Santa Claus Rally? More like a Powell Pivot

January 2024

 

The fourth quarter of 2023 was a testament to the pitfalls of market timing. With many stocks hitting 52-week lows in the last week of October, many investors reached their breaking point. Despite a strong run for equities into the end of 2021, the difficult market of 2022 and the seemingly directionless market of 2023 led to frustration and a crescendo of selling. Fears of persistent inflation and rising interest rates were widespread.

With the benefit of hindsight, we now know that the set-up for equities was compelling: sellers were exhausted, valuations were attractive, and most market participants were poorly positioned for a downside inflation surprise. On November 1st, when the Federal Reserve and its Chair Jerome Powell confirmed that inflation was expected to move towards its 2% target over the next few years, the stock market went on an impressive run. From October 27th to the end of the year, the Russell 2000 index rose 24.3% (in US dollars).

The surge in equity prices has, as expected, brought out the bears who are saying: “too far, too fast.” Perhaps they are right. On the other hand, the Russell 2000 is still down 7% since the end of 2021. The Canadian stock market is up only modestly over the same period, but has not had the same buoyant run through the end of 2021. Interest rates are higher than they were at the end of 2021, which is a negative for valuations. However, many companies have also grown their earnings and cash flow since then, which is a positive. There is therefore a case to be made that we are at the beginning of an interest rate decline and a period of economic acceleration.

Pembroke’s 55-year history has taught the investment team to spend more time evaluating companies and their ability to grow and create shareholder wealth than to predict the short-term direction of the stock market. As Nasem Taleb wrote: “Invest in preparedness, not prediction.” No one was writing about COVID in 2019. Even if they had, few would have predicted that the market would rally through the worst of the pandemic. The biggest risks and opportunities ahead of us are often the ones we cannot see. So what is Pembroke doing to prepare for the future?

1. Maintaining valuation discipline. Valuations of all holdings are measured against their growth prospects and financial return characteristics. Companies with compelling futures, but high valuations, are held at appropriate weights or sold, and capital is allocated to positions offering both valuation and growth upside.
2. Focus on balance sheets. Nothing prepares a company better for the uncertain future than a strong balance sheet. Financial strength enables companies to weather difficult times. Equally importantly, companies with strong balance sheets can go on the offensive when their competitors are weak. Many of Pembroke’s portfolio companies are buying complementary businesses or reducing their share base.
3. Ensure diversification. Pembroke’s portfolios are exposed to a wide range of industries, from consumer goods to financial services and technology. Limits on sector exposure force the investment team to reduce positions in “hot” industries, which has proven to be a good portfolio management discipline over time.
4. Look for opportunities. Certain sectors, such as healthcare, experienced headwinds in 2022 and 2023. These sectors are full of opportunities for patient, long-term investors. While Pembroke invests in high-quality growth companies, it does not simply “follow the crowd.” The firm identifies and backs companies that are committed to growing earnings per share over the long term, regardless of which sectors are in vogue.

 

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