There is no way to put a positive spin on the second quarter of 2022, which was marked by gruesome inflation data, an accelerating tightening cycle by the Federal Reserve, Bank of Canada and other central banks, the continuation of the war in Ukraine and mostly deteriorating economic indicators and sentiment. This potent cocktail of negative developments was a major shock for world stock and bond markets. Except for a few soaring commodities that benefitted from this environment, investors painfully saw significant negative returns across major stock markets and asset classes worldwide.
Fixed income to global equities and so-called inflationary instruments, such as gold and crypto money, all suffered during the quarter. Even high-grade corporate and government bonds, a relative safe haven in difficult economic and market conditions, incurred steep losses as interest rates rose dramatically. At the heart of every painful loss this quarter is the increasingly hawkish stance toward interest rates and the monetary policies of the U.S. Federal Reserve, Bank of Canada and major central banks worldwide. With soaring, persistent, inflation of a magnitude unseen for more than 40 years, central banks globally had to fight inflation and announce their resolve to quell soaring consumer and producer prices at any cost.
Historically, significant rate hikes to tame high inflation have led to a hard landing practically every time. In the second quarter, the combination of surging inflation, labor shortages, continued supply chain pressures made worst by China’s Covid-zero policy and rapidly rising interest rates started to dent economic activity, negatively impact business and consumer confidence, and put pressure on the outlook for corporate profits. Housing, one of the first areas of the economy to fall in this type of environment, took a turn for the worse. Other parts of the economy are expected to feel the heat from high inflation and soaring interest rates soon. Due to these pressure points, the dreaded “R” word — recession — was on everyone’s lips, becoming one of the most widely anticipated recessions in decades.
In the second quarter, an enormous deleveraging of the financial markets also took place as liquidity was reduced and removed from the monetary system by central banks worldwide. Due to substantial hikes in interest rates and, as a result, higher borrowing costs, debt-funded investing has become much more expensive, reducing capital market liquidity. Liquidity fell to levels last seen during the COVID-19 selloff two years ago, adding to volatility in an already-nervous market.
The risk-off sentiment, shockingly difficult macroeconomic backdrop and declining liquidity witnessed throughout the second quarter led to sustained negative returns, pushing global equity benchmarks toward one of their worst first halves in in history:
- A 17% plunge in the Russell 2500 brought it to an almost -22% total return year-to-date.
- The S&P 500 large-cap benchmark is off to its worst first half of any given calendar year since 1970 and down 20% in the first six months of the year, after falling 16% in Q2.
- The Russell 2000 small-cap benchmark had an even worse performance than the S&P 500 and saw only a -23.5% return for the first half of the year.
- The TSX Small Cap Index was off to a rough first half of 2022 at -13.9%, a return that could have been far worse had it not been for the positive contribution of the Energy sector.
- The selloff was also across all securities markets, with the iBoxx High Yield and Investment Grade bond indices dropping close to 10%.
- Even US Treasury Bond Yields moved up at an astonishing rate — and, consequently, prices went down.
On the opposite side of the world, Asia was no better, except for China-related stocks:
- Japan corrected -14%, Korea -26% and Taiwan -24% in the quarter.
- CSI A-shares were down -1% and Hang Seng (HK) only -1%.
- As expected, mega caps helped the MSCI China to a +3.5% performance over the quarter and -11.2% YTD.
- Chinese indices with less mega caps did much worse: the MSCI Golden Dragon saw -4.8% QTD and -19% YTD and the MSCI Golden Dragon Small Caps saw returns of -11.8% QTD and -19.7% YTD.
Canadian Small-Cap Equity Strategy
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 at June 30, 2022).
|VB Cdn. Composite||-15.95||-23.26||-18.98||-0.18||1.35||9.40||9.23||9.38||11.73|
|S&P/TSX Canadian Small Cap Index*||-20.83||-14.17||-13.81||2.95||3.43||4.27||4.13||3.99||6.06|
|S&P/TSX Composite Blended Index||-13.19
(VB minus S&P/TSX Small
*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.
In the face of a broad selloff across the market cap spectrum in the second quarter of 2022, our portfolio could not completely escape the deep and sustained paper losses so prevalent during this period. Quite simply, there were almost no places to hide for small-cap and large-cap investors, other than cash and low-quality energy stocks.
