Canadian Equity Strategies

October 2023

 

Over the last year, equity markets have rebounded from the 2022 lows. However, investors have faced challenges such as high inflation, increasing interest rates, and uncertainties about future economic growth. In the first half of 2023, there was a prevailing sense of optimism, with many anticipating a peak in inflationary pressures. However, economic data from the third quarter did not indicate any easing of these pressures, leading to a decline in valuation multiples. Persistently high interest rates have curtailed consumer spending and housing market activity. On the positive side, employment rates remain elevated, and wages continue to grow.

The recovery from the market lows has not been consistent. Large cap companies have demonstrated greater resilience compared to their smaller-cap counterparts, benefiting from the preference for safer assets in a market with limited liquidity. Additionally, growth-oriented stocks have not bounced back as robustly as value-oriented ones.

Canadian Growth Strategy

From an industry group standpoint, over the past twelve months, returns for the Canadian growth strategy were bolstered by positive performances in the financial, information technology, industrial, energy, and real estate sectors. Conversely, the strategy’s investments in the materials sector underperformed both in absolute and relative terms. This can be attributed to limited exposure to precious metals and particular challenges faced by individual companies.

Two stocks that made positive contributions to returns of the strategy during the past quarter

Black Diamond Corporation (“BDI”), a specialist in modular buildings and housing solutions for remote and temporary workforces, saw its shares rise positively in the third quarter. The company reported impressive financial results, highlighted by strong top-line growth, enhanced capacity utilization, considerable free cash flow generation, and a modest, well-funded dividend. Over the years, Black Diamond has skillfully expanded its operations beyond its foundational energy sector, now catering to a varied range of end markets such as infrastructure, education, and critical minerals. The company is well positioned for continued growth, underpinned by strategic additions to the rental fleet. This growth is supported by consistent demand driven by secular tailwinds and a rational competitive landscape. In addition to its core offerings, Black Diamond introduces intriguing possibilities through its LodgeLink subsidiary, an innovative workforce travel management platform set to transform the booking process for crew accommodations. Although BDI shares experienced an uptick during the quarter, their current valuation remains appealing given the company’s anticipated growth trajectory.

EQB Inc. (“EQB”), a financial services corporation that operates an exclusively online digital bank, provides a comprehensive range of residential and commercial lending solutions, along with deposit services, to Canadian consumers and businesses. The company’s shares performed well in the third quarter, building on another quarter of substantial financial outcomes that surpassed market forecasts, coupled with a sustained recovery in valuation multiples from the reduced levels observed at the previous year’s close. This positive momentum was driven by an amalgamation of vigorous loan expansion, potent performance in net interest margins, substantial non-interest income, and remarkable capital efficiency. Additionally, in light of the robust operational performance, the management seized the opportunity to augment its quarterly dividend once more, marking the seventh successive quarter of such increases. Looking ahead, it is our contention that EQB is strategically positioned for long-term growth compounding, as it is set to utilize its modern digital banking platform to secure additional market share from less agile competitors.

Two stocks that made negative contributions to returns of the strategy during the past quarter

In the third quarter, shares of Aritzia (“ATZ”), a vertically integrated design house specializing in everyday luxury apparel, experienced a downturn. The retailer has adeptly expanded its store network, judiciously choosing prime locations and crafting an enviable shopping ambiance. This environment, combined with exceptional customer service, has spurred word-of-mouth referrals. Notably, the company witnessed remarkable growth during times of escalating cost pressures and an uncertain macroeconomic climate, which subsequently delayed investments in their distribution and logistics network. A significant infusion of capital into their distribution centres was recently unveiled, momentarily impacting margins and free cash flow during a time marked by recessionary concerns and constrained consumer spending. Nevertheless, we are confident in the enduring viability of the business, underscored by robust unit economics and sustained brand traction in the United States. With a debt-free balance sheet, Aritzia is in an advantageous position to channel resources into its organic growth strategies and to navigate potential economic challenges.

Shares of the supply chain software provider Kinaxis (“KXS”) declined in the third quarter, despite the company’s strong growth trajectory and consistent positive free cash flow. Kinaxis provides customers with premier software to evaluate, adapt and enhance their supply chains in real time. Its capability to execute and assess thousands of scenarios daily and pinpoint potential impediments sets it apart from competitors. Pembroke’s investment team ranks Kinaxis among Canada’s foremost, advanced technology firms. The share price has been affected by diminishing valuations due to rising interest rates, and by capital moving from information technology to energy. Moreover, there is apprehension that extensive and complex software rollouts might be deferred as clients weigh long-term requirements against their intent to safeguard immediate profit margins. Even though deploying Kinaxis software is complex, it remains integral to operations and exhibits high retention. The company is also capitalizing on advancements in artificial intelligence to enhance its products’ speed, intelligence and relevance. Pembroke is inclined to overlook any transient setbacks, given Kinaxis’s vast market potential clear technology leadership.

