Although financial markets were largely influenced by inflation data and central bank rate decisions, the current environment presents opportunities for long-term small-cap stock investors to capitalize on the attractive valuations of high-quality companies poised for growth.
Market Review
The first quarter of 2023 in financial markets, particularly in the small-cap market, were largely influenced by inflation data and the rate decisions of the Bank of Canada and the U.S. Federal Reserve—as they continued their strategy of interest rate hikes to combat high inflation, which reached a 40-year high. However, the narrative took an unexpected turn in March with the failures of the U.S.-based SVB Bank and Signature Bank, as well as the distressed situations at First Republic Bank and Credit Suisse, which greatly complicated the macroeconomic picture and the U.S. Federal Reserve’s strategy. These events reminded many of the credit crisis in 2008-2009, but swift actions by regulators and the acquisition of troubled banks by stronger institutions helped calm investor concerns about a broader contagion in the banking industry.
Despite the volatility and deep swings experienced in the first quarter, returns in the small-cap market were relatively dull over the three-month period. The debate among market participants centered around whether the Canadian and U.S. economies were headed for a soft landing, a hard landing, or no landing at all, as macroeconomic data points were fluctuating and, at times, contradictory. The year started on a strong note in the small-cap market, with a rebound in Canadian and U.S. small-cap stocks in the first few weeks of the year due to signs of moderation in inflation data and optimism about the end of the Federal Reserve’s rate hike cycle. Economic data also showed the resilience of the Canadian and U.S. economies, leading to a rally in small-cap stocks in January, known as the “January effect.”
However, sentiment turned negative in February as concerns about the ongoing interest rate hikes, high inflation, geopolitical uncertainty, and downward revisions to earnings estimates weighed on the small-cap market, leading to consolidation and weakening, and ending the month in negative territory. The crisis in the banking industry in March further exacerbated the negative sentiment in financial markets, with small-cap stocks taking a hit, although some comfort was found in the belief that the banking crisis was not indicative of a broader and deeper issue in the industry. Toward the end of the quarter, there were encouraging signs of moderating inflationary pressures and the Federal Reserve’s efforts to bring prices under control, which helped spur a late rally in financial markets and reduced losses in the final month of the quarter.
Considering the highly unexpected “banking crisis” that developed in March that sent shock waves throughout financial markets around the world and the looming, widely anticipated recession by most market participants, equity markets and risk assets in general displayed rather remarkable resilience in this first quarter, with all major U.S. equity benchmarks, European indices, most Asian marketplaces and the MSCI ACWI global index all ending the period in positive territory. Furthermore, cryptocurrencies experienced a huge rebound after a catastrophic year in 2022, and gold and most industrial metals also delivered positive returns.
Although 2022 saw both Europe and Asia Pacific produce mixed results, China, which had been a laggard, is expected to catch up in 2023 as its credit concerns ease and its economy gains traction. Premier Li Qiang’s support for the private sector and innovation, as well as China’s focus on domestic and non-U.S. markets, have been positive drivers. However, rising geopolitical tensions and concerns over policy outlook and black swan events are holding back further fund flows and interest in China. Platform restructurings, such as Alibaba being split into six units, have raised concerns but are viewed positively for shareholder value in the long term. In Asia, overweighting in semi-cyclical sectors or buying China mega cap laggards were the paths to outperformance in the first quarter of 2023, while other markets showed subdued performance with varying degrees of negative earnings revisions.
Quarterly results by strategy
Canadian Small Cap Equity Strategy
Investment Performance
The following table shows the investment performance of the VB Canadian Pension Fund Composite, compared to the S&P/TSX Canadian Small Cap Index and the S&P/TSX Composite Index (as of March 31, 2023).
Portfolio performance returns are presented gross of fees
*Note: Results are the BMO Small Cap Blended Weighted Index from June 30, 1992 to December 31, 1999 and thereafter the S&P/TSX Canadian Small Cap Index.
** Note : June 30, 1992
Portfolio Positioning
In Q1, our portfolio showed a gain of 6.13%, outperforming the TSX Small Cap Index, which was up 4.50%, resulting in a value add of 1.63%. This marks the 4th consecutive quarter of outperformance despite market volatility, thanks to our favourable investment style and careful stock selection. Our focus on high-conviction, high-quality small-cap stocks with strong fundamentals has proven to be a winning strategy, generating significant value add and excess returns. Security selection was the main driver of alpha in the quarter, validating our investment process.
Despite an uncertain macro environment with growing inflationary pressures, our portfolio companies delivered solid financial results that met or exceeded our expectations. Most of our holdings showed resilience and coped well with the economic challenges, exhibiting pricing power and cost efficiencies. Moreover, our portfolio remains well positioned to handle soaring interest rates, with low leverage and minimal exposure to rate-sensitive stocks.
Notably, our Q1 outperformance was achieved despite the Materials Sector acting as a headwind, with a relative impact of 2.2% due to the rally in gold prices and gold equities following the SVB failure in March. As we had anticipated in 2022, the Canadian small-cap Energy Sector struggled in Q1 2023, with share prices continuing to falter and the sector down 5.7%. We remain confident in our decision to avoid exposure to Canadian Oil and Gas producers, as we believe that other sectors offer better risk-adjusted returns with superior investment opportunities.
In summary, our Q1 performance reflects our consistent ability to outperform the benchmark, driven by our disciplined investment approach, careful stock selection, and resilience of our portfolio companies. Despite market challenges, we remain confident in our strategy and positioning for continued success in generating alpha and delivering value for our investors.
Significant contributors to performance include the following stocks:
– Topicus.com (+35.9% in Q1) showed strong performance due to solid operating results in 2022, 19.5% acquisition growth and continued execution of its capital deployment strategy.
– ATS Automation Tooling Systems (+34.5% in Q1) reported solid Q3 results with 9.6% organic growth, robust bookings and a record backlog.
