US Equity Strategies

July 2023

 

For the first six months of 2023, the U.S. portfolios have performed absolutely well and remain ahead of their benchmark. Several technology holdings have surged on the back of artificial intelligence’s (AI) emergence, as they look to benefit from the massive infrastructure investment needed to harness the power of this ground-breaking technology. Additionally, positions tied to U.S. housing have performed very well. In fact, the country remains under-housed, providing a long runway for growth. Several software holdings have also seen their share prices increase following strong financial results and guidance.

Overall, Pembroke remains optimistic about its positions’ growth forecasts, balance sheets and reasonable valuations. Positions whose stock prices are approaching the firm’s multi-year price targets are being trimmed, and the firm has deployed the capital into two new holdings and existing positions with more growth potential.

U.S. Growth Strategy

Pembroke’s U.S. growth strategy rose in the second quarter of 2023, performing approximately in-line with the Russell 2000 index. Unfortunately, as discussed below, the mania surrounding artificial intelligence hit the stock prices of two large holdings, despite the fact that both companies may very well emerge as winners as a result of AI’s potential applications.

Globus Medical’s (“GMED”) decision to acquire Nuvasive (“NUVA”) also continues to weigh on its share price, as investors await clarity on the combined company’s growth and profitability. Given management’s track record, the strong pro forma balance sheet and cash flow, and the significant earnings accretion potential, Pembroke has taken advantage of the market’s short-term focus to add to its position. From today’s price, the upside versus downside analysis is favourable for investors with a view beyond the next 12 months.

Two stocks that made positive contributions to returns of the strategy over the past 12 months

Installed Building Products (“IBP”), an installer of residential and commercial insulation and complementary building products, returned over 23% in the second quarter, compared to a 5% return in the Russell 2000 benchmark. At a micro level, IBP benefitted from a strong first-quarter earnings report (over 40% year-over-year earnings per share growth). This report exceeded expectations, but was also aided by improving residential construction conditions in the U.S. At a macro level, despite higher mortgage borrowing costs, demand for new homes remained brisk as a lack of existing homes for sale has pushed buyers to new homes. Furthermore, home builders have quickly reacted to changing market conditions by increasing incentives, selecting lower priced materials, and cutting prices. Pembroke remains excited about IBP over the long-term, as new home demand is well in excess of supply and should take several years to clear.

Pure Storage (“PSTG” or “Pure”) is the leading vendor of all-flash storage hardware and software management solutions. The stock returned over 44% in the quarter, compared to a 5% return in the Russell 2000 benchmark. Coming off a disappointing fourth-quarter report in March, Pure posted in May strong first-quarter numbers that exceeded investor expectations. In addition, the company’s new product offering, announced during the quarter, both significantly expanded its market opportunity and widened its competitive moat. These factors, coupled with the potential to capitalize on spendings in artificial intelligence, drove enthusiasm for this disruptive category leader. Pembroke recognizes considerable long-term possibilities and remains fully invested, despite the recent strength.

Two stocks that made negative contributions to returns of the strategy over the past 12 months

The excitement surrounding artificial intelligence (AI) swept across financial markets in the second quarter of 2023. At the same time, investors started to worry that certain business models would come under pressure from AI’s capabilities. Two of Pembroke’s larger positions, Shutterstock (“SSTK”) and WNS Holdings (“WNS”), saw their stock prices decline despite their strong fundamentals, as a result of the possible threats posed by AI.

In the case of Shutterstock, which provides a platform for photographers to submit their work, and for advertisers, artists and designers to purchase it, the concern is that images will now be generated out of thin air and tailored exactly to the demands of end users. However, that possibility faces numerous obstacles.

First, artificial intelligence needs to be trained by a library of images. In fact, OpenAI, the leading AI-generative company, partnered with Shutterstock to train its models. Meta and other large companies are also coming to the company to leverage its library of images, music and videos in order to train their models. Second, copyright lawyers are salivating at the opportunity to hold advertisers accountable for using artwork while not paying for it. Shutterstock now offers them the possibility to purchase and edit art, or even to create their own art using OpenAI’s technology, while having the express legal right to use the output for commercial purposes.

Interestingly, Shutterstock owns all the images created by users on its AI platform that are not paid for, leading to significant growth in its library. Shutterstock, in other words, owns critical content that will enable the AI revolution to take hold. In the meantime, the company is managing through a slowdown in advertising spend, while still delivering modest revenue growth, earnings before interest, taxes, depreciation and amortization (EBITDA) margins over 27%, and robust free cash flow. The company just affirmed confidence in its competitive position and long-term growth outlook by announcing a $100 million share buyback. At less than seven times the projected EBITDA in 2024, Pembroke believes the opportunity in Shutterstock shares skews significantly to the upside.

The reaction of shares in WNS Holdings to the emergence of AI was very surprising. The company, which helps its customers move back-office processing work to low-cost geographies, has a long history of adopting new technologies to further enhance its advantages over in-house management of these tasks. In fact, the use of technology tends to increase the complexity of the services that WNS can provide, thereby expanding the company’s addressable market.