If there is any silver lining during the quarter, it was the excess return that we delivered versus our small-cap benchmark, the TSX Small Cap Index. We emerged from this difficult quarter with a substantial level of value-add largely driven by our positions in high-quality, reasonably valued small-cap stocks with superior fundamentals. Time and time again in bear markets and difficult macro conditions, our high-quality portfolio stocks have tended to hold up better and declined less than most small-cap stocks and our benchmark. The broad-based selloff in our small-cap market, however, showed little regard and consideration for company-specific fundamentals and valuations.
While the dramatic rally in energy stocks stalled in the second quarter, the sector still managed to significantly outperform the broader small-cap market, supported by very healthy oil and gas prices. As a result, our continued lack of exposure to energy remained a headwind to our relative performance.
Ultimately, our careful stock selection saved the day once again, leading to significant value-add and excess returns in the second quarter. Security selection generated alpha in most of our market’s largest sectors, particularly where we have significant exposure.
Due to both strong pricing power and solid cost efficiencies, our portfolio companies continued to provide very solid financial results, with the vast majority delivering numbers that meet or exceed our forecasts and investor expectations, despite growing pressure points on the economy. Even with soaring interest rates, our portfolio remains very well positioned with low levels of leverage and no significantly negative exposure to higher rates.
Significant contributors to performance in Q2 2022 (in terms of bps) include Element Fleet Management Corp. (+11.6%), IBI Group (+1.9%), CCL Industries (+8.3%), Definity Financial Corporation (+4.6%) and Linamar Corporation (-1.5%).
Stocks that detracted from our portfolio’s performance in Q2 2022 (in terms of bps) include AirBoss of America Corp. (-56.1%), Richelieu Hardware (-25.8%), ATS Automation Tooling Systems Inc. (-21.6%), Enghouse Systems (-27.6%) and Aritzia (-31.7%).
We continued to further enhance the quality and long-term positioning of our model portfolio through the following changes to add long-term alpha to the portfolio:
- We increased our position in some of our high-conviction holdings where current valuations no longer fairly reflect their long-term organic and acquisition growth potential, including meaningful additions to Richelieu Hardware, Aritzia and GDI Integrated Facility.
- We trimmed our position in some of our long-term winners, such as CCL Industries, Element Fleet Management and Definity Financial Corp., due to valuation and weight management considerations.
- We sold off our position in Recipe Unlimited Corporation, which no longer met our investment criteria due to a lack of growth and a challenging operating environment, enabling us to increase our position in our high-conviction holdings.
Unquestionably, the Canadian economy is heading toward a meaningful slowdown that could very well push it into a recession in the coming months. The combination of stubbornly high inflation and an aggressive rate hike strategy by the Bank of Canada and the U.S. Federal Reserve is likely to prove quite toxic for most sectors of the economy, ultimately reducing demand for goods and services coast to coast.
While we expect to see more pervasive financial guidance reductions and downward adjustments to earnings estimates, a recession is unlikely to be as severe and pronounced as what we experienced during the financial meltdown of 2008-2009. Although a recession would undoubtedly put pressure on profitability for most of our holdings, our portfolio companies should outperform their peers and are currently trading at a valuation that discounts most or all the looming recession, offering good downside protection from current levels and extremely attractive long-term return prospects.
With the portfolio trading almost 20% below intrinsic value, we should see significant absolute and relative value-add when the geopolitical, economic and commodity environment normalize, winning back even more of the relative performance we lost in the first half of 2022.
U.S. Small-Cap Equity Strategy
The following table shows the investment performance of the VB U.S. Pension Fund Composite (in US dollars), compared to the Russell 2000 Small Cap Index and the S&P 500 Index (as at June 30, 2022).
||1 Yr.%||2 Yr.%||3 Yrs.%
||4 Yrs.%||5 Yrs.%||10 Yrs.%||15 Yrs.%||20 Yrs.% ||Since inception
June 30, 2000
|Russell 2000 Index||-17.20||-25.20||10.09||4.21||2.28||5.17||9.35||6.33||8.17||6.99|
|S&P 600 Index||
|S&P 500 Index||-16.10||-10.62||12.18||10.60||10.55||11.31||12.96||8.54||9.08||6.47|
|Value added (portfolio minus
Due to a massive selloff across the market cap spectrum, our portfolio could not completely avoid the significant and widespread paper losses in the second quarter of 2022. Small-cap and large-cap investors alike had very few places to hide, aside from cash and low-quality energy stocks.