– Computer Modelling Group (+25.3% in Q1) saw inflected organic revenue growth, expanded EBITDA margins and a growing cash balance.
– Colliers International Group (+14.7% in Q1) recovered in Q1 after reporting double-digit earnings per share and pursuing accretive acquisitions.
– Stantec (+22.1% in Q1) reported solid Q4 results with 10.6% organic growth, record margins, and robust bookings.
– Trisura Group (-26.9% in Q1)
– Lumine Group (-12.7% in Q1)
– Sylogist (-11.5% in Q1)
– goeasy (-9.4% in Q1)
Portfolio Changes
We continued to further enhance the quality and long-term positioning of the portfolio:
- Our portfolio changes focused on adding long-term alpha to the portfolio, including increasing positions in high-conviction holdings such as Trisura Group and Aritzia.
- Our positions in long-term winners like Topicus.com and ATS Corporation were trimmed due to valuation and weight management considerations.
- Two positions were divested in Toromont Industries and CAE to recycle the proceeds into smaller-cap names with a better risk-reward profile.
- Two new positions were initiated in Lumine Group and Canada Goose Holdings. Canada Goose Holdings. is a luxury apparel retailer with global growth ambitions and strong sales growth since its IPO in 2017. Lumine Group is a leading global provider of vertical market software and platforms, with a successful track record in acquiring, developing and managing software platforms.
- Our most significant purchases were Lumine Group, Shawcor Limited, Canada Goose Holdings, Trisura Group and Andlauer Healthcare Group.
- Our most significant sales were Uni-Select, Topicus.com, Toromont Industries, ATS Corporation and CAE.
Outlook
The economy is displaying signs of losing momentum, with challenges in various sectors such as high inflation, interest rates, a weak housing market, tight capital markets, and a slowing job market. The recent turmoil in the U.S. banking industry may further tighten lending conditions, increasing the likelihood of a recession in the North American economy. Despite these concerns, our optimism towards small-cap stocks remains steadfast.
On one hand, small caps have underperformed large-cap stocks in recent quarters but have become cheaper and more attractive from a valuation perspective. The downward revision of earnings forecasts for 2023 may set the stage for positive surprises and outperformance compared to these lowered expectations. Additionally, small caps historically perform well in an environment of high but declining inflation, as is currently the case. Furthermore, after a bear market, small caps tend to rebound strongly, providing early opportunities for outperformance.
Although the market may remain volatile in the face of macroeconomic uncertainties, we believe that investors with a long-term horizon will achieve solid returns in the small-cap category from current levels. It is important to maintain positions in reasonably valued, high-quality small-cap stocks in this challenging macro environment, as we anticipate a favourable cycle for such stocks that is just beginning. While low-quality stocks may experience short-term gains, ultimately, companies with attractive valuations, strong business models, profitability, and balance sheets will be rewarded in an environment of high inflation, interest rates, and weaker economic activity. These companies are well-positioned to take advantage of secular growth trends, gain market share across economic cycles, and withstand market fluctuations.
In conclusion, despite concerns about the economy and market volatility, our optimism remains intact for small-cap stocks. The current environment presents opportunities for long-term investors to capitalize on attractive valuations and high-quality companies poised for growth in the face of macroeconomic challenges. It is prudent to stay focused on high-quality small-cap stocks with favourable business models, profitability and balance sheets for potential long-term returns.
As we start 2023, our portfolio is still trading at a sizeable 10% discount to its intrinsic value, exhibiting considerable upside potential. We remain quite enthusiastic about the long-term return prospects of our small-cap strategy and our continued ability to generate consistent excess returns through any cycle and virtually any market environment.
- Our positions in long-term winners like Topicus.com and ATS Corporation were trimmed due to valuation and weight management considerations.
- Two positions were divested in Toromont Industries and CAE to recycle the proceeds into smaller-cap names with a better risk-reward profile.
- Two new positions were initiated in Lumine Group and Canada Goose Holdings. Canada Goose Holdings. is a luxury apparel retailer with global growth ambitions and strong sales growth since its IPO in 2017. Lumine Group is a leading global provider of vertical market software and platforms, with a successful track record in acquiring, developing and managing software platforms.
- Our most significant purchases were Lumine Group, Shawcor Limited, Canada Goose Holdings, Trisura Group and Andlauer Healthcare Group.
- Our most significant sales were Uni-Select, Topicus.com, Toromont Industries, ATS Corporation and CAE.
Outlook
The economy is displaying signs of losing momentum, with challenges in various sectors such as high inflation, interest rates, a weak housing market, tight capital markets, and a slowing job market. The recent turmoil in the U.S. banking industry may further tighten lending conditions, increasing the likelihood of a recession in the North American economy. Despite these concerns, our optimism towards small-cap stocks remains steadfast.
On one hand, small caps have underperformed large-cap stocks in recent quarters but have become cheaper and more attractive from a valuation perspective. The downward revision of earnings forecasts for 2023 may set the stage for positive surprises and outperformance compared to these lowered expectations. Additionally, small caps historically perform well in an environment of high but declining inflation, as is currently the case. Furthermore, after a bear market, small caps tend to rebound strongly, providing early opportunities for outperformance.
Although the market may remain volatile in the face of macroeconomic uncertainties, we believe that investors with a long-term horizon will achieve solid returns in the small-cap category from current levels. It is important to maintain positions in reasonably valued, high-quality small-cap stocks in this challenging macro environment, as we anticipate a favourable cycle for such stocks that is just beginning. While low-quality stocks may experience short-term gains, ultimately, companies with attractive valuations, strong business models, profitability, and balance sheets will be rewarded in an environment of high inflation, interest rates, and weaker economic activity. These companies are well-positioned to take advantage of secular growth trends, gain market share across economic cycles, and withstand market fluctuations.