In other words, technology tools have historically been a catalyst for higher-value services and non-linear engagement models, which both benefit WNS. AI will undoubtedly be a tool used to bring speed and efficiency to various processes, allowing WNS to take on more work and deliver even more impressive cost savings than it is today. AI and generative-AI are tools, not solutions, and require firms such as WNS to combine them with domain expertise, analytics, process, as well as human talent and oversight.

Following the share price weakness, WNS also accelerated its share buyback program. The company recently guided to almost 14% revenue growth for the current fiscal year and expects to maintain operating profit margins above 20%. Given the robust free cash flow, Pembroke has urged the company to consider further share buybacks.

Concentrated Strategy

Over the last year, the Pembroke concentrated strategy’s achieved gains surpassing those of its benchmark, the Russell 2000 Index (“R2000”), on an absolute and relative basis. The strong performance of the strategy in the last quarter was driven by the investments in U.S. residential construction and technology businesses. These investments were slightly offset by headwinds in several of our business services and communication services positions.

Two stocks that made positive contributions to returns of the strategy over the past 12 months

Installed Building Products (“IBP”), an installer of residential and commercial insulation and complementary building products, returned over 23% in the second quarter, compared to a 5% return in the Russell 2000 benchmark. At a micro level, IBP benefitted from a strong first-quarter earnings report (over 40% year-over-year earnings per share growth). This report exceeded expectations, but was also aided by improving residential construction conditions in the U.S. At a macro level, despite higher mortgage borrowing costs, demand for new homes remained brisk as a lack of existing homes for sale has pushed buyers to new homes. Furthermore, home builders have quickly reacted to changing market conditions by increasing incentives, selecting lower priced materials, and cutting prices. Pembroke remains excited about IBP over the long-term, as new home demand is well in excess of supply and should take several years to clear.

Trex Company, Inc. (“TREX”) is the leading supplier of composite decking products, which over time are replacing wood decks in residential environments. TREX shares appreciated almost 35% in the quarter, compared to a 5% return in the Russell 2000 benchmark. Driving this strong performance was better than expected first-quarter earnings results, which eased fears that the company’s proactive inventory management efforts, initiated in the second half of 2022, would either take longer than expected or were masking weak end market demand. Neither were true. The inventory cycle is progressing on schedule, and customer demand remains solid despite higher interest rates and recession fears. Pembroke remains focused on TREX’s growth opportunity over the long-term as the leading brand in a market going from 25% composite, 75% wood decks, to 75% composite and 25% wood.

Two stocks that made negative contributions to returns of the strategy over the past 12 months

The excitement surrounding artificial intelligence (AI) swept across financial markets in the second quarter of 2023. At the same time, investors started to worry that certain business models would come under pressure from AI’s capabilities. Two of Pembroke’s larger positions, Shutterstock (“SSTK”) and WNS Holdings (“WNS”), saw their stock prices decline despite their strong fundamentals, as a result of the possible threats posed by AI.

In the case of Shutterstock, which provides a platform for photographers to submit their work, and for advertisers, artists and designers to purchase it, the concern is that images will now be generated out of thin air and tailored exactly to the demands of end users. However, that possibility faces numerous obstacles.

First, artificial intelligence needs to be trained by a library of images. In fact, OpenAI, the leading AI-generative company, partnered with Shutterstock to train its models. Meta and other large companies are also coming to the company to leverage its library of images, music and videos in order to train their models. Second, copyright lawyers are salivating at the opportunity to hold advertisers accountable for using artwork while not paying for it. Shutterstock now offers them the possibility to purchase and edit art, or even to create their own art using OpenAI’s technology, while having the express legal right to use the output for commercial purposes.

Interestingly, Shutterstock owns all the images created by users on its AI platform that are not paid for, leading to significant growth in its library. Shutterstock, in other words, owns critical content that will enable the AI revolution to take hold. In the meantime, the company is managing through a slowdown in advertising spend, while still delivering modest revenue growth, earnings before interest, taxes, depreciation and amortization (EBITDA) margins over 27%, and robust free cash flow. The company just affirmed confidence in its competitive position and long-term growth outlook by announcing a $100M share buyback. At less than seven times the projected EBITDA in 2024, Pembroke believes the opportunity in Shutterstock shares skews significantly to the upside.

The reaction of shares in WNS Holdings to the emergence of AI was very surprising. The company, which helps its customers move back-office processing work to low-cost geographies, has a long history of adopting new technologies to further enhance its advantages over in-house management of these tasks. In fact, the use of technology tends to increase the complexity of the services that WNS can provide, thereby expanding the company’s addressable market.

In other words, technology tools have historically been a catalyst for higher-value services and non-linear engagement models, which both benefit WNS. AI will undoubtedly be a tool used to bring speed and efficiency to various processes, allowing WNS to take on more work and deliver even more impressive cost savings than it is today. AI and generative-AI are tools, not solutions, and require firms such as WNS to combine them with domain expertise, analytics, process, as well as human talent and oversight.

Following the share price weakness, WNS also accelerated its share buyback program. The company recently guided to almost 14% revenue growth for the current fiscal year and expects to maintain operating profit margins above 20%. Given the robust free cash flow, Pembroke has urged the company to consider further share buybacks.

 

 

 

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