Investment Commentary & Outlook – Q1 2021
There is light at the end of this tunnel. It flickers at times, casting doubt on when it will shine brightest. But it is there. And rarely has the forward-looking nature of equity markets been on more full display than it is today. Long-term investors do not focus on the past or even the present. As Canadian hockey icon Wayne Gretzky famously said, they “skate to where the puck is going to be, not where it has been.” With the accelerating rollout of vaccines, and positive scientific updates from Pfizer about its vaccine’s efficacy, the puck is heading to an economic “re-opening”. Are there going to the bumps along the road? Will some countries emerge from this global pandemic ahead of others? Will certain vaccines prover safer and more effective than others? The answer to all those questions is yes. Nevertheless, the direction is positive, and investors around the world are embracing that fact not only by buying stocks, but by re-examining their industry and sector exposures to ensure they will benefit from the rising economic tide.
The equity markets in 2020 were clearly dominated by the unexpected and dramatic effects of the COVID-19 pandemic. Companies with business models deemed impervious to (or to be beneficiaries of) the virus saw their stocks soar. Similarly, the share prices of many highly valued growth companies jumped on the back of plunging interest rates. Meanwhile, shares in banks, energy companies, and other cyclical sectors struggled. Pfizer’s November 2020 vaccine announcement, combined with aggressive government spending plans being announced around the world, spurred a reversal of those trends. In the first quarter of 2021, the energy and financial sectors led the way for the S&P 500 index. Similarly, in the US small capitalization space, the Russell 2000 Value index had its 7th best quarter ever in the first quarter of 2021, which was impressive given that the final three months of 2020 were its best quarter on record. Finally, companies with high debt levels generally outperformed those with strong balance sheets; low share prices (at times a proxy for quality) beat high share prices; and many shares which jumped in 2020 have trailed in the first three months of 2021. In Canada, the story was similar. The S&P/TSX Composite saw the biggest contribution from the financials and energy sector, two sectors which negatively impacted returns in 2020.
What is Pembroke doing in this environment? Taking the same approach as it did when the pandemic took hold, which is to carefully examine each holding’s outlook given the current and prospective economic situation. During 2020, it was about ensuring our companies were well-positioned to weather the storm, could take advantage of the unforeseen circumstances, and had end markets expected to fully recover post-pandemic. In late 2020 and early 2021, the investment team has been reducing its weight in some holdings whose share prices surged in the past year, reducing their long-term upside. Quality growth, after all, is not only found in software and biotechnology sectors! Financial services firms, restaurant companies, and consumer goods businesses can also grow on a per share basis and enjoy strong balance sheets. It is important to note, however, that Pembroke is not making a broad macroeconomic “call” in adjusting its portfolio to the new reality. Rather, the team is basing decisions to trim, sell or buy positions based on a fundamental, bottom-up analysis of each holding and its corresponding share price. While Pembroke believes in holding winning stocks with a history of success, sometimes the valuation parameters become too difficult to justify. In these cases, positions are significantly reduced or even sold. The robust pipeline of new ideas across the firm’s mandates also creates healthy competitive tension, forcing overly expensive or underperforming positions out of the portfolio in favour of new holdings which meet the firm’s objectives for growth, balance sheet strength, and management alignment with shareholders.
We are committed to investing in companies that we believe can create wealth for shareholders by establishing strong competitive positions in large markets, growing their revenue and profitability, and earning healthy returns on invested capital. At the same time, even greatness has a price. Because the equity markets often chase “themes” and “trends”, sectors and stocks can become overpriced. For example, many software stocks have tested the limits of rational valuation in the past year. Pembroke has been around since 1968; the team is keenly aware of valuation risk, having lived many cycles. It is for that simple reason that some “hot” holdings from 2020 have been replaced by holdings with more compelling investment cases. That said, the firm will not reach into indebted companies, value stocks with threatened end markets, or low-quality business models just to chase short-term returns. Over the long-term, a disciplined approach to quality growth in combination with a reasonable approach to valuation will reward patient investors.
Pembroke believes that investors find themselves at an exciting but also precarious time in markets. The backdrop of aggressive government spending, (still) low interest rates, mind-blowing advances in biotechnology and healthcare delivery, and the incredible roll-out of work-from-home technologies offers incredible opportunity for investors in growth and innovation. At the same time, risky temptation abounds. The Canadian IPO market, for example, is on fire. The quality of these businesses varies, making discipline paramount. In the US, certain high-growth sectors of the market soared to all-time highs before correcting swiftly in a matter of weeks. The market doles out rough justice when discipline goes wanting.
As always, Pembroke is being very selective. Just because companies in deeply cyclical industries or companies with stretched balance sheets are poised to survive as the economy re-opens, it does not mean they make sound long-term investments. Certainly, a successful roll-out of the vaccine, government stimulus, and a growing economy could prop these companies – and their share prices – up for some time. It makes perfect sense for the gap to close between their valuations and those of some high-growth companies whose valuations expanded to unforeseen levels during the pandemic. The question for long-term investors is what happens after that “gap” closes? In prior cycles, rallies in low quality have often been followed by stronger performance in the shares of companies with superior growth, balance sheets, and financial returns characteristics. Strong companies with superior products or services are often able to maintain pricing power, even during inflationary periods.
We are also excited by the expanding investment opportunities in Canada, as new and exciting companies come to market with technology, healthcare, and green energy solutions that could have a big impact on the world. We are, however, satisfied to let many of these companies come to market and establish a track record before investing. Pembroke remains committed to investing with a focus on growth and quality.
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This report is for the purpose of providing some insight into Pembroke and the Pembroke funds. Past performance is not indicative of future returns. Any securities listed herein, are for informational purposes only and are not intended and should not be construed as investment advice nor is it a recommendation to buy or sell any particular security. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Pembroke seeks to ensure that the content of this document is correct and up to date but does not guarantee that the content is accurate and complete and does not assume any responsibility for this. Pembroke is not responsible for decisions or actions taken or made on the basis of information contained in this document.