• We increased our holdings in high-potential firms like Badger Infrastructure Solutions, Altus Group and Canada Goose Holdings, where current valuations don’t mirror their future growth prospects.
• We trimmed winning positions, including Richelieu Hardware, Lumine Group and GDI Integrated Facility Services for valuation and weight control.
• We initiated new positions in Ag Growth International, Jamieson Wellness and Mattr, key players in global food infrastructure, natural health products and materials technology markets, respectively.
• We divested from Real Matters, Stella-Jones, and Uni-Select, recycling the proceeds into more promising small-cap stocks.

Outlook

While recent economic news and a benign market environment during Q2 offer hope, uncertainties persist. Managing inflation and soft-landing the economy without provoking a recession is a complex task for the Bank of Canada and the Federal Reserve. If successful, a mild recession or a stable economy may allow stocks to perform reasonably.

However, a more aggressive stance could lead to a significant downturn and less appealing equities scenario. The market’s direction remains uncertain, influenced by both encouraging tailwinds and formidable headwinds.

Regardless of the macroeconomic outlook, our investment approach consistently yields alpha and excess returns. We avoid tethering our model portfolio to a specific macro view and instead focus on high-quality, undervalued small-cap companies. Our portfolio balance between defensive and growth cyclical stocks has consistently outperformed our small-cap benchmark. We maintain confidence in our “all-weather” portfolio to yield solid performance over complete market cycles.

In a challenging market influenced by high inflation, rising interest rates, and a sluggish economic outlook, we trust that investing in high-quality, reasonably valued small-cap stocks remains a rewarding strategy for our clients.

Our portfolio companies typically maintain strong fundamentals, exemplified by high returns on capital and equity, robust balance sheets, significant profitability, promising long-term earnings growth prospects, and appealing valuations. This superior positioning should propel us to deliver further outperformance in the coming quarters.

Our portfolio should continue to impress with its best-in-class financial metrics: a median return on equity of 14.6%, low debt levels (2.1x net debt/EBITDA) and expected 19.5% EPS growth in 2023.

Despite market rallies and robust portfolio returns in 2023 YTD, our small-cap portfolio still trades at a 7% discount to its intrinsic value. We see this profile as a compelling set-up for the long-term return prospects of our small-cap strategy and our sustained ability to deliver consistent excess returns through cycles and in various market conditions.

Lastly, Canadian small-cap stocks are trading at one of the largest discounts to large caps in 22 years. After years of underperformance, we anticipate that this discount may fuel the outperformance of Canadian small caps over large caps in the future.

• We finished building our position in Grocery Outlet this quarter, as the stock maintained its appealing range.
• Other additions to our portfolio included Avantax, Silicon Laboratories, Yeti, Gentherm, Fox Factory, Armstrong World Industries and Envestnet. These investments exhibited stable fundamentals and long-term potential despite recent underperformance.
• To fund these purchases, we divested from Acushnet and Thermon Group. Acushnet, a golf brand, yielded nearly a 170% price return since our initial investment in 2017. Despite our belief in the company’s enduring competitive advantages, we found growth avenues maturing beyond the pandemic-boosted phase, warranting a shift to higher return prospects. Thermon Group, an industrial sector business, with a 60% of its total revenues generated from high-margin aftermarket products, faced difficulties in consistent growth due to end market cyclicality. Despite its recovery in the past two years, we chose to redirect funds towards opportunities with superior risk/reward profiles.
• We took some profits in Federal Signal, maintaining it as a core portfolio position due to its promising long-term growth.
• We also rebalanced holdings like DigitalOcean, NMI Holding, Primoris Services, Shake Shack, Installed Building Products and DoubleVerify, given their recent outperformance and slightly elevated valuation multiples.

Outlook

Although the June quarter presented a more benign environment for stocks, we still face an uncertain economic landscape. Investors grapple with macro challenges, and the prospect of the Federal Reserve cooling down inflation without major disruption seems ambitious.

If this rate hike cycle results in a mild recession or flat economy, stocks may still perform reasonably well. However, a more significant downturn would offer a less appealing setup for equities. From a macro standpoint, we may encounter a mixed bag of encouraging tailwinds and fierce headwinds that could sway the trajectory of U.S. equities in various ways in the coming months.

Regardless of the broader market environment, our investment approach has proven to generate alpha and excess returns. We shall avoid positioning our model portfolio based on specific macro views. Our focus on high-quality small-cap companies and maintaining a balance between defensive stocks and undervalued growth cyclical names have allowed us to consistently outperform our small-cap benchmark across fluctuating markets.

