Canadian Equity Strategies

July 2023

 

Pembroke offers three equity strategies in Canada. Our flagship Canadian growth strategy continues to provide investors exposure to a collection of underfollowed, entrepreneurial businesses, which we believe have the management skill, alignment, business opportunity and financial wherewithal to compound capital for shareholders on a long-term basis. Our  dividend growth strategy invests in companies that can deliver well-funded dividend distributions, augmented by organic and acquisition driven growth that, combined, offer attractive total returns. Lastly, Pembroke’s all cap strategy provides exposure to a select group of companies across the market capitalization spectrum. These holdings offer compelling growth profiles that we believe are underpriced in the market.

Canadian Growth Strategy

After a challenging 2022, which saw equity markets struggle in the face of rising inflationary pressures, interest rate hikes, recessionary fears and valuation compression, Pembroke’s Canadian growth strategy rebounded from bear market lows in the past twelve months. While the macroeconomic environment remains uncertain and challenging, equity market investors are demonstrating a willingness to look past near-term headlines and focus on the earnings power of companies in an eventual recovery.

The progress made from market lows has been uneven. Large-cap tech companies have shown incredible resilience and rebounded sharply from the troughs of 2022, buoyed by “safe haven” flows as well as excitement over the emergence of artificial intelligence opportunities. However, the upturn for smaller, less liquid, growth-oriented stocks has been less pronounced, though narrow breadth is not unusual in the early stages of a market recovery.

From an industry group perspective, portfolio returns in the trailing twelve months were buoyed by gains from consumer discretionary, financial, energy and information technology holdings. The strategy’s materials holdings lagged on an absolute and relative basis due to its low exposure to precious metals and company-specific issues.

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

Shares in EQB Inc. (“EQB”), a financial services company offering Canadian individuals and businesses a diverse suite of residential lending, commercial lending and deposit solutions, performed well in the second quarter. This performance followed strong financial results that exceeded market expectations and bucked a trend of choppy earnings delivered by other banks. Results were propelled by a combination of robust loan growth, strong net interest margin performance, modest credit losses and impressive capital efficiency. Furthermore, given the strength in operating performance, management took the opportunity to increase its quarterly dividend by 6%. In the long term, we believe EQB is poised to compound growth by leveraging its modern digital banking offering to capture incremental markets share from less agile competition.

Shares in Sleep Country (“ZZZ”), Canada’s leading omnichannel specialty sleep retailer, rallied in the second quarter, as the company’s fundamental progress was better than expected in a difficult environment. Within a fragmented industry characterized by several independent retailers, Sleep Country’s healthy balance sheet and national scale are leading to market share gains at a time when competitors are retracting their investments. The company, acting in a countercyclical manner, has been active on the acquisition front during this current industry downturn, further bolstering its competitive position and differentiation. Despite the near-term demand weakness as inflation and higher interest rates weigh on consumers’ disposable income, we remain confident in the long-term prospects of the business. Given the depressed valuation, management also remains active in buying back shares. For these reasons, Sleep Country remains a core position.

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

The shares in Altus Group (“AIF”), a leading real estate software and services company sold off following the release of second-quarter results, which sent mixed signals to the market. Altus Group is made up of two key elements. Altus Analytics, a leading software platform for asset management and valuation for the real estate industry, and a tax consulting group that helps asset owners adjudicate tax disputes. The long-term investment thesis is predicated upon continuing penetration of the Commercial Real Estate Industry, both on the asset owner side and the service/intermediary side. In the most recent quarter, the reported results were excellent, with strong margin improvement and solid growth at Altus Analytics (AA). It was a weak booking number for a part of AA that concerned investors. The turmoil in banking and the fallout for Commercial Real Estate from the pandemic has slowed the deployment of capital in the sector, impacting bookings for the valuation module within AA. This is viewed to be a temporary dislocation, as valuation will be a key to re-establishing equilibrium in the various markets.

The long-term thesis remains intact and the next leg of growth for the company is the evolution of its data strategy.

