Canadian Equity Strategies

January 2024

 

Canadian equity markets rallied in 2023 from the lows of 2022, with gains concentrated in the second half of the year. The interplay between inflation, rising interest rates and economic growth remained the key driver of market returns. The prospect of moderating inflation and interest rate cuts in 2024 boosted investor sentiment in the fourth quarter. Corporate earnings reflected the headwinds of a subdued consumer and corporate spending environment and of cost pressures. However, valuation multiples eventually widened as investors anticipated a recovery in economic activity.

Progress from the market lows has been uneven, with significant variations in returns driven by different factor exposures. From a size perspective, larger capitalization stocks outperformed their smaller counterparts. In terms of industry groups, technology and healthcare issuers outperformed cyclical names. Finally, in terms of style, growth outperformed value, but this was largely driven by a narrow subset of very large companies that generated outsized returns.

Canadian Growth Strategy

The 2023 returns for the Pembroke Canadian Growth Strategy reflect the market dynamics discussed above. Much of the strategy’s progress in 2023 occurred in the last four months of the year, highlighting the difficulty of timing markets, particularly in an environment of significant economic flux. We remain confident that the robust business models, financial flexibility and management stewardship of our holdings are positioning the strategy for growth in earnings and cash flow per share over the long term.

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

Shares in Goeasy (GSY), a leading non-prime consumer lender in Canada, ended the quarter up 48% on the strength of very solid quarterly results. The company reported strong earnings that beat consensus expectations, driven by higher-than-expected loan growth, lower-than-expected charge offs and impressive operating leverage. The tightening of credit standards by the major banks has led to increased demand and higher quality borrowers for Goeasy. In the longer term, we expect Goeasy to continue to benefit from further market share gains and penetration into newer products, improving credit quality, reduced competition and operating leverage. Despite the strong run in the shares, the stock is still not expensive relative to its short- and long-term earnings potential.

Shares in Hammond Power Solutions (HPS), a leading manufacturer of dry-type transformers serving the North American markets, performed well in the fourth quarter. The company enjoyed continued operational momentum, as evidenced by strong financial results. Hammond is benefiting from a secular trend towards electrification, as efforts to address climate change through emissions reductions are driving increased demand for grid infrastructure. This demand backdrop is translating into record revenues, strong backlog growth, expanding margins and robust cash generation. While Hammond’s shares have reflected these attractive fundamentals with substantial gains over the past two years, they remain attractively valued given the company’s strong position in the North American transformer market, free cash generation and secular growth prospects.

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

Shares in Altus Group (AIF) fell during the fourth quarter, following weak results for the quarter ended September 30th. While the long-term thesis is intact, Altus is facing headwinds in both of its main businesses. Altus sells analytics software to the commercial real estate (CRE) industry, which faces cyclical challenges from rising interest rates and a degree of secular pressure due to changing post-pandemic patterns. Office vacancy rates are at all-time highs in many major cities. In the short term, less robust markets and investor reluctance to commit new funds to the sector are impacting usage and orders for Altus software. As for the company’s tax consulting business, the slowdown is attributable to the time lag associated with the implementation of new valuation rolls every three years in a number of key markets. Investors were also somewhat concerned about the additional debt incurred for an acquisition in the valuation space, an acquisition that is complementary to Altus’s existing business. By buying a competitor, Altus is strengthening its market position. Altus products are increasingly becoming a “must have” in the property investment industry, which supports our long-term positive view.

The shares of BRP (DOO) were unable to keep pace with the strong rally in the stock market at the end of the year. DOO shares fell 7% over the quarter, partly due to weak quarterly results and muted expectations for next year. The weakness in the demand for their highly discretionary power sports goods should not have come as a surprise in an economy characterized by high inflation and interest rates. Pembroke has held a position in BRP since its Initial Public Offering (IPO) in 2013, but has recently maintained a cautious portfolio weighting due to economic uncertainties. Despite the near-term headwinds, we believe the company can continue to grow through market share gains over a full cycle due to its strong competitive advantage. While its competitors use mass-production assembly lines in their plants, BRP has moved to a batch process that can accommodate a mix of different models. The line has the flexibility to produce a wide range of products with no set-up time between them. This allows BRP to leverage its innovation expertise and easily introduce a wide range of new, differentiated models in each product category. This is at the heart of the company’s past and future market share gains.

Dividend Growth Strategy

Pembroke’s Dividend Growth strategy delivered strong absolute and relative returns in 2023, ending the period with robust gains in the fourth quarter. Over the past year, the macroeconomic environment has been challenging for dividend-paying stocks, which have faced valuation pressure from the competitive yields currently on offer in bond markets. However, the strategy’s holdings are performing at a fundamental level by generating free cash flow and funding dividend distributions in spite of the cyclical headwinds facing their businesses.

The strategy’s returns during the year were primarily driven by holdings in the Industrials and Financials sectors, which are the two largest sectors by weight in the portfolio. Consumer Discretionary and Technology holdings were also positive over the period, while Energy, Communications, Materials and Utilities holdings detracted from performance.