We believe that our “all-weather” portfolio is designed to deliver substantial outperformance over full market cycles and during most phases of these cycles. In a market still grappling with high inflation, rising interest rates, and a sluggish economic outlook, we hold firm to the conviction that investing in high-quality and reasonably valued small-cap stocks will remain a rewarding strategy for our clients.

The fundamentals of our portfolio companies are robust, demonstrating high returns on capital and equity, firm balance sheets, high profitability, strong long-term earnings growth prospects, and appealing valuations. With this superior and distinct positioning, we eagerly anticipate delivering further outperformance for our clients over the coming quarters.

• Complete divestment took place from momo.com and Xinyi Energy due to high valuations and acquisition difficulties, respectively. The strategic exit timing ensured substantial returns, nearly double the current stock price.
• We added Weichai, Viva Goods and New Oriental to the portfolio, anticipating they’ll offer growth within the evolving Chinese market.
• We find Viva Goods attractive due to its strong cash position, proven operational expertise and discount to fair value, offering a well-protected downside for the portfolio. Viva Goods is set to transform from a holding company to a multi-brand fashion empire, with the successful turnaround of the beleaguered British shoe brand Clarks and its search for other struggling brands with strong revitalization potential.
• New Oriental adapted well to China’s changing educational sector. The company diversified into live-streaming, e-commerce and broadened its tutorial center offerings. Reduced competition, a strong balance sheet, the potential to double operating margins and its resilience and innovation in response to regulatory changes make New Oriental a compelling investment.
• Similar to Viva Goods’ success with Clarks, we see Weichai’s acquisition of KION Group, a leading intralogistics provider, as an example of strategic expansion into high-potential markets.

Outlook

As we gaze upon H2 2023, the Chinese economic landscape’s fog is lifting, revealing three pressing questions: When will the policy makers stimulate the economy? What shape will China’s recovery take? How will the U.S./China relationship baseline establish itself? Conversations on the ground in China suggest the government will soon ramp up economic easing. New Premier Li Qiang’s tour, highlighting China’s commitment to 5% GDP growth, signals imminent measures. As the economy’s recovery slackens, the space for political ease broadens. Instead of the past real estate-driven strategies, we anticipate policies will stabilize real estate and boost consumption sectors with mechanisms like auto tax subsidies, tax reductions, and consumer vouchers. With low inflation, China is well positioned for interest rate cuts and local government debt alleviation.

May and June saw crucial leadership positions within the State-Owned Enterprises (SOEs) and government filled, paving the way for a more stable execution of policies. This internal stability tends to precede policy easing. Economic recovery is anticipated with incoming stimulative policies and a resurgence in consumer confidence. China’s formidable 45% national savings rate signals potential for robust growth. The government’s strategy leans toward a steady climb rather than a V-shaped recovery to circumvent asset bubble formation and associated social issues. A prominent Chinese financial company indicated 2023 as the “market stabilization” year, with prioritized spending in smart industrials, technology and services.

Following a turbulent H1 2023, U.S./China relations appear to have hit rock bottom. However, recent visits from notable U.S. business leaders and political figures suggest an upward trend, notwithstanding potential noise from the upcoming elections in Taiwan and the U.S. in 2024. Even marginal positive sentiment could spark the Chinese markets, improving visibility and confidence. This will likely prompt multiples expansion for our standout companies from market troughs. Our portfolio currently trades at a compelling 11.1x forward earnings on a 20% long-term growth rate, positioning our investors well for the long term.

Based on our dedicated team’s two decades of experience, institutional knowledge and local insight, we remain confident in our approach to investing in solid companies with superior management. Even amid prevailing pessimism, we recognize we’re in an unusually long emerging market bear market. But history shows us that the bull phases often follow, offering trough-to-peak returns over 70% in 7 out of 10 instances after a significant emerging market trough. We look forward to H2 2023 with continued optimism.

• MarketAxess faced a challenging Q2 with a 32% stock drop after three months of lower-than-expected monthly volume and fee per million data. A weak 2022 and decreased new issuance in 2023 contributed to the decline.
• While the business remains profitable, slower growth in 2022 and 2023 has led to a significant de-rating of its P/E and EV/EBITDA multiples, resulting in a cyclical downturn. The stock is now the lowest weight in the portfolio and is near a five-year low on valuation.
• Despite these challenges, there’s no intention to sell out of the stock as it’s expected to bounce back. The move towards the electronification of fixed income continues to be a promising trend.
• Consideration is being given to increasing the MarketAxess position due to a delayed cyclical recovery. However, caution is warranted as the initial phase of electronic trading is complete, and further gains are expected to be more incremental.
• Given two consecutive years of stagnant growth, it’s challenging to see much value above $400 for MarketAxess. While this still offers significant upside from current levels, the $600 value seen in 2020 and 2021 appears unlikely in the prevailing interest rate environment.