Shares in Pet Valu (“PET”), Canada’s largest pet retailer, underperformed in the second quarter. The company announced a disappointing earnings guidance, largely explained by a substantial investment in supply chain logistics. This investment was needed since the company has outgrown its distribution capacity due to strong consumer demand. It resulted in a temporary impact on margins, slowing down earnings per share growth. Demand for pet food and supply remains robust, reinforcing our thesis that Pet Valu’s business is largely recurring, recession resistant and benefitting from premiumization. We remain optimistic about the outlook for the company and view these investments as necessary to sustain growth over the long term. This strategic initiative will ultimately lead to higher profitability through the implementation of greater automation and the termination of third party outsourcing deals). Additionally, these investments will enable the company to accommodate a store footprint that is twice as large as its current capacity, enhancing its ability to meet customer demand and capitalize on growth opportunities.

Dividend Growth Strategy

The Pembroke Dividend growth strategy posted strong absolute and relative returns in the past twelve months, despite facing challenging economic conditions with rising inflation, interest rate hikes and recessionary fears. While equity market investors continue to grapple with uncertainty about the trajectory of the economy and the cyclicality of corporate earnings, valuation multiples have rebounded as risk appetite has improved. The strategy’s holdings navigated this dynamic environment well, generating free cash flow and funding dividend distributions despite persistent headwinds to their businesses.

The strategy’s returns in the past year have been driven primarily by holdings in the industrial and financial sectors, which are the two largest sectors by weight represented in the portfolio. Consumer discretionary and energy holdings also were in positive territory for the period, whereas communication services, real estate, utilities, materials and technology stocks were detractors to performance. The distribution of returns experienced by the strategy reflects the uneven nature of the recovery in equity markets in the past year.

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

Shares in Sleep Country (“ZZZ”), Canada’s leading omnichannel specialty sleep retailer, rallied in the second quarter, as the company’s fundamental progress was better than expected in a difficult environment. Within a fragmented industry characterized by several independent retailers, Sleep Country’s healthy balance sheet and national scale are leading to market share gains at a time when competitors are retracting their investments. The company, acting countercyclical manner, has been active on the acquisition front during this current industry downturn, further bolstering its competitive position and differentiation. Despite the near-term demand weakness as inflation and higher interest rates weigh on consumers’ disposable income, we remain confident in the long-term prospects of the business. Given the depressed valuation, management also remains active in buying back shares. For these reasons, Sleep Country remains a core position.

Shares in Hammond Power Solutions (“HPS”), a leading manufacturer of dry-type transformers supplying the North American markets, performed well in the second quarter following very strong financial results. The company is benefitting from a secular trend towards electrification, as efforts to address climate change through emissions reductions are leading to burgeoning demand for grid infrastructure. This demand backdrop is translating into record revenues, strong backlog growth, expanding margins, and robust cash generation. While Hammond shares have reflected these attractive fundamentals with important gains in the past two years, they remain attractively valued in light of the company’s strong position in the North American transformer market, free cash generation, and secularly driven growth prospects.

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

Shares in Vecima Networks (“VCM”), a provider of integrated hardware, software and service platforms that enable broadband access and digital content delivery for cable and telecommunications customers, corrected in the second quarter. Key customers are expected to work through bottlenecks in their infrastructure deployment, resulting in a near-term plateauing of revenue levels. While this fluctuation in customer activity is a short-term setback, we remain very optimistic about Vecima’s longer-term prospects for growth. Cable and telecom companies are racing to provide consumers with competitive broadband upload and download speeds, and Vecima is an “arms merchant” in this fight for market share. We believe the investment in networks required to modernize cable and telecom infrastructure for an increasingly data-intensive world will drive a demand profile that is significant in both magnitude and duration.

Shares in Richards Packaging (“RPI.UN”) were weak in the second quarter. The company, which provides plastic and glass containers to small and medium sized businesses, healthcare packaging, and dispensing systems to pharmacies, as well as consumables and equipment to aesthetician clinics, continues to endure the after-effects of the unusually high pandemic-driven demand that has since dissipated. While the company capitalized on the episodic demand that peaked in 2020 by generating significant windfall earnings and cash flow, comparisons have been difficult and results have failed to match the highwater mark set during the height of the pandemic. We still have a positive outlook on the shares, as the valuation has corrected to very attractive levels and management has a strong record of compounding earnings and cash flow per share. The company is well capitalized to execute on acquisition opportunities, which we believe are becoming more prevalent in a challenging macroeconomic and financing environment.