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

Shares in Goeasy (GSY), a leading non-prime consumer lender in Canada, ended the quarter up 48% on the strength of very solid quarterly results. The company reported strong earnings that beat consensus expectations, driven by higher-than-expected loan growth, lower-than-expected charge offs and impressive operating leverage. The tightening of credit standards by the major banks has led to increased demand and higher quality borrowers for Goeasy. In the longer term, we expect Goeasy to continue to benefit from further market share gains and penetration into newer products, improving credit quality, reduced competition and operating leverage. Despite the strong run in the shares, the stock is still not expensive relative to its short- and long-term earnings potential.

Shares in Hammond Power Solutions (HPS), a leading manufacturer of dry-type transformers serving the North American markets, performed well in the fourth quarter. The company enjoyed continued operational momentum, as evidenced by strong financial results. Hammond is benefiting from a secular trend towards electrification, as efforts to address climate change through emissions reductions are driving increased demand for grid infrastructure. This demand backdrop is translating into record revenues, strong backlog growth, expanding margins and robust cash generation. While Hammond’s shares have reflected these attractive fundamentals with substantial gains over the past two years, they remain attractively valued given the company’s strong position in the North American transformer market, free cash generation and secular growth prospects.

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

Shares in Topaz Energy (TPZ), a royalty and energy infrastructure company with a diversified portfolio of assets in Western Canada, fell in the fourth quarter, in line with weakening energy prices. While lower commodity prices will reduce the company’s energy production cash flow generation in the short term, the company’s dividend remains well funded through its infrastructure assets. In addition, Topaz’s management team has a proven track record of deploying capital counter-cyclically. The company has a balance sheet with sufficient flexibility to make opportunistic acquisitions. We believe Topaz’s shares are attractively valued given the company’s growth trajectory and dividend policy.

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

Canadian All Cap Strategy

The equity market rally in the fourth quarter extended to the Pembroke All Cap strategy. It therefore contributed to the strategy’s strong absolute and relative results throughout 2023. Leading the performance for the year were the outstanding returns from the strategy’s Industrial holdings, in particular the two engineering services companies, AtkinsRéalis and Stantec. Both companies posted accelerating revenue and earnings growth, fuelled by large government programs. Performance was also boosted by the rebound in the Information Technology sector after the declines in 2022.

Returns were broadly diversified with almost 75% of positions contributing positively. In addition, all sectors contributed to performance with the exception of Consumer Discretionary, where earnings were impacted by inflation-induced cuts in consumption.

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

Cargojet (CJT) is a carrier of freight within the Canadian domestic market and to points of origin or destination in Canada. The company has a dominant market share in Canada, handling the vast majority of overnight packages, with its largest customers including Amazon, Purolator, UPS and DHL. During COVID-19, the company benefited from a surge in e-commerce volumes. Charter services were also purchased from the company as healthcare supplies were needed to deal with the pandemic. Against this backdrop, CJT announced an aggressive fleet expansion plan, with the majority of the incremental fleet additions to be driven by international growth. Since this announcement in late 2022, investors had become increasingly concerned that cash flow would become significantly negative as this investment initiative was pursued. Over the same period, profitable charter work also declined and the company’s core earnings suffered from inflationary costs without the ability to fully pass these on. As a result, the share price declined. In recognition of shareholder concerns, management partially reversed course on its investment plans to limit cash burn and maintain a reasonable level of balance sheet leverage. This announcement was made in the fourth quarter, which also coincided with the reporting of cost containment efforts that pleasantly surprised investors. This led to a rally from depressed levels. Given management’s long-term track record and the strategic partnership with DHL, we are confident in the company’s ability to grow internationally over time. We continue to be excited about the growth prospects and remain shareholders.

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

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

Shares in Franco-Nevada (FNV), a gold-focused provider of royalty and streaming financing solutions with a diversified portfolio of producing, development and exploration assets, were weak in the fourth quarter. While the underlying commodity environment was favourable with precious metal prices strengthening, the shares sold off due to uncertainty surrounding one of the company’s investments in Panama. Social unrest in the country has disrupted production at a copper mine in which Franco has a significant gold streaming interest, and the likelihood and timing of a restart are in question. The risk-reward profile of FNV shares remains attractive given this quarter’s correction, but we have reduced our position in the company in order to diversify into other attractive investments in the sector.

The shares of BRP (DOO) were unable to keep pace with the strong rally in the stock market at the end of the year. DOO shares fell 7% over the quarter, partly due to weak quarterly results and muted expectations for next year. The weakness in the demand for their highly discretionary power sports goods should not have come as a surprise in an economy characterized by high inflation and interest rates. Pembroke has held a position in BRP since its Initial Public Offering (IPO) in 2013, but has recently maintained a cautious portfolio weighting due to economic uncertainties. Despite the near-term headwinds, we believe the company can continue to grow through market share gains over a full cycle due to its strong competitive advantage. While its competitors use mass-production assembly lines in their plants, BRP has moved to a batch process that can accommodate a mix of different models. The line has the flexibility to produce a wide range of products with no set-up time between them. This allows BRP to leverage its innovation expertise and easily introduce a wide range of new, differentiated models in each product category. This is at the heart of the company’s past and future market share gains.

 

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