In conclusion, despite concerns about the economy and market volatility, our optimism remains intact for small-cap stocks. The current environment presents opportunities for long-term investors to capitalize on attractive valuations and high-quality companies poised for growth in the face of macroeconomic challenges. It is prudent to stay focused on high-quality small-cap stocks with favourable business models, profitability and balance sheets for potential long-term returns.
As we start 2023, our portfolio is still trading at a sizeable 10% discount to its intrinsic value, exhibiting considerable upside potential. We remain quite enthusiastic about the long-term return prospects of our small-cap strategy and our continued ability to generate consistent excess returns through any cycle and virtually any market environment.
U.S. Small Cap Equity Strategy
Investment Performance
The following table shows the investment performance of the VB U.S. Pension Fund Composite (in U.S. dollars), compared to the Russell 2000 Small Cap Index and the S&P 500 Index (as of March 31, 2023).
Portfolio performance returns are presented gross of fees
* Note : June 30, 2000
Portfolio Positioning
In the first quarter of 2023, our small-cap investment strategy yielded strong results, outperforming our benchmark by about 800 basis points. Our portfolio’s focus on high-quality, reasonably valued small-cap stocks with superior fundamentals and financial characteristics delivered sustained outperformance despite market fluctuations. We were able to add value in both strong and weak markets, showcasing the benefits of our balanced approach that includes defensive and growth cyclical stocks. Our ability to achieve positive security selection in all sectors, except for healthcare, further underscores the strength of our stock-picking strategy.
Sector allocation finally turned more favorable to us in this March quarter, with our higher portfolio weights in the outperforming Consumer Discretionary and Information Technology sectors and our lower portfolio allocation to the under-performing Energy and healthcare sectors more than offsetting our larger portfolio sector weight in the Financials sector that was the worst-performing area of our market and our lack of exposure to the Materials sector, the net result being decent alpha generated from our favorable sector positioning.
Despite a larger portfolio weight in the worst-performing Financials sector, our exposure is mainly in insurance, capital markets, investment banking, and asset management industries, which have different business cycles than the banking industry and may even benefit from weak market and economic conditions. We remain confident in our well-diversified, well-capitalized, and strong market leader holdings in the Financials sector.
Amidst the turmoil in the banking sector that emerged in March, it’s worth noting that our portfolio only includes one bank stock with a minimal portfolio weight, significantly less than the bank industry weight in our benchmark. This limited exposure to the banking industry, along with our holdings in industries that may benefit from volatile and uncertain environments, mitigates the risks associated with the banking crisis.
In conclusion, our portfolio’s focus on high-quality small-cap stocks with superior fundamentals and financial characteristics, combined with careful stock picking and sector allocation, has yielded strong results in the first quarter of 2023. Our ability to outperform in both strong and weak markets underscores the resilience of our investment approach, and we remain confident in the performance of our portfolio holdings despite challenging market conditions.
Four stocks significantly contributed to our performance in Q1 2023. DigitalOcean delivered over 50% absolute returns and contributed 76 basis points to performance due to strong growth and profitability. DoubleVerify’s stock was up 39% and contributed 70 basis points to performance, bucking the trend of advertising spending pullbacks. Cerence’s stock soared just over 50%, adding 77 basis points to performance, driven by improved execution. MarketAxess rebounded 40% in March, adding 65 basis points to performance, benefiting from higher interest rates, increased volatility and wider spreads in its fixed income instruments.
Globus Medical and Bank OZK were the biggest detractors in in Q1 2023 for our small-cap strategy.
Globus Medical’s stock was down 22% due to the proposed acquisition of Nuvasive, triggering a sell-off despite potential synergies and cost savings. Bank OZK’s stock declined 14% amid turmoil in the banking sector but has a successful track record and well-managed risk compared to Bank SVB.
Portfolio Changes
Despite limited new investment ideas in Q1 2023, our team conducted due diligence and deep research on high-quality candidates.
- We initiated a new position in Grocery Outlet (GO) after extensive research, including store visits and discussions with management. GO generates robust store-level financial results with attractive economics, targeting 10% annual unit growth.
- We took advantage of weakness in Globus Medical stock to bring our portfolio weight back to previous levels at more attractive valuations.
- We continued to build our position in Armstrong World Industries (Armstrong) despite concerns about commercial end markets.
- We added to our positions in HealthEquity, Ormat Technologies, YETI Holdings, Gentherm, Envestnet and other high-quality stocks.
- While GO was the only new position in Q1 2023, our team remains proactive in conducting research and making strategic investments.
- We remain confident in the long-term return prospects of our portfolio holdings, including GO and other high-quality stocks.
- As a source of funds for this buying activity that we executed on in the March quarter, we significantly reduced our position in Acushnet Holdings. Also, we took advantage of the significant intra-quarter strength in Avantax’s stock, fueled by steadier management execution, significant stock buyback activity, and the huge benefit to its business model and profitability from the much higher interest rates, to take meaningful profits in this name and reduce our position.
- We also took some healthy profits in the stocks of Iridium Communications, Silicon Laboratories, Thermon Group, Tempur Sealy International, Blackbaud and Federal Signal.
Outlook
The US economy is showing signs of losing momentum, with challenges such as high inflation, interest rates, a weak housing market, and a slowing job market. Despite these macroeconomic concerns, our optimism towards small-cap stocks remains intact. Small caps have become even more attractive from a valuation standpoint, with potential for positive earnings surprises after downward revisions. Additionally, historically, small caps have performed well in environments of high but falling inflation, tending to rebound strongly after bear markets.
Investors with a multi-year horizon will likely achieve solid long-term returns in the small-cap category. In this challenging macro environment, we recommend positioning in reasonably valued, high-quality small-cap stocks. We believe that a long and powerful cycle favourable to high-quality small caps is underway, with the potential for steady growth and high returns. Companies with attractive valuations, strong profitability, returns on capital and equity, and robust balance sheets are likely to outperform, despite potential short-term fluctuations. In our model portfolio, we own a collection of incredibly high-quality businesses that are trading below their intrinsic valuation, positioning us for continued alpha generation over our small-cap benchmark for the foreseeable future.
