Pembroke Concentrated Fund Commentary

Over the last year, the Pembroke Concentrated Fund (“PCF”) has declined in absolute terms along with the market, as a combination of inflation, interest rate, recession and geopolitical fears have pressured financial assets globally. The most recent quarter provided a reprieve, with the Fund posting gains of almost 5%. On a relative basis, PCF outperformed its benchmark, the Russell 2000 Index (“R2000”), for the second quarter in a row. However, it is trailing the Russell over the prior 12-month period*.

* All performance metrics stated for PCF A-Class units in CAD. Detailed performance by class and currency listed below.

	1-Month	3-Month	YTD	1-Year	3-Year	Since Inception, annualized	Since Inception, cumulative
PCF A, CAD	-4.56	4.81	-23.55	-20.28	8.20	10.52	59.51
PCF A, USD	-9.16	-1.90	-29.64	-26.53	6.85	7.90	42.60
PCF F, CAD	-4.66	4.52	-24.20	-21.18	n/a	6.56	20.98
PCF F, USD	-9.26	-2.17	-30.23	-27.36	n/a	5.23	16.41
R2000, CAD	-5.47	4.04	-19.02	-17.70	5.49	4.94	25.22
R2000, USD	-9.58	-2.19	-25.10	-23.50	4.29	2.52	12.30
S&P 500, CAD	-5.08	1.18	-17.69	-9.06	9.41	9.67	53.83
S&P 500, USD	-9.21	-4.88	-23.87	-15.47	8.16	7.14	37.96

FTSE Russell is a trading name of FTSE International Limited (“FTSE”), Frank Russell Company (“Russell”), FTSE TMX Global Debt Capital Markets Inc. and FTSE TMX Global Debt Capital Markets Limited (together, “FTSE TMX”) and MTS Next Limited. The Russell 2000 is a market cap weighted index that includes the smallest 2,000 companies covered in the Russell 3000 universe of US-based listed equities. The index is designed to be broad and unbiased in its inclusion criteria and is recompiled annually to account for the inevitable changes that occur as stocks rise and fall in value. Russell refers to the various indices copyrighted and trademarked by the Frank Russell Co. The S&P/TSX Composite is the headline index for the Canadian equity market. It is the broadest in the S&P/TSX family. The S&P/TSX Completion Index is comprised of the constituents of the S&P/TSX Composite Index that are not included in the S&P/TSX 60 Index. The index was formally the S&P/TSX MidCap Index. The FTSE TMX Indices comprise of a series of benchmarks which are designed to track the performance of bonds denominated in Canadian Dollars (CAD). The FTSE TMX Canada Universe Bond Index is the broadest and most widely used measure of performance of marketable government and corporate bonds outstanding in the Canadian market.

Performance Commentary

Since its inception in January of 2018, PCF has compounded value at approximately 10.5% per annum compared to the R2000 at roughly 4.9%. While the third quarter of 2022 was a bright spot, with PCF gaining 4.8% compared to the 4.0% move in the R2000 and the 1.9% move in the S&P 500 (in CAD), the experience over the year-to-date and prior 12 months has been significantly more challenging.

The reasons for this difficult year-to-date performance remain consistent with our commentary earlier this year: high levels of inflation have prompted aggressive interest rate hikes from the US Federal Reserve (“Fed”). Rising geopolitical risks in Europe, and increasingly China, have added to investor uncertainty. Despite those forces, job growth, employment levels as well as consumer spending in the US remain robust and, at least through September, have helped keep inflation metrics high. Thus, any Fed pivot towards a more market-friendly narrative is delayed, and the risk of economic recession and a negative corporate earnings cycle is increased.

To state the obvious, these are all factors outside of Pembroke’s control. As investors, we can only control where we choose to allocate capital. In the PCF, we allocate capital to high-quality businesses with enormous market opportunities, rapid growth potential, sustainable competitive advantages and strong balance sheets, that are run by aligned management teams. Furthermore, we limit our capital to a concentrated group of companies with objectively high-quality fundamental characteristics. Our belief is that these high-quality growth businesses will compound value over the long-term and help protect capital in downturns.

While market downturns are never fun experiences, they create immense opportunity, particularly for well-run businesses. Competent teams with financial flexibility often “do their best work” in downturns. They make smart organic investments, game-changing acquisitions or key management hires when their weaker peers are worried about surviving. Our businesses often use down markets to invest in what they know best: themselves. In fact, over 50% of the portfolio is currently buying back their own stock.

We share our companies’ optimism in themselves. Using our 4-year target prices, the PCF has upside potential in excess of 100%. Just as our companies often do their best work in market downturns, so too do our investors.

Portfolio Management Commentary

We did not initiate any new position or exit any existing position in the quarter. We did, however, reallocate a modest amount of capital into two names we have highlighted in the past, Trex and SiteOne. These two titles have underperformed largely due to their proximity to the US residential housing market, an interest rate sensitive pocket of the economy. We also added to SPS Commerce, a software company that entered the portfolio earlier in the year. SPS commands a dominant position in the retail and consumer product supply chain space.