Dividend Growth Strategy

The Pembroke dividend growth strategy posed strong absolute and relative returns over the past twelve months. Despite a promising start to 2023, the strategy experienced a downturn in the third quarter, mirroring the broader concerns about escalating inflation, increasing interest rates, and doubts concerning future organic growth. In a context of rising interest rates, dividend-paying stocks have come under valuation pressure, particularly as fixed income securities present competitive yields. Nevertheless, the strategy’s holdings have shown resilience, generating free cash flow and maintaining dividend distributions even amidst ongoing challenges.

During the past year, the strategy’s performance has been significantly influenced by investments in the industrial and financial sectors, which hold the largest weightings in the portfolio. The technology and energy sectors also recorded positive returns during this period. In contrast, sectors such as real estate, utilities, materials, and communications services detracted from the overall performance. The distribution of these returns underlines the uneven nature of the recovery in equity markets over the year.

Two stocks that made positive contributions to returns of the strategy during the past quarter

Shares in Computer Modelling Group (“CMG”), which provides reservoir simulation software designed for hydrocarbon production and carbon sequestration modelling, experienced gains in the third quarter of 2023. This uptick was largely a response from investors to both the impressive financial results of the company and its recent acquisition of a tech enterprise that specializes in subsurface decision-making, including seismic interpretation. Historically, CMG has been notable for generating considerable free cash flow and maintaining a robust cash-centric balance sheet. The induction of a new CEO in 2022 revitalized the company’s growth momentum. This organic growth is now propelled by gains in market share and the rise of carbon capture as a burgeoning commercial industry. Concurrently, the management is judiciously leveraging the company’s financial solidity to extend its technical expertise into markets beyond its conventional reach. The shares of CMG continue to present a compelling value, especially when considering the long-term potential of the enterprise.

Shares of Fairfax Financial Holdings (“FFH”), a global company specializing in property and casualty insurance and reinsurance, rose approximately 12% in the third quarter, as FFH continued a trend of robust fundamental performance in terms of both growth and profitability. The surge is attributable to the company’s comprehensive success, as hard insurance markets and a higher interest rate environment drove FFH’s insurance underwriting operations as well as its investment income to beat expectations. Although the stock’s valuation has grown in response to more stable operating results, there remains substantial potential for further expansion, as it currently trades at approximately one times book value, a figure markedly lower than that of comparable entities with similar returns on equity (ROEs). Despite the impressive performance year-to-date, it is our assessment that there is additional potential for share price appreciation as insurance markets continue to maintain their resilience for the foreseeable future, thereby driving sustained, robust growth in both revenue and net income, along with further valuation expansion.

Two stocks that made negative contributions to returns of the strategy during the past quarter

Shares in Supremex (“SXP”), a leading North American manufacturer of envelopes and growing provider of packaging solutions, experienced a correction in the third quarter subsequent to the surge in demand seen in 2022. The company is currently navigating the residual effects of this surge in demand, where customers placed excessive orders during a period of constrained supply. While the company took advantage of this peak demand, it now confronts immediate challenges as customers deplete surplus inventory in the face of economic ambiguity. Despite these transient obstacles, Supremex maintains a commanding 85% market share in the Canadian envelope sector, demonstrates considerable pricing authority, and is augmenting its market presence in the U.S., thereby optimizing capacity utilization. The firm is strategically employing its cash flows to drive growth within the packaging division. Our stance on SXP’s shares remains positive, as the valuation has adjusted to particularly appealing levels, and we are confident in the company’s financial readiness to realize its long-term strategic objectives, with numerous prospects for consolidation on the horizon.

Shares in Sleep Country (“ZZZ”), Canada’s premier omnichannel specialty sleep retailer, declined in the third quarter. However, the company has outperformed expectations in a challenging environment. While many independent retailers populate the industry, Sleep Country’s robust balance sheet and nationwide scale have enabled it to expand its market share at a time when competitors are scaling back their investments. During this industry downturn, Sleep Country has been proactive in its acquisition strategy, further strengthening its omnichannel competitive stance to offer the optimal sleep ecosystem to consumers. Even with the short-term demand slump due to factors such as inflation and rising interest rates impacting consumers’ disposable income, we maintain our optimism about the long-term trajectory of the business. The management also intends to persist with its share buyback initiative at a rate comparable to the previous year. For these reasons, and others, Sleep Country continues to be a core holding.