It’s important to note that while low-quality stocks may experience temporary periods of outperformance, the combination of high inflation, high interest rates, and weaker economic activity is expected to favour companies with strong fundamentals and growth prospects. These high-quality companies are likely to have the ability to take advantage of secular growth tailwinds, grow their market shares in all phases of the economic cycle, and generate stronger profitability and returns on capital and equity. Furthermore, a strong balance sheet that allows for self-funding of growth and resilience against market weakness is crucial in the current uncertain economic environment.
As we assess the outlook for our model portfolio, we remain confident in the collection of high-quality stocks we own. These companies are trading below their intrinsic value, providing potential for future appreciation. With a focus on long-term horizon and prudent risk management, we believe our portfolio is positioned for continued alpha generation, outperforming our small-cap benchmark. It’s worth noting that market volatility and turbulence may persist in the near term due to ongoing macroeconomic uncertainties. However, we remain steadfast in our conviction that our small-cap holdings, comprised of fundamentally strong companies, will deliver solid performance over the long run.
Despite the challenges in the current economic environment, our optimism towards small-cap stocks remains unwavering. We believe that high-quality small-cap companies with attractive valuations, strong profitability and resilient balance sheets are well-positioned to outperform in the long term. With a focus on prudent risk management and a multi-year investment horizon, we are confident in our ability to generate alpha for our investors and deliver steady growth and high returns through the next cycle.
- We remain confident in the long-term return prospects of our portfolio holdings, including GO and other high-quality stocks.
- As a source of funds for this buying activity that we executed on in the March quarter, we significantly reduced our position in Acushnet Holdings. Also, we took advantage of the significant intra-quarter strength in Avantax’s stock, fueled by steadier management execution, significant stock buyback activity, and the huge benefit to its business model and profitability from the much higher interest rates, to take meaningful profits in this name and reduce our position.
- We also took some healthy profits in the stocks of Iridium Communications, Silicon Laboratories, Thermon Group, Tempur Sealy International, Blackbaud and Federal Signal.
Outlook
The US economy is showing signs of losing momentum, with challenges such as high inflation, interest rates, a weak housing market, and a slowing job market. Despite these macroeconomic concerns, our optimism towards small-cap stocks remains intact. Small caps have become even more attractive from a valuation standpoint, with potential for positive earnings surprises after downward revisions. Additionally, historically, small caps have performed well in environments of high but falling inflation, tending to rebound strongly after bear markets.
Investors with a multi-year horizon will likely achieve solid long-term returns in the small-cap category. In this challenging macro environment, we recommend positioning in reasonably valued, high-quality small-cap stocks. We believe that a long and powerful cycle favourable to high-quality small caps is underway, with the potential for steady growth and high returns. Companies with attractive valuations, strong profitability, returns on capital and equity, and robust balance sheets are likely to outperform, despite potential short-term fluctuations. In our model portfolio, we own a collection of incredibly high-quality businesses that are trading below their intrinsic valuation, positioning us for continued alpha generation over our small-cap benchmark for the foreseeable future.
It’s important to note that while low-quality stocks may experience temporary periods of outperformance, the combination of high inflation, high interest rates, and weaker economic activity is expected to favour companies with strong fundamentals and growth prospects. These high-quality companies are likely to have the ability to take advantage of secular growth tailwinds, grow their market shares in all phases of the economic cycle, and generate stronger profitability and returns on capital and equity. Furthermore, a strong balance sheet that allows for self-funding of growth and resilience against market weakness is crucial in the current uncertain economic environment.
As we assess the outlook for our model portfolio, we remain confident in the collection of high-quality stocks we own. These companies are trading below their intrinsic value, providing potential for future appreciation. With a focus on long-term horizon and prudent risk management, we believe our portfolio is positioned for continued alpha generation, outperforming our small-cap benchmark. It’s worth noting that market volatility and turbulence may persist in the near term due to ongoing macroeconomic uncertainties. However, we remain steadfast in our conviction that our small-cap holdings, comprised of fundamentally strong companies, will deliver solid performance over the long run.
Despite the challenges in the current economic environment, our optimism towards small-cap stocks remains unwavering. We believe that high-quality small-cap companies with attractive valuations, strong profitability and resilient balance sheets are well-positioned to outperform in the long term. With a focus on prudent risk management and a multi-year investment horizon, we are confident in our ability to generate alpha for our investors and deliver steady growth and high returns through the next cycle.
Greater China Growth Strategy
Investment Performance
The following table shows the investment performance results of the VB Golden Dragon Pension Fund Composite (in U.S. dollars), compared to the MSCI China and the MSCI Golden Dragon Small Cap Index (as of March 31, 2023).
Portfolio performance returns are presented gross of fees.
* Note : December 31, 2011
Portfolio Positioning
In the first quarter of Asia, the key to outperforming was to heavily invest in the semi-cyclical space or buy China’s mega-cap laggards, as narrow breadth kept most other markets subdued. Market performance can be categorized into three buckets:
- High performers with 20% or more returns from Korea and Taiwan, offsetting negative earnings revisions with large multiple expansions as investors priced in a second-half recovery in the semi-conductor sector.
- Muddle-along performers with less than 5% returns from Singapore and China, driven by positive earnings revisions without re-rating.
- Sub-zero performers from Hong Kong and Southeast Asian countries, with higher-than-expected negative earnings revisions.
Despite our portfolio’s relative underperformance in Q1 2023, we expect to see stronger relative performance as investors deploy capital into the region and select solid structural companies in our portfolio.
The China markets, including both A-shares and MSCI China, issued the weakest set of pre-announcements in two years. Except for Energy and Food & Staples, all industry groups had more negative than positive alerts. All sectors disappointed on the top line, reflecting the macro shock in Q4 2022 due to the massive wave of COVID-19. In China, policy alignment has always been an important driver of share prices and would be argued as equivalent to earnings trends in importance. In Q1 2023, the only bright spots were companies with resilient operational efficiencies, such as Trip.com, Galaxy and Yum China, which were relatively larger weights and high conviction picks in our portfolio.
