US Equity Strategies

July 2024

 

Since the beginning of the year, Pembroke’s US equity strategies have faced persistently high interest rates. This environment took a toll on housing-related holdings as investors digested a short-term slowdown in new construction versus the long-term need for more housing to accommodate new household formations. Health care also came under pressure as companies grappled with a slowdown in biotechnology venture capital funding. As for equipment suppliers, they continued to struggle with excess inventory built up by customers during the height of the pandemic.

On the other hand, information technology stocks exposed to artificial intelligence spending continued to rise. For Pembroke’s US strategies, this surge in technology holdings was highlighted by Monolithic Power (MPWR) and Pure Storage (PSTG), both of which hit new all-time highs in June.

US Growth Strategy

The Pembroke US Growth Strategy declined in the second quarter, but remains in positive territory on both an absolute and relative basis for the first six months of the year. In the current environment, Pembroke has taken advantage of the mixed backdrop of company-level progress and a challenging equity market to sell or reduce some positions with less certain futures.

We redeployed this capital into new holdings that are benefiting from clear, long-term secular tailwinds, such as aggressive information technology spending by banks, the need to train more people for trades such as nursing and auto repair, and the construction of new data centres to meet the growing needs of artificial intelligence.

Positive Contribution to Returns of the Strategy in the Past Quarter

In 2023, Pembroke’s position in Global Medical (GMED) was challenged by the company’s decision to acquire a major competitor. Globus, known for its spinal surgery products, faced skepticism about its ability to integrate the two companies’ sales forces, rationalize costs, and cross-sell its spinal surgery robot into the target’s installed base of customers.

Pembroke was reassured by management’s exceptional track record of achieving industry-leading growth and margins, as well as its history of innovation. In addition, the combined company would have no net debt and would immediately begin to generate high levels of free cash flow. The company’s founder and largest shareholder also supported the transaction.

In 2024, Globus has begun to deliver on its promises. Organic growth remains strong, retention of key sales personnel has been impressive, and the opportunity to eliminate duplicative costs and cross-sell products remains compelling. As a result, Globus shares jumped in the second quarter on the back of strong financial results. However, they remain undervalued relative to peers and the company’s growth and margin expansion prospects.

Negative Contribution to Returns of the Strategy in the Past Quarter

Shares of Installed Building Products (IBP), which installs insulation in new homes and buildings, pulled back as investors digested the possibility of a slowdown in single-family home construction caused, in part, by stubbornly high interest rates. Recent permitting activity supports that concern, but Pembroke notes that the multifamily construction backlog is robust and should keep IBP installers busy until interest rates come down and the single-family market recovers. The US remains structurally underserved, with housing starts still 45% below peak levels despite consistent household formation.

From a long-term perspective, the market remains highly fragmented and IBP will continue to acquire smaller players using its robust free cash flow. IBP’s main competitor is TopBuild (BLD) and both companies have shown a willingness to pass on input price increases to their fragmented customer base. The Pembroke investment team remains optimistic about the multi-year opportunity for this proven organic grower and effective consolidator.

Concentrated Strategy

Pembroke’s Concentrated Strategy declined in the second quarter of 2024, but remains in positive territory on both an absolute and relative basis for the first six months of the year. The underlying holdings are performing well in line with the Pembroke team’s expectations.

Positive Contributions to Returns of the Strategy in the Past Quarter

In addition to Monolithic Power (MPWR) and Pure Storage (PSTG), distributors such as Core & Main (CNM) and SiteOne Landscaping (SITE) continue to consolidate smaller competitors in order to leverage their economies of scale. Gentherm (THRM), which sells technology to efficiently control the climate experience in automobiles, is also winning record new business.

Negative Contributions to Returns of the Strategy in the Past Quarter

Shares of Trex Company (TREX), which makes a composite alternative to natural wood for outdoor decking, fell along with shares of Installed Building Products (IBP), which installs insulation in new construction. Both companies have enviable long-term growth opportunities and excellent track records, but are affected by short-term cyclical concerns. As always, Pembroke looks for attractive entry points to build its holdings in companies that are well positioned to grow shareholder capital over many years.

Strategy Actions

The investment team decided to exit Sprout Social (SPT), which provides valuable services to businesses looking to improve their online marketing. The company’s growth rate slowed due to its transition from serving mid-market companies to focusing primarily on large enterprises.

WNS Holdings (WNS), which provides business process automation services from low-cost countries such as India, was also sold as its growth slowed due to a loss of customers. Investors are also trying to gauge how much artificial intelligence will replace the need for WNS’s services. This situation could limit the stock’s upside until that question is clearly answered.

Finally, AAON (AAON) was added to the strategy. The Pembroke team has been following this stock for years and took advantage of a cyclical pause in demand to initiate a position. AAON’s cooling systems will benefit from data centre demand, onshoring of US manufacturing, as well as secular trends around decarbonization and electrification.

Overall, the strategy’s holdings have sustainable competitive advantages and balance sheets. They also benefit from long-term tailwinds that will support their growth ambitions.

 

Other Articles Of Interest