If there is any silver lining during the quarter, it was the excess returns that we delivered versus our small-cap benchmark. We could have generated even more alpha, had the market environment and investor sentiment been more rational and discriminating. Nevertheless, we emerged from this difficult quarter with a substantial level of value-add largely driven by our positions in high-quality, reasonably valued small-cap stocks.
In bear markets and difficult macro conditions, our high-quality portfolio stocks tend to hold up better than most small-cap stocks and our benchmark. Our sector allocation, however, was largely unfavorable relative to our small-cap benchmark and did not provide any tailwinds to our excess.
While the dramatic rally in energy stocks stalled over the past three months, the sector still managed to significantly outperform the broader small-cap market. As a result, our continued lack of exposure to energy remained a headwind to our relative performance. In addition, our larger allocation to consumer discretionary stocks once again played against us, as investor sentiment toward the sector soured further, with most stocks unable to find a bottom despite the steep contraction in valuations. Ultimately, our careful stock selection saved the day, leading to significant value-add and excess returns in the second quarter. Security selection generated alpha in most of our market’s largest sectors, particularly where we have significant exposure.
Due to both strong pricing power and solid cost efficiencies, our portfolio companies continued to provide very solid financial results, meeting or exceeding expectations, despite growing pressure points on the economy. Even with soaring interest rates, our portfolio remains very well positioned with low levels of leverage and no significantly negative exposure to higher rates.
Significant contributors to performance in Q2 2022 include FTI Consulting (+15.3%), StoneX (+5.4%) and RLI Corp. (+5.9%), defensive companies with lower betas and modest correlation with the broader economic cycle. In addition, Federal Signal (+5.9%), Acushnet (+4.0%) and Brady Corp. (+2.6%) also crossed into positive territory.
Most of our largest detractors and weakest performers in the second quarter were in the Consumer Discretionary sector, including stocks like Shake Shack (-39.8%), Purple Innovation (-47.7%), RE/MAX (-29.4%), Marriott Vacations Worldwide (-26.0%), Fox Factory (-16.9%), Brunswick (-18.7%), Euronet Worldwide (-22.7%) and NMI (-19.3%), which came off meaningfully more out of fear than actual significant changes to their near-term (or long-term) financial outlook.
Our investment team continued to build an incredibly rich and high-quality pipeline of investment candidates that fully meet our style and investment criteria in this broad bear market.
In many cases, investment candidates in our current pipeline have been on our active “wish list” of the most outstanding small-cap companies for quite some time. These stocks had not, until recently, reached a valuation level attractive enough to meet our long-term return hurdle rates — until their stock got hit hard in this bear market.
- We finally initiated a position in Yeti Holdings, an innovative consumer products company with compelling fundamentals.
- We focused our buying activity on existing portfolio stocks such as Shake Shack, Cerence and DoubleVerify, compelling investment opportunities due to significant contractions in their valuation multiples.
- We rebalanced our positions, adding to portfolio names such as Installed Building Products, Maximus and Tempur Sealy International.
- We exited our position in RE/MAX Holdings to fund our new investment in YETI
- We also took some profits in some of our portfolio stocks, including StoneX, Grand Canyon Education and Blucora, which have held up remarkably well despite a broad pullback in our small-cap market.
Unquestionably, the U.S. economy is heading toward a meaningful slowdown that could very well push it into a recession in the coming months.
The combination of stubbornly high inflation and an aggressive rate hike strategy by the U.S. Federal Reserve is likely to prove quite toxic for most sectors of the economy, ultimately reducing demand for goods and services coast to coast.
While we expect to see more pervasive financial guidance reductions and downward adjustments to earnings estimates, a recession is unlikely to be as severe and pronounced as what we experienced during the financial meltdown of 2008-2009.
Although a recession would undoubtedly put pressure on profitability for most of our holdings, our portfolio companies should outperform their peers and are currently trading at a valuation that discounts most or all the looming recession, offering good downside protection from current levels and extremely attractive long-term return prospects.
With our portfolio of high-quality stocks currently trading at a 20%+ discount to its intrinsic value — a level achieved only twice in the past 15 years (in 2008 and in 2020) — our U.S. small-cap strategy should continue to add value and generate excess returns in the near term within this difficult environment and, longer term, as we come out of this economic downturn.