Our five top performers contributed 2.5% to our portfolio in the first quarter:
- Hua Hong (+27%)
- Novatek (+38%)
- Kulicke (+20%)
- China Overseas Property (+17%)
- DADA (+22%)
Our bottom five stocks detracted -4.8% from the portfolio in Q1 2023:
- Country Garden Services (-31%)
- Weimob (-27.5%)
- VNET Group (-47.4%)
- Geely (-12%)
- L’Occitane (-20%)
Portfolio Changes
Opportunities for investments continue to be abundant from a valuation standpoint, keeping the portfolio busy with only a 2% cash level.
- We took profits in these names in the middle of the quarter as valuations approached fair value territory.
- In Q1 2023, we shifted from Taiwan and Singapore to cheaper Chinese stocks, reallocating profits from reopening plays to consumption and technology names.
- This quarter saw us rotating our semi-conductor names mostly from Taiwan and reopening names into Chinese domestic names in consumer, industrial and property management sectors, which are expected to thrive in the second half of the year with China’s economic recovery and government policy support.
- Our total weight in Taiwan and Singapore stocks decreased by 3%.
- We also added further exposure to U.S. ADRs with VIPS and swapped Straits Trading from Singapore into ESR, a similar business story with more Chinese exposure in the new property sectors of Logistics and Data Centers.
- We made a full switch from Straits Trading in Singapore to ESR in Hong Kong after the payment of ESR special dividend from Straits, exiting small positions such as VNET and Merry.
- Li Ning, expected to grow at 15-20% revenue CAGR and 20%+ earnings CAGR through product upgrades, was added as a new position in the portfolio.
Outlook
In our discussions with our portfolio companies, the focus has shifted towards positive signs of recovery, with “green shoots” emerging in various sectors. The liquidity environment has also eased, allowing for a measured pace of growth in the property markets. However, we do not anticipate a swift “V-shaped” recovery for China’s reopening economy, as consumers still need time to recover from the phenomenon of “revenge spending” witnessed post-pandemic.
Nevertheless, the consumption sector, which constitutes almost one-third of our portfolio and is our preferred sector, is expected to contribute significantly to China’s overall economic growth. This is crucial as the government aims to achieve a GDP growth target of 5% or higher without relying solely on infrastructure spending.
The recent conclusion of the “Two Sessions” has established the government leadership responsible for driving consumption-oriented policies for the broader economy. Furthermore, the Chinese Yuan (CNY) has resumed its strengthening trend against the US dollar, which we believe provides a favourable setup for Chinese equities to outperform other emerging markets and global markets. In fact, China has been the best performing market since October 2022, even after the US regulator’s takeover of SVB Bank. Notably, local investors continue to support the markets through stock connect programs, with significant net inflows recorded in both Southbound and Northbound connect channels in Q1 2023.
Valuation-wise, the MSCI China forward price-to-earnings (P/E) ratio has fallen back to around 10x, trading at levels last seen in November 2022, while earnings growth is forecasted at 15%. We view this as a beatable target, which highlights the attractive investment opportunity in the Chinese markets. With major policy news now behind us, we expect more certainty in the coming months as the government’s execution of its policies unfolds, creating further potential for capital flows to return to China.
As we move into Q2 and beyond, we believe that the investment environment will shift towards stock picking opportunities, rather than top-down rebalancing. Our portfolio is currently trading at 16.7x forward earnings based on a long-term growth rate of 20%, which we believe will provide rewarding returns for our investors over the long term. We remain optimistic, drawing on our team’s dedication, two decades of experience, and our on-the-ground insights to carefully evaluate and invest in great companies with solid business models and exceptional management teams.
Despite the current challenges and uncertainties, historical data since 1997 shows that we are in the longest emerging market bear market period, exceeding 600 days. This is noteworthy as previous bull phases have often been as dramatic as bear markets, generating trough-to-peak returns of over 70% in seven out of ten instances following major emerging market troughs.
- We made a full switch from Straits Trading in Singapore to ESR in Hong Kong after the payment of ESR special dividend from Straits, exiting small positions such as VNET and Merry.
- Li Ning, expected to grow at 15-20% revenue CAGR and 20%+ earnings CAGR through product upgrades, was added as a new position in the portfolio.
Outlook
In our discussions with our portfolio companies, the focus has shifted towards positive signs of recovery, with “green shoots” emerging in various sectors. The liquidity environment has also eased, allowing for a measured pace of growth in the property markets. However, we do not anticipate a swift “V-shaped” recovery for China’s reopening economy, as consumers still need time to recover from the phenomenon of “revenge spending” witnessed post-pandemic.
Nevertheless, the consumption sector, which constitutes almost one-third of our portfolio and is our preferred sector, is expected to contribute significantly to China’s overall economic growth. This is crucial as the government aims to achieve a GDP growth target of 5% or higher without relying solely on infrastructure spending.
The recent conclusion of the “Two Sessions” has established the government leadership responsible for driving consumption-oriented policies for the broader economy. Furthermore, the Chinese Yuan (CNY) has resumed its strengthening trend against the US dollar, which we believe provides a favourable setup for Chinese equities to outperform other emerging markets and global markets. In fact, China has been the best performing market since October 2022, even after the US regulator’s takeover of SVB Bank. Notably, local investors continue to support the markets through stock connect programs, with significant net inflows recorded in both Southbound and Northbound connect channels in Q1 2023.
Valuation-wise, the MSCI China forward price-to-earnings (P/E) ratio has fallen back to around 10x, trading at levels last seen in November 2022, while earnings growth is forecasted at 15%. We view this as a beatable target, which highlights the attractive investment opportunity in the Chinese markets. With major policy news now behind us, we expect more certainty in the coming months as the government’s execution of its policies unfolds, creating further potential for capital flows to return to China.
