Pembroke’s Canadian equity portfolios have experienced a very challenging economic and investment environment in the past twelve months. Inflationary pressures have emerged throughout the global economy, fuelled by aggressive monetary and fiscal measures to address the impacts of the pandemic, the supply chain disruptions, the Russian invasion of Ukraine and tight labour markets.
While central banks were initially slow to act on early signs of inflation, subsequent economic data spurred them to implement significant interest rate hikes and to signal that additional increases are on the horizon. This rapid emergence of a higher interest rate environment has been very difficult for capital markets, as valuation multiples have contracted markedly.
Moreover, restrictive monetary conditions are creating significant uncertainty regarding the outlook for economic growth, which is leading to downward revisions to corporate earnings expectations for the remainder of 2022 and 2023.
Growth-oriented stocks have sharply underperformed value stocks in this downturn, as have smaller capitalization issuers. While Pembroke’s Canadian holdings are in robust financial health and are positioned to weather difficult economic times, returns on both an absolute and relative basis have been pressured meaningfully.
Canadian Growth Fund
Pembroke’s Canadian Growth Fund posted losses on an absolute basis in the past twelve months. From an industry group standpoint, the Fund has significant weightings in the technology and industrial sectors, which underperformed in the prevailing economic environment. The portfolio has also limited exposure to the energy and mining sectors, which have performed relatively well, corresponding with strong underlying commodity prices. Lastly, the Fund’s financial holdings feature specialty lenders, insurance underwriters and asset managers, which tend to trail the performance of large, diversified banks in times of economic turmoil.
Two stocks that made positive contributions to returns of the Fund over the past 12 months
Auto collision repair shop operator Boyd Group (“BYD”) is navigating through the industry-wide shortage of qualified technicians and the resulting wage pressures. Demand remains strong as the number of accidents recovers along with miles driven. The ability to meet demand is limited by available capacity. As such, Boyd is receiving price concessions from insurance carriers who wish to have their clients’ cars serviced first. Margins are starting to normalize, with price increases soon approaching the wage increases. Considering its healthy balance sheet, the company is in a great position to continue its industry consolidation strategy going forward.
Shares of kitchen hardware distributor Richelieu Hardware (“RCH”) have been held in Pembroke portfolios since 1993. Over that period, we have witnessed the company operate successfully through various economic cycles. Richelieu keeps posting solid earnings growth, helped by strong sales to its kitchen cabinet manufacturer customers, as well as expanding margins. With a healthy balance sheet, we expect the company to actively pursue its acquisition strategy, particularly as the economy slows down and attractive opportunities present themselves.
Two stocks that made negative contributions to returns of the Fund over the past 12 months
Airboss of America (“BOS”) is a manufacturer of rubber compounds, solutions and value-added products. The company services customers in industries ranging from industrials, to defence and to automotive. The company was a beneficiary of large US Government awarded contracts during the past two years. These contracts were related to the pandemic and the need for personal and protective equipment for the health care industry. Part of our investment thesis was using the assumption that these large contracts were not one-offs, that there would be a need to restock and a need to better prepare for potential future health care crises. Although Airboss showed an ability to deliver in large volumes and do so in short order, we have been disappointed that despite government rhetoric, the company has yet to be awarded additional contracts. With many other holdings down in this environment, we are currently assessing the risk and reward equation of this holding when compared to others, whose fundamental progress has held in better shape during the past two years.
Sangoma Technologies (“STC”) provides communication software and equipment to small and medium sized businesses in North America. The company has over 70% of its revenue under multi-year contracts and produces industry-leading profit margins. Following two significant transactions over the past two years, management is committed to paying down debt. At the same time, the company’s current valuation is compelling, at just over five times the projected EBITDA for the 2023 fiscal year. Therefore, the Board’s decision to simultaneously buy back shares is reasonable. Sangoma’s closest peers have also seen their share prices decline significantly, as concerns about rising competition from Microsoft and a possible recession have led many investors to exit the sector. However, Sangoma operates with discipline and profitability, unlike many competitors, and has built out an impressive, broad suite of products. The company’s commitment to superior customer service positions it well to win new customers and retain existing contracts. Should the company execute against its plan to deliver revenue growth, over $30M of free cash flow, and expanding profit margins in fiscal year 2023, the upside from current share price levels could be significant.