Canadian All-Cap Strategy

After the lows of 2022, the Pembroke Canadian all cap strategy maintained its momentum in the second quarter, both on an absolute and relative basis, comfortably beating its benchmark. Continued strong performance from technology and industrial stocks contributed to the strong performance given the strategy’s sizable exposure to both sectors. Additionally, appropriate security selection in the energy and financial sectors further helped results.

While our consumer discretionary holdings detracted from performance, decade-low valuations combined with solid balance sheets and a focus on profitability provide downside protection from a potentially weaker economic environment and the potential for attractive future returns.

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

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 second quarter. The company delivered financial results that were well received by the market. The highlights of the quarter included solid equipment sales, impressive product support growth, margin expansion, as well as healthy backlog levels. While cyclical concerns still linger in market sentiment, end-market demand in the infrastructure and materials sectors has proven durable. Moreover, the company continues to return capital to shareholders in the form of dividends and opportunistic buybacks. Even following their recent rally, Finning’s shares remain attractively valued on both relative and absolute measures. We believe the company is well positioned to deliver market share gains and margin expansion, while retaining the financial capacity to opportunistically acquire additional dealership territories when they become available.

Shares in Boyd Group (“BYD”), one of the largest operators of corporate-owned auto-collision repair centres in North America, outperformed in the second quarter. A strong demand environment, as miles driven continued to recover from pandemic lows, coupled with a tight labour market, has constrained industry capacity. As a result, Boyd is leveraging its pricing power with insurance companies struggling to secure enough capacity to service their customers. This has allowed Boyd to grow sales at a rapid pace. The company also continues to prioritize reinvesting in technician wages and training programs to drive additional capacity, positioning it for further market share gains. Furthermore, as supply chain headwinds are abating, the mix of aftermarket parts is approaching historical levels, which provides a tailwind for gross margin expansion. The company continues to reduce debt rapidly, opening the door for accretive acquisitions. In the long run, the average repair cost will continue to rise from increased complexity, price per part, as well as scanning and calibration requirements. Boyd remains a core position across our Canadian strategies.

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

Aritzia (“ATZ”) is a vertically integrated design house for everyday luxury apparel. Despite the company’s successful and calculated expansion of its retail stores, it encountered extraordinary growth in the context of an unstable macroeconomic landscape accompanied by inflation. These external factors led to a temporary delay in investments geared towards improving the company’s logistics and distribution network. Subsequent to these challenges, the company announced a substantial investment in its distribution centres. While this initiative is expected to strengthen the firm’s long-term operational efficiency, it is predicted to exert temporary pressure on the firm’s profitability during a period punctuated by concerns of an impending recession. However, we believe the long-term opportunity for the business remains attractive and unchanged, reinforced by strong unit economics and continued brand momentum in the United States. With no debt on the balance sheet, the company is well positioned to continue investing in organic growth initiatives and weather a potential challenging macro environment.

Shares in Wheaton Precious Metals (“WPM”), a provider of streaming and royalty finance solutions to precious metals companies around the world, declined in the second quarter, retracing gains made in a strong first quarter. The company’s short-term share price performance is highly influenced by underlying commodity prices. As such, weakening precious metals markets served to depress Wheaton shares during the period. Despite the short-term downdraught, we remain convinced that Wheaton is well positioned to add value for shareholders in a multitude of pricing environments. During bear markets, the company can opportunistically invest in world-class projects at attractive terms, as other financing methods are typically unavailable. During periods of market optimism, the company capitalizes on the rising commodity prices, while being shielded from increasing operating and capital expenses. In addition, regardless of the market conditions, Wheaton consistently profits from discoveries spurred by exploration activities and operational expansions.

 

 

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