As we move into Q2 and beyond, we believe that the investment environment will shift towards stock picking opportunities, rather than top-down rebalancing. Our portfolio is currently trading at 16.7x forward earnings based on a long-term growth rate of 20%, which we believe will provide rewarding returns for our investors over the long term. We remain optimistic, drawing on our team’s dedication, two decades of experience, and our on-the-ground insights to carefully evaluate and invest in great companies with solid business models and exceptional management teams.
Despite the current challenges and uncertainties, historical data since 1997 shows that we are in the longest emerging market bear market period, exceeding 600 days. This is noteworthy as previous bull phases have often been as dramatic as bear markets, generating trough-to-peak returns of over 70% in seven out of ten instances following major emerging market troughs.
U.S. Small-Mid Cap Equity Strategy
Investment Performance
The following table shows the investment performance of the VB U.S. Small-Mid Cap Pension Fund Composite (in U.S. dollars), compared to the Russell 2500 Small Cap Index and the S&P 500 Index (as of March 31, 2023).
Portfolio performance returns are presented gross of fees.
* Note : September 30, 2017
Portfolio Positioning
In the first quarter, our portfolio saw a strong return of over 11%, driven by broad-based outperformance across several positions. Interestingly, the top ten performers in Q1 had underperformed the Russell 2500 in 2022, highlighting the importance of focusing on fundamentals and valuation rather than reacting solely to share price movements. We had ten stocks that delivered a total return of over 30% in Q1.
We believe that sticking with quality stocks on reasonable valuations may not outperform in every market condition, but it can deliver strong performance in the most commonly occurring periods of the stock market, such as small up-and-down days when interest rates are on hold. We anticipate that these conditions are likely to persist throughout 2023. In terms of selection versus allocation, this quarter saw 85% of the added value coming from stock selection, with the remaining from allocation. Our overweight position in Financials weighed down our allocation performance by -90bp, but strong performance from individual stocks such as MKTX, EEFT, HLNE and VCTR offset the drag. As a result, the overall benefit from stock selection was notable.
During the quarter, our portfolio saw some changes in sector weights. The Financials sector, for the first time since Q4 2019, is no longer the biggest overall weight, with the Consumer Discretionary sector taking its place at 22.7% compared to 23.6%. We also added exposure to a new sector, Consumer Staples, through the purchase of Grocery Outlet, bringing our total investments to eight out of the eleven GICS sectors.
We continue to have no exposure to Energy, Materials, and Real Estate, which represent a significant portion of the overall Russell 2500 Index. While this is not a deliberate strategy, it reflects the lack of high-quality, through-the-cycle opportunities in these sectors. We remain open to finding investment opportunities in these sectors, but we prioritize quality and long-term returns over short-term sector hedges. From an allocation perspective, we have ample exposure (91% of the portfolio) to key sectors such as Consumer Discretionary, Financials, Health Care, Industrials, and IT, which together make up 72% of the overall index weight. We will continue to monitor the market conditions and make adjustments to our portfolio as needed to capture opportunities and manage risks.
Despite underperforming in 2022, the top performers in Q1 are now gaining traction as the market shifts focus from macro factors to fundamentals and valuations. Sotera Health was the biggest gainer, up 115% due to a favourable legal settlement. MarketAxess also rebounded, up 40%, as cyclical headwinds eased. DoubleVerify rose 37% after concerns over digital ad spending subsided. Despite recent gains, these stocks still offer value and growth potential in the current market environment.
Undervalued stocks like OZK (-13%) and BOK Financial (-18%) had a weak Q1 due to the overall decline in the banking sector. OZK has high ROE and efficient cost base but faces cyclical loan growth. BOKF suffered from flawed comparisons to SVB due to different exposure. Globus Medical fell 18% due to the acquisition announcement of NuVasive, a company with fluctuating growth and profitability focus.
Portfolio Changes
Overall portfolio turnover in Q1 2023 was low due to the consistent performance of most of our holdings.
Three new positions were added to the portfolio: PTC Inc, Bio-Techne and Grocery Outlet:
- PTC has shown organic growth and product leadership, with high customer retention rates and recurring revenue based on multi-year contracts.
- After tracking Grocery Outlet for over a year, a new position was initiated due to favourable valuations.
- Bio-Techne, positioned for higher double-digit growth with 16 acquisitions and minimal net debt, competes on value, not price, with products that are critical to the research process, resulting in gross margins above 65% and operating profit margins in the 30s.
The addition of these new positions aligns with the strategy of upgrading into quality names during market downturns.
Three positions—Take-Two Interactive, Virtu Financial and Thermon—were exited to make way for our new ideas:
- Take-Two Interactive’s acquisition of Zynga for $12 billion in mid-2022 has negatively impacted its return on capital and return on equity, leading to a negative longer-term view.
- Virtu Financial‘s acquisition of ITG in 2019 has resulted in inconsistent earnings and declining earnings multiple, coupled with regulatory scrutiny and limited earnings visibility, prompting a decision to sell.
- Thermon Group‘s cyclical peaks and falls in stock price, reaching highs in 2013, 2018, and 2019 but experiencing significant declines in 2014 and 2020, led to the decision to exit as stock price approached all-time high.
Outlook
Our portfolio saw strong performance in the early part of 2023, after a period of challenges where interest rate sensitivity had been a significant concern for stocks. During this period, there was a high level of sector correlation, resulting in a lack of differentiation based on quality. In addition, stock dispersion was low, indicating a lack of diversity in stock performance.
Despite these challenges, we have maintained our core portfolio holdings. This strategic decision is beginning to yield benefits. Many of the companies in our portfolio were not fundamentally broken, but rather faced negative market sentiment, which caused them to be overlooked or undervalued. However, we believe that their solid financials and strong market positions position them well for future growth.