U.S. Small & Mid Cap Equity Strategy
The following table shows the investment performance of the VB U.S. Small-Mid Cap Pension Fund Composite (in US dollars), compared to the Russell 2500 Small Cap Index and the S&P 500 Index (as at June 30, 2022).
||1 Yr.%||2 Yrs.%||3 Yrs.%
||4 Yrs.%||Since inception September 30, 2017 %|
|Russell 2500 Index||-16.98||-21.00||11.65||5.91||4.86||6.39|
(portfolio minus Russell 2500)||2.71||1.36||-5.51||-1.28||0.26||1.02|
With our portfolio outperforming our benchmark, the Russell 2500 Small Cap Index, we started to claw back a solid chunk of the underperformance we saw in the first quarter — due to strength in the energy sector.
Through our stock selection, we aim to deliver a 15% compound annual return over five-year periods. That aim has taken a beating this year due to the significant market selloff in the first part of 2022, but we are more positive now about our ability to outperform the market than at any point in the last three years.
The era of free and cheap money is over — not only for companies that built up heavy debt loads, but also for markets and speculators. Inflation is creating business challenges that only some companies will manage, and investors are nervous and selling entire sectors on broad themes.
These difficult conditions, however, offer investment opportunities for a strategy built on finding superior business models with steady consistent growth on reasonable multiples. We saw these opportunities start to play out, based on the quality of names that we have in our pipeline right now.
In the second quarter, our outperformance was due mostly to stock selection and partly to sector allocation. Given our bottom-up strategy, stock selection tends to drive all the value we add, but we were slightly surprised that outside of the 50bp benefit from holding a cash balance of 3.5%, no other sector added or subtracted more than 30bp from an allocation perspective.
The only sector where we underperformed was in Health Care, with all others performing either in line with or better than the benchmark return.
The majority of our value-add came from stocks in IT, Consumer Discretionary, Industrials and Communication Services:
- StoneX was the outstanding stock of the quarter with a 5.2% total return and along with its high weight in the portfolio produced over 50bp of attribution.
- RLI and Federal Signal also produced 5% returns but slightly lower attribution due to lower weights.
- Installed Building Products was down 1.2% in the quarter and Laureate Education was only down 2.4% to round out the best contributors to the overall return in the quarter.
While we were pleased to return to a quarter of outperformance, we also had our share of weak performers over the past three months.
In the second quarter, 12 stocks declined more than 20%, including Shake Shack (-42%), Virtu Financial (-36%), Pennant Group (-31%), Cerence (-30%), Purple Innovation (-30%) and Envestnet (-29%).
The significant downturn in the market dramatically improved the number and quality of names in our pipeline of new opportunities, with valuations finally starting to make sense for certain long-term favorites on our watchlist. As a result, we sold two names completely and bought one new position, ending up with a 40-stock portfolio.
- We sold both Purple Innovations and Frontdoor due to issues that brought into question the long-term quality of both companies.
- We bought one new position, YETI holdings, a small-cap stock with compelling fundamentals and more reasonable valuation.
In terms of other material buys and sells in the second quarter, turnover was relatively modest:
- We sold close to half our position in IPG Photonics in April at 598 and subsequently bought it back at 587 when the valuation touched a five-year low.
- We bought some IBP right at the start of the quarter following its decline in Q1.
- We added to TTWO as the overhang from the Zynga deal began to subside.
- We sold some CHE and LOPE from a weight management perspective, since both stocks performed well in a weak market quarter, but their weights drifted a little higher than we liked.
- In June, our focus shifted to looking more critically at the long-term positioning of some names as opposed to just reallocating weights.
The first half of 2022 has been tough for almost all investment classes with few places to hide. This shakeout has resulted in the fire sale of many solid companies, along with deserved multiple reductions in many lower-quality businesses.
As we enter a period of downward adjustments to earnings for the market, our low cyclical exposure and limited exposure to stocks with high financial leverage should start to pay dividends. We believe this approach represents a solid formula for outperformance in the second half of the year.
After clawing back more than half of the first quarter shortfall, we are hopeful we can fully recover the rest of the initial underperformance, getting us back to our long-term goal of value-add for this portfolio strategy.