Dividend Growth Fund
The Pembroke dividend Growth Fund is a Pooled fund. This is a prospectus-exempt product that is only available to investors who meet the definition of an “accredited investor” under securities legislation. This strategy also forms a significant component of the Canadian Balanced Fund.
With equity market headwinds prevalent throughout global financial markets, the Pembroke Dividend Growth Fund posted losses on an absolute basis in the past twelve months. Overall, the Fund’s returns modestly trailed large cap benchmarks in the past year, but are comfortably ahead of smaller capitalization indices over the same period.
Most industry groups were in negative territory during the period, reflecting the difficult prevailing market environment. However, while the Fund’s underweight positions in energy and mining companies were meaningful headwinds to relative performance, its balanced approach of weighing growth and dividends provided reasonable ballast in turbulent times for equity investors.
Two stocks that made positive contributions to returns of the Fund over the past 12 months
Shares in Mullen Group (“MTL”), a provider of transportation services including less-than-truckload shipping, truckload shipping, warehousing, specialized hauling and third-party logistics in Western Canada, performed well in the third quarter as investors embraced a strong earnings report and an updated financial guidance surpassing expectations. The company’s results benefited from strong volumes, pricing increases and the successful integration of a series of trucking businesses acquired during the pandemic. Moreover, Mullen is seeing a favourable operating environment marked by constrained trucking capacity and a rebound in the Western Canadian economy following a significant spell of energy market-related weakness. Despite the recent share price strength, Mullen continues to sport an attractive, well-funded dividend. Moreover, we believe future growth will be driven by continued market share gains, opportunistic acquisitions and an expansion of its nascent, but promising, third-party logistics business in the US.
Shares in Watsco (“WSO”) gained 9% in the third quarter of 2022, bringing the stock’s year-to-date performance to -16%. Watsco is one of the largest US distributors of residential and commercial heating, air conditioning and refrigeration (HVAC) equipment. The company has benefited from a relatively stable organic market growth, punctuated by well-timed and well-priced inorganic growth, which, along with continuous management improvement and operating leverage, has led to substantial margin expansion. More recently, WSO has invested heavily in its technology stack, which is driving accelerated market share gains and a new round of margin expansion. Despite a significant recent inflation in HVAC products, WSO’s strong pricing power has allowed it to stay ahead of original equipment manufacturers (OEMs) price increases, thus expanding margins and driving earnings upside. The company remains committed to a disciplined, balanced growth, which is not surprising, as management owns over 15% of the company.
Two stocks that made negative contributions to returns of the Fund over the past 12 months
Shares in software consolidators OpenText (“OTEX”) declined after the company announced its intention to acquire Micro Focus, a UK-based software company, in a US$6Bn transaction. While OpenText has a successful record of acquiring companies, reducing costs, driving free cash flow and paying down debt, this acquisition fell outside the Pembroke investment team’s comfort zone. The debt associated with this surprisingly large acquisition leaves little room for error and delays in execution. In addition, currency fluctuations and the risks associated with a possible economic slowdown, when burdened with this much debt, contributed to Pembroke’s decision to sell the position.