Looking ahead, we have a bullish outlook for our portfolio, even in the face of potential economic headwinds, such as a recession in the second half of 2023. This confidence is based on our belief that our portfolio companies are well-positioned to weather economic downturns due to their solid balance sheets and strong market positions. Additionally, we expect several of our holdings to be able to generate positive earnings growth, even in a mild recession scenario, further bolstering our confidence in our portfolio’s performance.
Three new positions were added to the portfolio: PTC Inc, Bio-Techne and Grocery Outlet:
- PTC has shown organic growth and product leadership, with high customer retention rates and recurring revenue based on multi-year contracts.
- After tracking Grocery Outlet for over a year, a new position was initiated due to favourable valuations.
- Bio-Techne, positioned for higher double-digit growth with 16 acquisitions and minimal net debt, competes on value, not price, with products that are critical to the research process, resulting in gross margins above 65% and operating profit margins in the 30s.
The addition of these new positions aligns with the strategy of upgrading into quality names during market downturns.
Three positions—Take-Two Interactive, Virtu Financial and Thermon—were exited to make way for our new ideas:
- Take-Two Interactive’s acquisition of Zynga for $12 billion in mid-2022 has negatively impacted its return on capital and return on equity, leading to a negative longer-term view.
- Virtu Financial‘s acquisition of ITG in 2019 has resulted in inconsistent earnings and declining earnings multiple, coupled with regulatory scrutiny and limited earnings visibility, prompting a decision to sell.
- Thermon Group‘s cyclical peaks and falls in stock price, reaching highs in 2013, 2018, and 2019 but experiencing significant declines in 2014 and 2020, led to the decision to exit as stock price approached all-time high.
Outlook
Our portfolio saw strong performance in the early part of 2023, after a period of challenges where interest rate sensitivity had been a significant concern for stocks. During this period, there was a high level of sector correlation, resulting in a lack of differentiation based on quality. In addition, stock dispersion was low, indicating a lack of diversity in stock performance.
Despite these challenges, we have maintained our core portfolio holdings. This strategic decision is beginning to yield benefits. Many of the companies in our portfolio were not fundamentally broken, but rather faced negative market sentiment, which caused them to be overlooked or undervalued. However, we believe that their solid financials and strong market positions position them well for future growth.
Looking ahead, we have a bullish outlook for our portfolio, even in the face of potential economic headwinds, such as a recession in the second half of 2023. This confidence is based on our belief that our portfolio companies are well-positioned to weather economic downturns due to their solid balance sheets and strong market positions. Additionally, we expect several of our holdings to be able to generate positive earnings growth, even in a mild recession scenario, further bolstering our confidence in our portfolio’s performance.
Global Small-Cap Equity Strategy
Investment Performance
The following table shows the investment performance of the Van Berkom Global Small Cap Fund, compared to the MSCI ACWI Small Cap Index in CAD (as of March 31, 2023).
Portfolio performance returns are presented gross of fees.
* Note : July 31, 2022
Portfolio Positioning
Despite a volatile quarter, the global portfolio continued to perform as designed, similar to Q4 2022.
The year started with the “January Effect” in full force: as China reopened, Europe experienced a warmer winter, and the U.S. avoided a “soft/no landing,” leading to a strong market rally worldwide. Due to the growth profile of the portfolio, it rallied over 13% in the first four weeks of the year, maintaining an outperformance versus the index.
By the end of the first quarter, the reopening sentiment in Asia had faded, replaced by heightened geopolitical sentiment. In the U.S., a banking crisis led to a risk-off sell-off. However, the portfolio was able to maintain its lead with a 7.30% return for the quarter and expand our relative outperformance, given the strong balance sheet of the portfolio companies.
Our portfolio’s ability to add value in both strong and weak markets showcases the benefits of active management—by balancing high-quality defensive stocks with high-quality yet cheap growth cyclical stocks. Ultimately, our security selection created most of the value add (262 basis points) for the quarter.
Significant contributors to performance in Q1 2023 include the following names:
– Digital Ocean (53.8%)
– Double Verify (37.3%)
– ATS Automation (34.6%)
Stocks that detracted from our portfolio’s performance in Q1 2023 include the following stocks:
– Frontier Development (-46.8%)
– Country Garden Services (-30.5%)
– Globus Medical (-23.7%)
Portfolio Changes
Throughout the quarter, we took advantage of market volatility and added high-quality investment candidates at attractive valuations.
- Armstrong World, a market leader in commercial ceiling systems based in the U.S., has high margins (30%+ EBITDA margin) in a defensive replacement-driven end market and a ROE above 35%. The stock trades at 14x earnings and 8.8x EV/EBITDA
- Computer Modeling Group, a Canadian-based key supplier of advanced reservoir modeling software, has high margins (40%+ EBITDA margin) and ROE ~40%. The company also has a recurring revenue model and trades at 20x earnings and 13x EV/EBITDA
- Autostore, an innovative Norway-based hardware and software warehouse automation company, has a 90%+ market share in cubic storage (~15% top line AS/RS industry growth), high margins (45%+ EBITDA margin) and trades at 22x EV/Forward EBITDA.
- Befesa, a global leader in the regulated and critical Environmental Recycling Services sector (for Norway-based industries), invented the technology for steel dust recycling and operates mostly in regions where recycling is mandated by regulators. The company has a consistent margin (20%+ EBITDA margin) independent of economic cycles and ROE above 20%. Its stock also trades at 9x EV/EBITDA.
- Bank OZK, a regional full-service bank in the U.S. focused on commercial real estate lending, has an industry-leading net interest with one of the lowest net charge offs in the sector. The recent banking crisis has depressed its P/B multiple to 0.9x. 1 stan dev below historical multiples, despite healthy financials.
We exited Temper Sealy, Altus Group, Virtu financial, and Installed Building products based on relative opportunities for the portfolio. Our decision to divest from Frontier Development was driven by a careful analysis of the company’s financial fundamentals, which showed a decline in performance. Additionally, the operational results of the company deviated from our original investment thesis, prompting us to initiate our sell process.