Canadian All Cap Strategy

In the third quarter, the Pembroke Canadian all-cap strategy experienced a slight decline in returns, offsetting some of the robust gains achieved since the start of the year. However, on a relative basis, the portfolio continued to distance itself positively from the performance of the benchmark. We remain satisfied with the performance of the stocks within the portfolio. This performance can be attributed not only to the market’s preference for larger cap companies, but also to solid stock selection.

The surge in oil prices meant that the energy sector bolstered the portfolio’s performance during this quarter. Additionally, industrial holdings associated with the engineering and construction, including SNC-Lavalin, Stantec, Toromont and Finning, positively impacted performance. Conversely, stocks linked to discretionary consumer spending, such as Aritzia, Gildan and BRP, saw a decline due to elevated interest rates.

Two stocks that made positive contributions to returns of the strategy during the past quarter

Shares of SNC-Lavalin, now trading as AtkinsRéalis (“ATRL”), have seen remarkable performance this year, reflecting the investor community’s recognition of the Company’s transformative efforts over the past three years. Historically, SNC grappled with ethical dilemmas, notably concerning bribery practices in Libya, Canada and several other countries. In response to these challenges, the Company embarked on an extensive restructuring process. This overhaul resulted in the replacement of its board of directors and management team, the cessation of operations in select geographies and specific sectors, such as oil and gas, as well as the winding down of its lump-sum turnkey construction activities. Once these changes are fully implemented, the renewed SNC will emerge as a specialized engineering services firm, poised for growth both organically and through acquisitions. A significant milestone marking the Company’s renewed journey is its recent rebranding to AtkinsRéalis (“ATRL”). The resurgence of Atkins and the renewed confidence of its shareholders can also be attributed to potent industry momentum, driven by the need to address aging infrastructure and governmental pledges of financial outlays. Additionally, there’s a growing resolve to refresh and modernize older assets in the quest to attain zero greenhouse gas emissions. As the investment community becomes increasingly aware of the Company’s metamorphosis, it is anticipated that the stock will align more closely in valuation with its industry counterparts.

Shares in Arc Resources (“ARX”), which stands as Canada’s third-largest natural gas producer and the top condensate producer, showcased strong performance in the third quarter. This was due to investors recognizing the promising blend of growth, cash flow generation, and capital returns that the company’s shares present. ARC boasts an expansive land presence in the Montney geological formation, located in Northwest Alberta and Northeast British Columbia. This formation is renowned as one of the most productive, cost-efficient, and profitable hydrocarbon reservoirs in North America. The exceptional productivity of Arc’s holdings enables the company to provide consistent production growth coupled with significant returns on capital, projected to continue for decades. Furthermore, with the upcoming launch of Canadian liquified natural gas capacity anticipated to considerably tighten the North American gas supply and demand dynamics, we expect that pricing will favourably impact the company’s fundamentals in the foreseeable future. The shares of Arc continue to present an appealing valuation, offering a free cash yield that is challenging to locate in other sectors.

Two stocks that made negative contributions to returns of the strategy during the past quarter

In the third quarter, shares of Aritzia (“ATZ”), a vertically integrated design house specializing in everyday luxury apparel, experienced a downturn. The retailer has adeptly expanded its store network, judiciously choosing prime locations and crafting an enviable shopping ambiance. This environment, combined with exceptional customer service, has spurred word-of-mouth referrals. Notably, the company witnessed remarkable growth during times of escalating cost pressures and an uncertain macroeconomic climate, which subsequently delayed investments in their distribution and logistics network. A significant infusion of capital into their distribution centres was recently unveiled, momentarily impacting margins and free cash flow during a time marked by recessionary concerns and constrained consumer spending. Nevertheless, we are confident in the enduring viability of the business, underscored by robust unit economics and sustained brand traction in the United States. With a debt-free balance sheet, Aritzia is in an advantageous position to channel resources into its organic growth strategies and to navigate potential economic challenges.

Shares of the supply chain software provider Kinaxis (“KXS”) declined in the third quarter, despite the company’s strong growth trajectory and consistent positive free cash flow. Kinaxis provides customers with premier software to evaluate, adapt and enhance their supply chains in real time. Its capability to execute and assess thousands of scenarios daily and pinpoint potential impediments sets it apart from competitors. Pembroke’s investment team ranks Kinaxis among Canada’s foremost, advanced technology firms. The share price has been affected by diminishing valuations due to rising interest rates, and by capital moving from information technology to energy. Moreover, there is apprehension that extensive and complex software rollouts might be deferred as clients weigh long-term requirements against their intent to safeguard immediate profit margins. Even though deploying Kinaxis software is complex, it remains integral to operations and exhibits high retention. The company is also capitalizing on advancements in artificial intelligence to enhance its products’ speed, intelligence and relevance. Pembroke is inclined to overlook any transient setbacks, given Kinaxis’s vast market potential clear technology leadership.

 

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