Investment Commentary & Outlook

Investment Commentary & Outlook – Q2 2020

After one of the worst quarters on record for North American stocks, prices reversed sharply in the second quarter of 2020  as investors grappled with the implications of COVID-19 offset by aggressive fiscal and monetary stimulus and hopes for a vaccine. Locked down for weeks, economies from China to Europe to to Canada have started to re-open, giving further reason for optimism. At the same time, the medium-term and long-term effects of the virus on the global economy are unknown as it has caused massive dislocations and changes in industries from travel to retail to technology.

Against the backdrop of fear and skepticism, stocks confounded many investors with their rapid rise over the last three months. Pembroke is not a macroeconomic research firm, but believes that some possible drivers of the market’s gains include:

1. Fiscal stimulus: short-term measures enacted by governments around the world have helped many businesses maintain payrolls during the shutdown, and ordinary citizens have benefited from income and stimulus programs to keep money in their pockets.
2. Monetary stimulus: against a backdrop of falling employment and economic uncertainty, central banks have flooded their economies with cash. Why? First, to prevent a credit squeeze. Second, to guard against deflation. And third, to inflate assets prices – from home prices to stocks – so that already suffering consumers would not see the value of their homes and retirement plans collapse, which would have exacerbated the crisis. Essentially, central banks are forcing investors into “risk” assets to help drive economic growth by lowering the yield on less risky investments such as government bonds.
3. The market looks forward: while the COVID-19 crisis is real and ongoing, the market looks forward. Investors are betting that like many crises of the past, from wars to disease to depressions, this too shall pass.
4. Businesses have adapted: the use of technology has facilitated an incredible transformation of many businesses in a shockingly brief period. Retailers have moved more online. Group meetings have been replaced by video conferences. Companies have assessed and implemented cloud software to meet the changing ways they interact with their customers. Despite all the headwinds, the world economy did not grind to a lasting halt. Rather, some of best and most well-positioned companies have taken advantage of the circumstances to accelerate adoption of their products and services.

Will there be losers in all of this? Of course. Will some of the outcomes be extremely unfair and unforecastable? Certainly. But there will also be winners. It is the harshness and beauty of capitalism played out over an unusually brief period of time. COVID-19 has acted as an accelerant, fuelling shifts in business and consumer habits that were underway but taking a long time to develop. Work-from-home technologies, telemedicine, and e-commerce have all seen their fortunes jump with unforeseen speed. At the same time, other industries such as commercial real estate and travel are facing structural risks to demand. While Pembroke’s investment team expects the global economy to recover, “normal” might look very different than expected only six months ago. It is with that reality in mind that the firm’s portfolio managers and analysts are assessing current and prospective holdings.

What is Pembroke Doing in this Environment?

In the last issue of Perspectives and during our series of virtual lunches (available at www.pml.ca), Pembroke detailed its focus on balance sheets and its decision to reduce holdings facing structural headwinds brought on by the virus. Many fast-growing companies with strong secular tailwinds will weather this crisis, with offerings so compelling that they can grow rapidly right through the disruption. Other more cyclical growth companies might see deferrals of purchases, but the likelihood that they encounter structural, longer-term headwinds is low. These include some healthcare businesses, such as Pembroke holding Globus Medical (“GMED”), which sells equipment used in back surgeries. Conversely, some companies have seen their end markets dramatically altered. These include movie theatres and travel businesses. The investment team is spending a lot of time understanding which of its companies should continue to grow or at least see a full recovery in demand for their services, and which might be at risk of a lower demand environment for the foreseeable future. As long as the current period of significant uncertainty exists, balance sheet strength will remain paramount.

The investment team believes that the combination of muted global GDP growth and low interest rates should continue to favour growth stocks, but that careful stock selection is critical given the challenges and opportunities facing many companies. While we remain optimistic that the COVID-19 crisis will pass, its effects are likely to be long-lasting. Each company’s shifting competitive landscape and growth prospects need to be carefully weighed against valuation considerations. The siren song of fast-growing companies in areas such as software-as-a-service, trading at increasingly inflated prices, poses a real risk. These companies offer products and services compelling enough that they are able to continue their rapid growth despite the economic disruption caused by COVID-19. Pembroke has holdings in some of these exciting companies, but the investment team manages its portfolio weightings based on their competitive advantages, the sustainability of their growth rates, and their balance sheets. At the same time, we remain committed to running diversified portfolios, continuing to hold positions in companies with strong track records but which fall outside the “hot” areas of the market. The firm’s 52-years of experience indicate that market trends can change quickly, and that stock selection should be based on fundamentals rather than market momentum. Overall, the investment team is taking a balanced approach to its focus on growth stocks, with portfolios made up of high-growth businesses combined with more modest growers that are profitable, well-financed, and positioned to win market share over time.

Outlook

While the ongoing Pandemic creates significant uncertainty, Pembroke maintains a healthy outlook for North American small and mid-capitalization growth equities despite the headwinds posed by COVID-19. Many companies in both the Canadian and US portfolios should grow through this crisis, and those that have faced more serious disruptions are financed to survive and eventually thrive. The investment team has been impressed by how quickly many holdings have adapted, with retailers such as Aritzia re-focusing their efforts on e-commerce and leisure companies such as LCI Industries and BRP ramping up production to meet rising demand. Further, important trends in technology, such as software’s migration to the cloud, and in healthcare, such as home-based care, are accelerating.

The lingering policy effects of the financial crisis of 2008/2009, stresses in global trade, demographic pressures, and COVID-19 are contributing to lower global GDP growth and to keeping interest rates low. The firm remains committed to running portfolios diversified across industry sectors and to investing in companies that are well-positioned to deliver revenue and earnings growth over a multi-year period. In short, the firm’s approach to growth stock investing remains unchanged.

LEARN MORE:

• See Our Solutions page for Pembroke’s range of funds.
• Learn about Pembroke’s Investment Philosophy.
• You can also Meet the Team here at Pembroke.

 

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