Shares in Waterloo Brewing (“WBR”), an innovative Canadian-based brewer and leading provider of co-packing services to global alcoholic beverage companies, declined in the third quarter of 2022, as supply chain disruptions impacted its customers’ ability to deliver key ingredients, ultimately delaying production and impacting the firm’s financial results. Additionally, the stock’s deletion from the S&P/TSX SmallCap Index triggered mechanistic and indiscriminate selling, further pressuring the shares. With the worst of the supply chain headwinds behind us and two additional sizable co-pack partnership wins announced, WBR remains well positioned to fill its manufacturing capacity faster than initially expected, and to improve its profitability materially in 2023. Despite the setback in WBR shares in the past year, the stock’s current valuation is quite attractive for a business that continues to progress fundamentally in a difficult operating environment. We continue to be shareholders.
Canadian All-Cap Fund
Despite improved absolute and relative performance in the last two quarters, the Pembroke Canadian All-Cap Fund’s year-to-date results continue to be hampered by a difficult first quarter. The Fund’s lack of exposure to Energy – the only Canadian sector up this year – has been a drag on performance.
However, the portfolio continues to be helped by investors’ flight to the quality and relatively stronger performance of larger cap equities. While fundamental performance continues to be strong, decade-low valuations in our more economically sensitive holdings, combined with solid balance sheets, provide downside protection from potential earnings revisions.
Two stocks that made positive contributions to returns of the Fund over the past 12 months
Auto collision repair shop operator Boyd Group (“BYD”) is navigating through the industry-wide shortage of qualified technicians and the resulting wage pressures. Demand remains strong as the number of accidents recovers along with miles driven. The ability to meet demand is limited by available capacity. As such, Boyd is receiving price concessions from insurance carriers who wish to have their clients’ cars serviced first. Margins are starting to normalize, with price increases soon approaching the wage increases. Considering its healthy balance sheet, the company is in a great position to continue its industry consolidation strategy going forward.
Women’s apparel retail Aritzia’s (“ATZ”) stock price posted impressive returns in the last quarter as well as year-to-date on the back of solid results and an expanding stock multiple. Strong sales south of the border in both the online and bricks-and-mortar channels have provided investors confidence in ATZ’s ability to operate in challenging conditions, and to capitalize on the large opportunity in the US. With currently only 42 stores and a small e-commerce penetration, the company can grow for several years in that market. The Aritzia brand is gaining momentum, while the number of attractive real estate opportunities has grown from a combination of competitors’ store closures and Aritzia becoming a desired tenant due to its sales productivity.
Two stocks that made negative contributions to returns of the Fund over the past 12 months
Cargojet (“CJT”) is a Canadian operator of air freight services operating domestically and at points that begin or terminate in Canada. As a result of the company’s operational success from a service and reliability standpoint, Cargojet has been rewarded with a near monopolistic position in the domestic overnight air freight market, which represents a meaningful part of its revenue. During the last quarter, the stock lost ground following news from FedEx, who pre-announced disappointing numbers for the remainder of the year. While we do not have any specific investment views on FedEx, we were surprised with the market’s reaction, given that most of the bad news was related to earnings and not top-line revenue, implying that it is more a company-specific issue than a broader market problem. The other issue Cargojet investors are focused on is the amount of capital expenditures required to fund the company’s growth in their fleet over the next three years. This period of investment will result in little free cash flow, but ultimately sets up the company to produce at higher levels once we look beyond the next few years. As always, we take a multiple year investment time horizon when looking at Cargojet. We are encouraged by the potential earnings the business will generate as it grows its business and expand its relationships internationally. We are not deterred by the near-term negative sentiments from the market and remain shareholders.
Shares in software consolidators OpenText (“OTEX”) declined after the company announced its intention to acquire Micro Focus, a UK-based software company, in a US$6Bn transaction. While OpenText has a successful record of acquiring companies, reducing costs, driving free cash flow and paying down debt, this acquisition fell outside the Pembroke investment team’s comfort zone. The debt associated with this surprisingly large acquisition leaves little room for error and delays in execution. In addition, currency fluctuations and the risks associated with a possible economic slowdown, when burdened with this much debt, contributed to Pembroke’s decision to sell the position.
Other Articles Of Interest
Disclaimer
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.
