, as they become part of their customers’ supply planning toolset, which means the company is building a base of recurring, high-margin revenue.

Shares in Wheaton Precious Metals (“WPM”), a provider of streaming and royalty finance to precious metals companies around the world, performed well in the first quarter, in tandem with strong gold and silver markets. The company is a direct beneficiary of higher underlying commodity prices, as the streaming and royalty model insulates the company from the escalating capital and operating costs that periodically affect the mining industry. Moreover, Wheaton has a long history of identifying projects with exploration and production upside, which allow shareholders to benefit from the discovery and recovery of additional precious metal resources. We believe WPM shares offer meaningful exposure to precious metal prices, while maintaining the optionality from new discoveries, and protecting investors from operating issues inherent in mining operations.

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

Shares in Tourmaline Oil (“TOU”), one of Canada’s leading natural gas exploration and production companies operating in the Western Canadian Sedimentary Basin, were weak during the first quarter in the context of softening natural gas prices caused by an unseasonably mild winter that dampened heating-driven demand. While near-term prices were indeed soft, we believe the longer-term outlook for natural gas prices is bullish, given the upcoming commissioning of liquified natural gas export capacity in Canada. European and Asian prices for natural gas are orders of magnitude higher than those in North America, and geopolitical unrest involving Russia has only heightened the urgency for diversification of natural gas supply. We believe Tourmaline is poised to reap the benefits of the globalization of natural gas markets, while continuing to deliver profits and cash flow from its low-cost resource base in the interim.

Shares in Aritzia (“ATZ”), a vertically integrated design house for everyday luxury apparel, declined in the first quarter. The retailer has been successfully expanding its store network with a balanced approach, carefully selecting the best locations, and creating an aspirational shopping environment with unmatched customer service fuelling word-of-mouth referrals. Their unique combination of creative and data-driven talent has allowed them to grow their product catalogue in a sustainable and measured manner, with proven sellers driving repeatable sales. While Aritzia’s competitive positioning and growth potential appear unchanged, shares have retreated due to macroeconomic concerns around consumer spending. Inventory levels and promotional activity were key concerns amongst retailers, and we believe Aritzia is managing those challenges better than most. We remain confident that their brand momentum in the U.S. will continue to drive strong same store sales growth in a profitable way. Additionally, inventory levels are under control, with investments largely limited to proven sellers. This reduces fashion risk, while the breadth of brands resonates with its higher income consumer base. As such, we took advantage of the recent valuation discrepancy and added to our position.

 

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