Asia Small Cap Equity Strategy
The following table shows the investment performance results of the VB Golden Dragon Pension Fund Composite (in US dollars), compared to the MSCI China and the MSCI Golden Dragon Small Cap Index (as at June 30, 2022).
||2 Yrs.%||3 Yrs.%||4 Yrs.%||5 Yrs.%||
||Since inception Dec. 31, 2011%|
|MSCI Golden Dragon Small Cap Index||-11.75||-19.72||-22.37||9.89||9.23||4.46||6.16||3.42||6.79||7.11|
|Value added (portfolio minus MSCI China)||-4.51||2.94||8.87||15.18||11.36||9.62||5.68||3.32||2.61||3.62|
Since the macro concerns that have delinked the stock prices of our Chinese companies persisted in the second quarter of 2022, we continued to slowly top up our core positions tactically, whenever valuations were in line with further government green signals.
To identify further investment opportunities, we continued to closely monitor the Chinese government’s progress in restructuring China’s economy through its “common prosperity” policy. April and May, as a result, were quiet for the portfolio in terms of trading because valuations remained very cheap awaiting further policy guidance and follow-through.
In late May, the government flashed additional green signals, prompting us to take profit in some of our outperformers and rotate them for more Chinese exposure. Accordingly, all positions added to the portfolio continued to follow President Xi’s mantra of “common prosperity” policy tailwinds.
Although the operating environment in China has grown more complex, we are poised to capitalize on the government’s commitment to improving the quality of life, boosting household wealth, narrowing the wealth gap and pursuing broader ESG initiatives. Specifically, we continued to bulk up the business and earnings quality of our portfolio during this government’s policy storm.
Although our goal is to keep high-quality goals for the long term, market volatility in China can cause stock prices to move to extreme levels in the short term, prompting us to trim losses or take profits, initiating and trading positions at suitable entry and exit points.
Our top five names contributed 4.6% to portfolio performance in the second quarter: Geely (+46%), Xinyi Electric (+70%), Lotus (+40%), Trip.com (+17%) and Tongcheng Elong (+20%).
Our top three names this quarter — Geely, Xinyi Electric and Lotus — clearly illustrate the success of our disciplined, nimble and research-focused investment approach to buying and selling high-conviction stocks when Chinese market volatility drives valuations through the roof or through the floor.
Our bottom five stocks detracted from our portfolio’s performance by 3.6% in the second quarter: Kulicke (-23%), Techtronic (-35%), Novatek (-32%), iFast (-33%) and TCI (-22%).
Our top two detractors — Kulicke and Novatek — both participated in the semi downturn and could not escape the bearish sentiment, despite strong executions and continued market share gains.
Our high-conviction, stock selection strategy was paused in the first half of the second quarter and restarted in late May, after the positive government green signals.
In the second quarter, investment opportunities were abundant, keeping us extremely busy. Over the past three months, we further trimmed lower-conviction names and replaced them with higher-conviction stocks.
- We had only one new addition (in JD Health).
- We topped up our Chinese ADR holdings and Hong Kong names, such as Geely, Techtronic, Bank of China Aviation, L’Occitane, Hua Hong and Country Garden Services.
- We took profits from Kulicke, ASM, Novatek (in the semi space), Xinyi Electric, CSPC and HKTV.
Fears of oversupply and lower consumer electronics demand in the U.S. left Chinese tech stocks nursing their wounds. As a result, our sector exposure going into this downturn was reduced significantly.
- We took profits in Lotus, Kulicke, Xinyi Electric and Coli Prop, rotating them to Geely, Galaxy and Chinese tech names, which marked a bottom.
- Despite sector bearishness, we kept Kulicke at relatively higher portfolio weight due to its compelling fundamentals.
We believe that mid-March finally marked the bottom for Chinese markets. We expect most of the negatives in play have been fully discounted by the market — now at an attractive juncture point of low risk and high reward. This is an opportune time for investors to step back into China:
With a higher quality mix of companies versus higher financials, Chinese stocks valuations are now much more attractive. In addition, the message from the Chinese government continues to emphasize growth. Our growth portfolio is ready to catch the next strong rally in the region and should continue to outperform.
Although China’s economy today is held back by COVID lockdowns that impede economic growth, we firmly believe that this portfolio will reward our investors as we stay bottom-up focused, investing into long-term sustainable growth companies in Asia’s consumption and services sectors.
Our portfolio is trading at 16x forward earnings and 28% discount to DCF on a 23% long-term growth rate, which should reward our investors well into the long term.
Going forward, this portfolio should continue to benefit from our institutional knowledge, local perspective and time-tested approach to investing in high-quality companies with solid quantitative and qualitative metrics.
STRATÉGIE À TITRE INFORMATIF : MONDIAL