In Q1 2021, we turned over 25%+ of the portfolio. PCF investors might recall our COVID-inspired turnover in March-April of 2020 also approximated 25%, and subsequently added 400 basis points of incremental performance to the fund. So why did we act decisively in Q1? The answer is, for two inter-related reasons: based on our bottom-up, company-specific analysis, which in turn was informed by the pronounced changes in the top-down economic environment. We will explain both.
We believe this economic and market cycle will be strikingly different from the last. The post-GFC decade was characterized by persistently “lower for longer” economic growth (2.3% average GDP growth), inflation (core CPE of 1.6%), and interest rates (10-year treasury yield averaging 2.4%). This environment drove a multi-year re-rating in long duration growth businesses, like cloud software companies, where more of their value creation took place in the out years vs. the near years. The combination of controlling more of their own growth in a low growth environment, and directly benefitting from persistently declining interest rates re-rated these types of stocks higher.
Compare that to the coming years. U.S. GDP is forecast to grow 6% in 2021 and 4.5% in 2022. Inflation expectations are at 2.5% and trending up. “Reflation, re-acceleration and recovery” is likely, and the seven long duration growth stocks we sold could no longer satisfy our high hurdle for multi-year upside potential. And to be fair, we had already been paid for material future growth in these stocks. Some were up 100%+ in 2020, and multiple times that over the last 3 years.
We model all our businesses from the bottom-up, and we insist on using reasonable free cash flow multiples and reasonable discount rates in our DCFs. It was not reasonable to assume that 2020’s interest rate environment would persist. Thus, it was very reasonable to assume our discount rates and multiples should revert to more normal, pre-COVID levels. That work led us to conclude these seven businesses failed our upside requirement tests and no longer deserved a position in PCF.
Furthermore, the new positions we added have all the requisite quality metrics we demand, while also offering the significant multi-year upside potential that guides our stock selection process. In making these changes we also further diversified the portfolio’s industry exposure and boosted several of our key portfolio-level quality metrics.
Change, however unsettling, is the cradle of opportunity. In a year of profound and seemingly continuous change, we believe the last 3-4 months ushered in a paradigm shift that will define the next cycle. As a result of our disciplined but decisive actions, our portfolio is well suited to benefit and we anxiously await the future. Thank you for your continued. support.
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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.