US GROWTH EQUITY STRATEGY – Q2 PORTFOLIO COMMENTARY
Pembroke’s US portfolios rebounded after a difficult first quarter. Additionally, the firm’s stock selection and allocation to well-positioned industry groups helped drive outperformance versus the Russell 2000 Index. Holdings in the information technology, industrial, and consumer discretionary sectors drove significant gains in the past three months. During the first half of the year, the investment team reduced holdings in companies whose business models were negatively impacted by COVID-19, added to holdings whose business models were unaffected in the medium to long-term, and increased exposure to companies positioned to benefit from the changed circumstances. The outcome of these decisions is a portfolio that is better-financed, growing faster, and more competitively positioned than before the COVID-19 crisis erupted. Further, Pembroke initiated new positions in several companies, finding entry points that offered a favourable risk/reward profile. Overall, it was satisfying to see the team’s focus on quality, growth, and balance sheet strength rewarded coming out of the first quarter.
Shares in Installed Building Products (“IBP”), returned close to 70% in the second quarter, due to a combination of both market-level and segment-level macro factors. On the market side, the belief that COVID-19 would not permanently impair the US and global economies contributed to the stock’s sharp recovery following an equally sharp decline in Q1. On the segment level, signs of strong pent-up demand for housing and a quick resumption in home construction activity led investors to regain confidence in stocks like IBP that provide materials and services to US homebuilders. While IBP’s Achilles heel remains its cyclicality, it has generated consistently high returns on capital, has a compelling growth strategy, and is led by a shareholder-aligned and effective management team. As such, it remains a core position.
The recent share price performance of Kornit Digital (“KRNT”), which sells machines that allow clothing manufacturers to efficiently execute limited product runs, is an example of investor short-termism manifesting itself in violent near-term trading swings. In March, the shares dropped 50% from their peak as investors fretted that not only would new machine sales abate, but factories using existing machines would shut and ink sales would fall dramatically. Admittedly, the environment during the COVID-19 pandemic is not conducive to new sales of digital printing machines, but the long-term opportunity remains compelling and Kornit is capitalized to see its way through the current slowdown. The price decline presented an opportunity, and Pembroke increased its weight in the investment during this period. Following the company’s first quarter report and management commentary that not only disabused investors of their worst fears but gave them reason for optimism, the share price retraced all of its losses.
During the quarter, Pembroke sold its position in Vocera Communications (“VCRA”), which provides communications equipment to hospitals. The need to improve patient care and provide better working environments and communication systems for nurses and doctors is real. Pembroke’s investment team, nevertheless, decided that Vocera’s offerings would not find themselves at the top of many hospitals’ capital budgets in an environment where they are facing major headwinds from reduced elective procedures which are critical to hospital profits. Further, Vocera had faced execution challenges in recent years as sales cycles elongated and the company transitioned to a next-generation version of its core product. The holding was sold while Pembroke maintained and invested in other healthcare companies.
Despite the company reporting solid Q1 results, Healthstream’s (“HSTM”) stock languished in the second quarter of 2020 as the business outlook weakened on the impact of COVID-19. Several of its hospital clients have been negatively impacted by the postponement of elective procedures. As a result, they have laid off or furloughed workers and delayed systems implementations, including those tied to workforce training offered by Healthstream. The company continues to gain share and more normal patient flows are returning as states lift restrictions on elective procedures. The environment, however, remains rocky and the second wave of COVID-19 patients taking up hospital beds is not helping. The company has a compelling business model and large market opportunity but is held at a small weight in Pembroke’s US portfolios as it has not delivered consistent growth.
CONCENTRATED GROWTH EQUITY STRATEGY – Q2 PORTFOLIO COMMENTARY
The Pembroke Concentrated Fund gained by 36.7% during the quarter, outperforming its benchmark the Russell 2000 Index which gained by 20.5% during the quarter. Given the magnitude of the benchmark’s recovery during the quarter, the concentrated fund’s excess return of 16.2%, with only 17 holdings, is a testament to the strategy’s strict discipline and focus on high-quality growth companies. Since its inception on January 31, 2018, the fund has posted a 16.7% annualized return compared to the Russell 2000 Benchmark’s annualized return of 2.1%, an excess annualized return of 14.6%.
The main source of excess return during the quarter was the fund’s security selection in the information technology (IT) sector where eight of the fund’s nine IT holdings advanced and seven of the nine advanced more than the benchmark’s IT sector average. The fund’s industrial sector holdings also added value. The fund’s IT and industrial sector holdings account for 65% of the fund’s weight. The fund’s zero allocation to financials and materials also contributed to positive relative performance. The fund’s health care and consumer discretionary holdings all gained during the quarter but did not keep pace with the benchmark’s sector averages. Approximately 89% of the fund was invested in the US at quarter-end and 11% in Canada.
Two stocks made notable positive contributions to returns during the quarter:
Shares in Kinaxis (“KXS CN”), a cloud-based provider of supply chain planning software, gained in the second quarter of 2020 as the company reported strong financial results. Moreover, management indicated that demand for its core offering, RapidResponse, is accelerating as organizations are relying on the company’s concurrent planning solutions to navigate disruptions caused by COVID-19. Drawing on its strong balance sheet, the company made two acquisitions in order to enhance their artificial intelligence forecasting abilities, increase supply chain resiliency, and further penetrate into new and existing verticals. With its market leadership, strong financial position, and management’s ability to strike a balance between growth and profitability, Kinaxis is positioned to remain a long-term structural winner in Canada.
Shares in Installed Building Products (“IBP US”), returned close to 70% in the second quarter, due to a combination of both market-level and segment-level macro factors. On the market side, the belief that COVID-19 would not permanently impair the US and global economies contributed to the stock’s sharp recovery following an equally sharp decline in Q1. On the segment level, signs of strong pent-up demand for housing and a quick resumption in home construction activity led investors to regain confidence in stocks like IBP that provide materials and services to US homebuilders. While IBP’s Achilles heel remains its cyclicality, it has generated consistently high returns on capital, has a compelling growth strategy, and is led by a shareholder-aligned and effective management team. As such, it remains a core position.
Two stocks made notable negative contributions to returns during the quarter:
The shares of Euronet Worldwide (“EEFT US”) declined during the second quarter. The company provides secure electronic financial transactions (EFT) solutions including a global payment network for prepaid mobile top-up, a global money transfer company, and an independent international ATM network. With clients in some 170 countries, the company announced that global population movement restriction measures had resulted in decreases in business transactions in some areas (international transactions in the EFT business) and increases in other areas (the money transfer segment). The impact on the electronics payments business has so far been mixed with some negative impacts in areas where population restriction measures are in place and some positive impacts from increased use of mobile devices, streaming, and gaming. The company prudently announced in March that first quarter results could not be reasonably estimated, and it withdrew its previously issued first quarter guidance.
The shares of Globus Medical (“GMED US”) gained during the second quarter but did not keep up with the benchmark and therefore made a negative contribution to relative performance. The company, a leading musculoskeletal implant manufacturer with expertise in computer-assisted robotic spine surgery solutions, withdrew previously announced full-year guidance in April due to uncertainties resulting from the COVID-19 pandemic. Despite industry concerns about delays for spinal procedures and hospital budget cuts, the company announced first quarter sales increases of more than 4% along with the launch of three new spine products. The company also highlighted its conservative financial situation and ability to maintain its long-term growth initiatives.
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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.