Pembroke Concentrated Fund Commentary

January 2024

 

Since its inception in January of 2018, the Pembroke Concentrated Fund (PCF) has compounded value at approximately 11.9%* per annum compared to its benchmark, the Russell 2000 Total Return (R2000), at roughly 7.1%. Over the last year, the fund gained approximately 15.5%*, compared to a 14.2% gain in the R2000. More recently, in the fourth quarter, the strategy rose 11.6%, almost exactly in line with its benchmark.

*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	5-Year	Since Inception, annualized	Since Inception, cumulative
PCF A, CAD	10.87	11.56	15.48	15.48	2.32	13.04	11.94%	95.00%
PCF A, USD	14.08	14.36	18.34	18.34	1.14	13.77	10.60%	81.53%
PCF F, CAD	10.73	11.21	14.12	14.12	1.12	n/a	9.26%	45.68%
PCF F, USD	13.94	14.00	16.96	16.96	-0.04	n/a	9.33%	45.98%
R2000, CAD	9.28	11.55	14.18	14.18	3.53	9.29	7.10%	50.07%
R2000, USD	12.22	14.03	16.93	16.93	2.22	9.97	5.79%	39.49%
S&P500, CAD	1.80	9.26	23.32	23.32	11.41	14.97	12.58%	101.62%
S&P500, USD	4.54	11.69	26.29	26.29	10.00	15.69	11.20%	87.40%

Performance Commentary

The solid performance in the quarter was driven by strength in Information Technology, Industrials and Consumer Discretionary holdings. After a difficult start to October, equities rallied towards the end of the year, driven by falling interest rates, an improving inflation picture and an increased likelihood that the US economy will avoid recession. In addition, investor sentiment was cautious, with cash on the sidelines steadily moving into equities as the quarter progressed.

At a more granular level, the PCF exhibited healthy breadth over the quarter, with approximately 75% of the portfolio increasing in value. Our largest weightings and highest conviction names showed significant strength.

Two stocks that made positive contributions to returns of the fund over the past quarter

Shares of Installed Building Products (IBP) rose 44% in the fourth quarter, compared with a 14% gain for the Russell 2000 benchmark. IBP is one of the largest installers of residential insulation in the US and, as such, is heavily exposed to new home construction. In 2023, IBP benefited from a combination of strong multifamily construction, solid contribution from the company’s well-oiled merger and acquisition engine, price inflation tailwinds and margin expansion, all of which more than offset a relatively weak single-family housing backdrop. Driving shareholder interest in the fourth quarter was the macroeconomic backdrop: falling interest and mortgage rates, a healthy consumer, low unemployment and a better-than-expected economy are all supportive of the housing market and stocks like IBP. As we look forward to 2024, this macro environment combined with solid execution should allow IBP to grow free cash flow at a double-digit rate. Beyond that, we see many years of profitable growth for this attractively valued, founder-led growth stock.

Shares in Core & Main Inc. (CNM) rose by 37% in the fourth quarter of 2023, compared with a 14% gain for the Russell 2000 benchmark. CNM is one of the largest distributors of water, wastewater, storm drainage and fire protection products in North America and has many of the characteristics of successful Pembroke distribution investments. It sits at the nexus of an ideal industry structure, benefiting from a highly fragmented pool of customers, suppliers and competitors. CNM is attacking a huge market that is growing at around 4% to 6% organically. Additional growth comes from an active merger and acquisition engine funded entirely by internal free cash flow. Add in margin expansion from operating leverage and efficiency, and the company should deliver double-digit earnings growth for many years. These factors, combined with a reasonable valuation and a well-aligned management team, make CNM one of our higher conviction investments.

Two stocks that made negative contributions to returns of the fund over the past quarter

Shares in Paycom, Inc. (PAYC) experienced a fall of around 39% in the Concentrated Fund, compared with a 14% gain for the Russell 2000 benchmark. While several factors were to blame, the market reacted negatively to PAYC’s weaker-than-expected third-quarter results and its outlook for fourth-quarter and 2024 revenue growth. PAYC is struggling with a new product launch that, while ultimately in the best interests of its customers, will result in slower revenue growth, at least through 2023 and part of 2024. While we believe management’s initial guidance for 2024 is conservative, the company does not provide sufficient detail to allow us to forecast the trajectory of revenue, margins and earnings growth in 2024. As a result, we have significantly reduced our position, but have not sold it outright. The logic for this is as follows: the company’s competitive position remains strong and unchanged; the growing pain of new product launches is finite in nature; PAYC remains the best sales organization in the sector and few things matter more in payroll/human capital management software; and the valuation is now compelling.

Shares in WNS Holdings (WNS) struggled after posting strong results for the third quarter. The company reduced its guidance for its current fiscal year due to a delay in the ramp-up of a large contract and a slight slowdown in demand from its travel customers. However, the company still expects revenue growth of 8% to 12% and trades at a reasonable valuation. WNS shares have been under pressure for much of 2023, with investors concerned that artificial intelligence will disrupt the company’s revenue model. After extensive diligence and discussions with management, industry experts and competitors, Pembroke concluded that, as has often been the case throughout WNS’s history, technological advances are likely to help the company. Pembroke worked with management and encouraged the company to take advantage of the market’s short-term focus to buy back its own shares. On September 21, shareholders approved a buy-back of approximately 7% of the company’s outstanding shares. As growth reaccelerates and the company proves its resilience to artificial intelligence, Pembroke expects WNS shares to move higher.

Portfolio Actions

Trading activity was modest during the quarter, with two new purchases (Federal Signal [FSS] and Vertex [VERX]) and one sale (Paycom [PAYC]). Long-term investors will recognize PAYC as one of our “Original Six” stocks. As mentioned above, the stock fell sharply following disappointing results and guidance.

Despite its long-standing presence in the portfolio and impressive growth as a business over that time, the decision to sell was an easy one. The stock hit our stop-loss threshold and we sold. While some of these stop-loss driven sales will save capital and some will not, Pembroke’s 55 years of experience in growth stock investment tells us that, on balance, they are the right decision.

While it is exiting the portfolio, our work on PAYC does not end (although a 30-day “cooling-off” period begins during which we cannot repurchase the stock). As PAYC remains a high-quality business with long-term compounding potential, we view this recent dislocation as a future buying opportunity. We have appointed a “fresh set of eyes” to start from zero and review the investment thesis. While we have not yet repurchased PAYC in the portfolio, we may do so in the future.

Portfolio Characteristics

Pembroke believes that a portfolio of stocks with the following characteristics should, over the long term, better protect capital in down markets and outperform in up markets. Our holdings tend to grow faster than the market, have higher margins, higher returns, and are better financed and more aligned with investor interests. While you pay a small premium in the short term, the faster growth rate of our portfolio typically reverses this dynamic. As we often say, PCF is “expensive in the short term, and cheap in the medium to long term.”

Metric	Strategy	Russell 2000
Price/NTM Earnings	26.6x	22.2x
NTM Sales Growth	9.1%	4.5%
NTM Earnings Growth	13.5%	8.4%
Return on Equity (ROE)	13.3%	7.5%
Return on Invested Capital (ROIC)	10.3%	4.6%
Net Debt to NTM EBITBA	0.4x	2.0x
Market Cap in $ Billions (Weighted Average)	$8.54	$3.29
Insider Ownership	13.1%	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 December 31, 2023 in USD retrieved on January 8, 2024.

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