These three companies are all high-quality businesses with enormous market opportunities, sustainable competitive advantages and aligned management teams. We remain confident in their ability to create substantial value over the long-term and welcome the opportunity to add to our positions at the current depressed levels.

Portfolio Characteristics

Pembroke believes that a portfolio of stocks containing the following attributes should, over the long-term, better protect capital in down markets and outperform in up-markets. Our holdings generally show faster growth, higher margins and higher returns, and are better financed and more aligned with investor interests, as compared to the market.

Metric	Strategy	Russell 2000
Price/NTM Earnings Growth	22.8x	17.7x
NTM Sales Growth	12.9%	11.1%
Standard Deviation	29.8%	26.5%
Return on Equity (ROE)	14.4%	7.7%
Return on Invested Capital (ROIC)	11.3%	4.3%
Net Debt to NTM EBITBA	0.2x	2.0x
Market Cap (Weighted Average)	$6.3B	$2.5B
Insider Ownership	7.5%	4.2%

Source: Pembroke, Bloomberg, Earnings and revenue data based on Bloomberg next twelve months consensus estimates.  Standard deviation and beta calculated over a 1-year period.  The beta of the portfolio is calculated against the Russell 2000 Total Return Index. Data as of March 31, 2022 in USD retrieved on April 5, 2022.

 

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

WNS’s (“WNS”) share price rose modestly in the third quarter of 2022 despite the difficult underlying market conditions. The stock is now down 4.4% for the year, which is significantly better than the Russell 2000’s performance. WNS helps its customers reduce their costs by outsourcing back-office business processes to low-cost jurisdictions, such as India. For example, insurance companies use WNS for claims processing and adjudication, and travel companies such as Expedia use WNS to help with bookings. As the economy has reopened following the pandemic, WNS has seen its sales from travel clients and other particularly hard-hit verticals recover significantly. The company typically signs multi-year contracts, which gives it high levels of revenue visibility. Further, building economic concerns are leading many companies to look for ways to lower their cost structures, and WNS is consistently winning new customers and expanding its relationships with existing clients. While the company faces modest revenue headwinds from a falling British pound, its profit margins should benefit from the weakness in the Indian rupee. WNS has a long record of revenue growth, industry-leading profit margins and cash flow, and prudent capital stewardship.

Shares in Paycom Software (“PAYC”) gained 18% in the third quarter of 2022, bringing the year-to-date performance to -21%. Paycom is a leading vendor of payroll and human capital management software solutions for US business customers. Since Pembroke initially invested in 2017, the company’s innovative product set and superior technology foundation have allowed it to gain market shares and disrupt incumbents, such as ADP and Paychex. More recently, in the third quarter, the company’s strong execution in a difficult environment has led to a significant outperformance in comparison to the broader market and its software peers. Paycom combines many of the elements of a true Pembroke stock: an enormous market opportunity, a sustainable competitive advantage, a rapid growth, a profitable business model, and an aligned and entrepreneurial management team. For these reasons and others, Paycom remains a core position in Pembroke’s US growth mandates.

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

Trex Company (“TREX”), a long-time Pembroke holding, and a manufacturer of composite decking products, posted strong results during the last quarter, but gave cautious indications for the remainder of 2022. During the first half of the year, the Company continued to benefit from strong demand for its products, helped by consumers embracing outdoor living and a switch in buying behaviour from wood to composite decks. Trex’s stock has continued to decline along with other housing-related stocks. Also hurting the stock was the Company’s announcement that its customers were proactively reducing inventory ahead of reduced consumer demand. With a debt-free balance sheet, we are confident that Trex will weather the upcoming economic storm and emerge as an even stronger player in the industry.

Shares in Gentherm (“THRM”) have come under pressure as investors worry that rising interest rates and a slowing economy will bite into demand for new cars. Gentherm is the leading provider of heated and cooled seats for the automotive industry. It has leveraged its technology and customer relationships to launch heated steering wheels and climate-controlled cup holders as well. Even more importantly, Gentherm is uniquely positioned in its industry to benefit from the shift to electric vehicles, as its current and future products offer an efficient and highly customizable way to heat and cool passengers. The company recently acquired a German business which offers comfort solutions, such as massage chairs, to automotive customers. The acquisition should help further establish Gentherm’s brand and capabilities with several large car manufacturers that were previously only small customers. Gentherm’s management is committed to running the business profitably and with a strong balance sheet. While a near-term decline in automotive demand is possible, the sector has also been undersupplied since the onset of the pandemic. Regardless of the next year’s outlook, the company’s multi-year prospects remain exciting. Furthermore, they are backed up by hundreds of millions of dollars of new contracts being awarded on a quarterly basis as well as a growing interest in its highly integrated, industry-leading climate solution for cars of the future.

 

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