Outlook

Navigating the first half of the year, we have seen the marked resilience of the US economy, with a forecasted recession now delayed. With various economic indicators reflecting stability, we find ourselves in a position of cautious optimism. Despite challenges, the overall stock market outlook appears to have improved. However, we note that interest rate peaks are creeping higher, potentially introducing fresh complexities to the financial landscape.

This uptick in the interest rate peak is attributed to persistent inflation, coupled with a robust consumer sector demonstrating resilience amidst economic turbulence. The combined influence of these factors appears to set the stage for continued nominal economic growth.

Looking forward, we anticipate another rate hike in the fall. Predictions suggest this may be the final one in the immediate term, facilitating a strong market close to the year and transition from the wavering yet mainly lateral movement experienced throughout 2022 and early 2023.

Large-Cap technology continues to present challenges with persistent valuation concerns. In contrast, we find a more favourable environment within the Small-Cap world. Here, the market picture is somewhat more encouraging, with attractive valuations and less prevalent market distortions.

The more constructive outlook for Small-Cap stocks is worth noting for investors, reminding us that even within uncertain market climates, certain sectors can offer compelling opportunities. While these areas may not garner as much attention as their Large-Cap counterparts, they present viable investment options amidst the current financial landscape.

As we move forward into the second half of the year, the key to successful investing will be prudent risk management paired with strategic opportunity identification. This balance necessitates not just monitoring macroeconomic trends such as interest rate movements and inflation rates but also delving into specific market sectors to unearth potential opportunities. The delay in the recession and the US economy’s resilience offer hope for the upcoming quarters, suggesting stabilization, renewed growth, and potential financial gains.

• Norva24, a regional leader in infrastructure maintenance services that specializes in monitoring and cleaning sewage pipes in the Nordic and DACH region. By consolidating the highly fragmented industry through acquisitions and focusing on operational excellence, Norva24 aims to achieve consistent growth. Given its revenue model is based on long-term contracts and the tailwind from aging infrastructure, the business is highly resilient.
• Aritzia, a leading Canadian retailer that recently experienced a derating following record results. The company is currently investing in its distribution infrastructure after a period of rapid growth. Although this may have a short-term financial impact, we believe it is a positive move for the long-term health of the company. We capitalized on the price weakness to establish a position in Aritzia.
• We exited Kulicke & Soffa and Fox Factory based on relative opportunities to fund the new positions.

Outlook

Our team had the privilege of meeting with European, Japanese, and U.S. companies at various investment conferences during the quarter. 

Caution remains the common theme from these meetings. U.S. firms froze or delayed spending decisions following the collapse of SVB and resumed their activities more cautiously after the debt ceiling debacle. Additionally, consumers are starting to feel the impact of high-interest rates and are beginning to ration their purchases of high-ticket items.

In Asia, Japanese companies are focusing on the digital transformation of processes that are sometimes still handled manually—essentially similar to what the U.S. experienced 15 years ago. In China, sentiment remains subdued, with private businesses exercising caution until there is more policy clarity. Consumers are also more restrained in near-term spending given the prevalence of negative sentiment post-reopening. Interestingly, we noticed a continuous trend of investors reallocating capital from China to Taiwan given the hype surrounding AI and the negative perception of China. Ironically, if the worst-case scenario of conflict escalation happens, in our opinion, the Taiwan market is the most at risk.

Despite the mixed signals we observed during our channel checks, we maintain our optimism about the returns of our portfolio for two main reasons.

Firstly, the fundamentals of our portfolio companies have proven to be more resilient than we initially anticipated at the beginning of the year. Most of our holdings are experiencing growth that surpasses our initial targets. This is primarily due to unique drivers specific to each company, as we tend to invest in leading companies in niche markets. Consequently, these holdings are less correlated with general macro conditions. The current full-year revenue growth expectation for the portfolio stands at 16.5%, compared to 5.1% for the index.

Secondly, the market has already priced in a recessionary scenario, regardless of the actual results. Our portfolio is trading at 14% discount to our modeled intrinsic value despite our portfolio companies exhibiting higher growth (16% vs 5%), higher ROE (13.5% vs 9.4%), and lower leverage (Net Debt/EBITDA 1.3x vs 2.6x) compared to the benchmark.

In conclusion, we firmly believe that as our portfolio companies continue to deliver solid results in an uncertain environment, their positioning will ultimately lead to superior returns.