Canadian Equity Strategies

July 2024

 

Canadian capital markets delivered mixed returns in the second quarter of 2024 as investors weighed the interplay of uneven economic growth, inflationary pressures and emerging secular trends around artificial intelligence and onshoring. With price levels sufficiently stabilized and economic activity showing signs of fragility, the Bank of Canada cut interest rates in early June for the first time since the onset of the pandemic.

While this long-awaited policy shift was supportive for valuation multiples, concerns about the near-term resilience of the country’s economic activity grew. Against this backdrop, domestic equity markets delivered mixed returns over the quarter.

Canadian Growth Strategy

In line with broader markets, Pembroke’s Canadian Growth Strategy sold off during the period after a strong start to the year. Holdings in the Industrials, Consumer Discretionary and Real Estate sectors declined, including many of the strategy’s larger portfolio weights that had risen in the first quarter. In addition, the strategy’s underweight exposure to precious and base metals companies proved to be a headwind to relative returns during a period of strength in underlying commodity prices.

Despite the pullback, we remain confident in the long-term per-share growth prospects of our holdings and their valuation upside.

Dividend Growth Strategy

Pembroke’s dividend strategy posted modest gains in the second quarter, adding to its returns in the first quarter of the year. The strategy benefited from the proposed acquisition of Canadian Western Bank by the National Bank of Canada at a significant premium to prevailing market prices.

While such corporate actions are episodic and not a consistent source of returns, they highlight the widening gap between the discounted valuations of Canadian public equities and those paid by strategic and private equity buyers. Our dividend strategy continues to provide investors with growth supplemented by well-funded distributions.

Canadian All Cap Strategy

Pembroke’s All Cap Strategy delivered solid positive returns in the second quarter, benefiting in particular from contributions from the Materials and Financials sectors. The strategy’s precious metals holdings rallied in line with the gold price, while holdings exposed to insurance, credit and foreign exchange boosted the Financial sector’s performance.

In addition, the strategy benefited from a favourable ratio of winners to losers over the period as well as from a limited downside from the stocks that declined. The strategy’s focus on entrepreneurial growth and selective approach differentiate it from broader Canadian indices.

Positive Contribution to Returns of the Strategies in the Past Quarter

From a company-specific perspective, EQB Inc. (EQB), a leading digital financial services provider offering deposit taking, lending and wealth management services to retail and commercial customers, performed well in all our Canadian strategies in the second quarter. The company is making significant market share gains in an oligopolistic industry.

While traditional Canadian banks are largely content to reap profits from their core banking operations and redeploy capital to other businesses and geographies, EQB is successfully onboarding new retail and commercial clients by leading with a modern technology platform that delivers the user experience expected from digital service providers.

Growth to date has been impressive and we remain encouraged by the company’s prospects given its modest market penetration and compelling value proposition to customers. We expect further success to manifest itself in the form of growth in assets, deposits and, ultimately, earnings and book value per share. Lastly, valuation upside remains as EQB’s shares still trade at modest multiples relative to its growth prospects and return on capital metrics.

Negative Contribution to Returns of the Strategies in the Past Quarter

Shares in Hammond Power Solutions (HPS.A), a leading manufacturer of dry-type transformers serving the North American economy, were weak in the second quarter and were a headwind to the performance of both our growth and dividend strategies. HPS.A shares had rallied throughout 2023 and the first quarter of 2024, but pulled back sharply in the second quarter as the Canadian government’s change to the capital gains inclusion rate prompted investors to crystallize gains ahead of the policy change in order to avoid paying additional taxes.

While the sell-off in Hammond shares has been painful, at current levels, we are optimistic about the risk/reward profile of this investment. The company is benefiting from the intersection of powerful secular trends: electrification, onshoring and artificial intelligence. Industry supply is constrained, leading to growing backlogs, price increases and impressive revenue visibility.

We expect Hammond to capitalize on demand tailwinds and its leading position in the dry-type transformer market to deliver solid earnings per share growth and significant free cash flow generation.

 

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