Outlook
Since the beginning of the year, our team has traveled to the U.S., Europe and Asia to meet with companies, often for the first time in person since the beginning of the pandemic.
Asia
During our trip to Tokyo, we observed the relaxation of local Covid rules and China’s reopening, driving a positive outlook in the region. The companies we visited are optimistic about the near-term demand trend. However, the long-term headwind from the acceleration of an aging population is a concern across all our meetings. The Japan Ministry of Trade estimated that over 600,000 profitable businesses could close down by 2025 due to a lack of successors, and that number is only increasing.
To solve the perpetual labour shortage exacerbated by Covid, companies are increasingly adopting technology and finally abandoning the fax. They are also using more outsourced labour domestically and internationally in lieu of internal hiring. We see companies in IT outsourcing, M&A advisory, labour outsourcing and senior care all benefiting from providing solutions to this structural issue.
Europe
We met with over a dozen senior executives of local champions in Milan. Like the Japanese corporates, Italian companies are also pushing full steam ahead on digitalization, especially with strong incentives from the government. Overall, the tone of the European economy is improving due to increasing clarity on the path of inflation and rates. Moreover, Europe is more leveraged to the renormalization of supply chains and inventory positions. All these factors allow firms to do long-term planning and reinvest in their businesses accordingly. Consequently, there is a notable trend of increased willingness among companies to allocate capital expenditures for growth purposes. Interestingly, most of this growth capital spending is either in the US or Asia.
U.S.
We were fortunate to attend Credit Suisse’s 24th and final financials conference in Miami just before the banking crisis. It was the calm before the storm, and ironically, when asked what the first crack in the economy would be, none of the presenting firms said the banking system. Since then, all indicators (PMI, yield curve, labour) point to a classic recession happening in the U.S. Going forward, we believe that the acute crisis in idiosyncratic sectors (such as crypto, venture and regional banking) will move towards broader distressed markets in every sector. Weaker companies will suffer from inflation-driven margin compression and higher debt servicing costs. In fact, we are seeing a significant pick-up in bankruptcy activities through our conversations with our portfolio’s restructuring specialists and from court data.
Not all is doom and gloom. We attended an automation trade show in Chicago with 45,000 attendees and over 1,000 exhibitors, where we saw that U.S. industrial demand remains robust. Overall, the major theme is the acceleration of automation. With changing consumer behaviour throughout the pandemic, coupled with labour shortages and improving robot technology, automation is no longer a luxury but a necessity for companies dealing in physical goods. Combined with our European and Asian industrial company discussions about their U.S. expansion plans, an industrial/manufacturing renaissance mosaic in the U.S. is forming. In fact, according to the U.S. Census, construction spending related to manufacturing reached $108 billion in 2022, a 25-year high.
Finally, our global view for 2023 remains unchanged. The new interest rate regime will likely create liquidity crisis, prompting investors to be more focused than ever on balance sheets and cash flow. Nevertheless, we remain confident that high-quality, profitable, growing companies are set to continue outperforming.
Asia
During our trip to Tokyo, we observed the relaxation of local Covid rules and China’s reopening, driving a positive outlook in the region. The companies we visited are optimistic about the near-term demand trend. However, the long-term headwind from the acceleration of an aging population is a concern across all our meetings. The Japan Ministry of Trade estimated that over 600,000 profitable businesses could close down by 2025 due to a lack of successors, and that number is only increasing.
To solve the perpetual labour shortage exacerbated by Covid, companies are increasingly adopting technology and finally abandoning the fax. They are also using more outsourced labour domestically and internationally in lieu of internal hiring. We see companies in IT outsourcing, M&A advisory, labour outsourcing and senior care all benefiting from providing solutions to this structural issue.
Europe
We met with over a dozen senior executives of local champions in Milan. Like the Japanese corporates, Italian companies are also pushing full steam ahead on digitalization, especially with strong incentives from the government. Overall, the tone of the European economy is improving due to increasing clarity on the path of inflation and rates. Moreover, Europe is more leveraged to the renormalization of supply chains and inventory positions. All these factors allow firms to do long-term planning and reinvest in their businesses accordingly. Consequently, there is a notable trend of increased willingness among companies to allocate capital expenditures for growth purposes. Interestingly, most of this growth capital spending is either in the US or Asia.
U.S.
We were fortunate to attend Credit Suisse’s 24th and final financials conference in Miami just before the banking crisis. It was the calm before the storm, and ironically, when asked what the first crack in the economy would be, none of the presenting firms said the banking system. Since then, all indicators (PMI, yield curve, labour) point to a classic recession happening in the U.S. Going forward, we believe that the acute crisis in idiosyncratic sectors (such as crypto, venture and regional banking) will move towards broader distressed markets in every sector. Weaker companies will suffer from inflation-driven margin compression and higher debt servicing costs. In fact, we are seeing a significant pick-up in bankruptcy activities through our conversations with our portfolio’s restructuring specialists and from court data.
Not all is doom and gloom. We attended an automation trade show in Chicago with 45,000 attendees and over 1,000 exhibitors, where we saw that U.S. industrial demand remains robust. Overall, the major theme is the acceleration of automation. With changing consumer behaviour throughout the pandemic, coupled with labour shortages and improving robot technology, automation is no longer a luxury but a necessity for companies dealing in physical goods. Combined with our European and Asian industrial company discussions about their U.S. expansion plans, an industrial/manufacturing renaissance mosaic in the U.S. is forming. In fact, according to the U.S. Census, construction spending related to manufacturing reached $108 billion in 2022, a 25-year high.
Finally, our global view for 2023 remains unchanged. The new interest rate regime will likely create liquidity crisis, prompting investors to be more focused than ever on balance sheets and cash flow. Nevertheless, we remain confident that high-quality, profitable, growing companies are set to continue outperforming.
