• We trimmed our positions in some of our long-term winners, such as Trisura Group, Boyd Group Services and Stella Jones, due to valuation and weight management factors.
• We initiated two new positions, namely Computer Modelling Group (a leading global supplier of advanced process reservoir modelling software) and Tecsys (a provider of enterprise distribution management software).
• We sold off two positions—Exco Technologies (a manufacturer of precision-engineered tooling for automotive and industrial markets) and FirstService Corporation (a leading provider of branded essential property services)—to recycle the proceeds in other smaller-cap names with a more attractive risk-reward profile.
• Since we strongly believe in a focused, high-conviction, well-researched portfolio, our most significant purchases include Computer Modelling Group, Tecsys, Tucows, Colliers International Group and Spin Master Corp.

Outlook

Most of the headwinds and pressure points that strangled financial markets and decimated investor sentiment in 2022 did not magically disappear on the last day of the year. In fact, inflation remains at stubbornly high levels, with little sign of cooling, and interest rates are bound to move up before the mighty hike cycle is over. This terrible combination is likely to cause what many investors dread in the early part of 2023: a significant economic slowdown and, most likely, a recession worldwide. With this particularly difficult macro outlook, corporate earnings are bound to face stiff pressure and growth is likely to decelerate and turn negative, at least for some sectors. Therefore, there is the potential for additional downward pressure on earnings estimates, despite the significant downward revisions well underway last year.

As long-term, bottom-up investors, however, we are quite optimistic about our small-cap category’s risk/reward profile for long-term investors. With such a dramatic decline in our small-cap market, we believe that most small-cap stocks, especially high-quality companies trading at very reasonable valuations, are already largely discounting the near-term prospects of a recession, limiting material additional downside risk, should a recession officially materialize.

In addition, small-cap stocks have almost always led the way out of bear markets, outperforming large-cap stocks and other asset classes early in the cycle. In fact, historically, bear markets, like the one that we suffered in 2022, tend to act as a key catalyst for the next small cap outperformance cycle, plus most of the excess returns delivered by small-cap stocks versus large caps and other asset categories usually occur early in the cycle. Historical data shows that when inflation is high but lower than the previous year, small-cap stocks tend to perform quite well, both in absolute terms and relative to large caps.

After many years of underperformance, Canadian small-cap stocks are currently trading at the most substantial discount in 22 years. For investors with long-term investment horizons, we believe that this point in the cycle should prove to be an excellent entry point, with very attractive long-term return prospects from the current depressed valuations. We are even more bullish about our portfolio’s long-term return prospects. With high inflation, high interest rates, a more challenging operating environment, a weaker economy and pressure on earnings, we strongly believe that only the stocks of high-quality, well-managed, attractively valued companies with superior business models, sustainable competitive advantages and stronger growth will outperform.

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.

• We continued to build our positions in Armstrong World Industries, Cerence and DigitalOcean, since the stocks of these high-quality companies underperformed significantly in the recent months, despite no real changes to their long-term fundamentals, opening up nice investment opportunities at incredibly attractive valuations.
• We added to our positions in Euronet Worldwide, Silicon Laboratories, Envestnet, HealthEquity and Hamilton Lane, to name a few, outstanding companies with solid fundamentals that, nevertheless, suffered from a meaningful contraction in their valuation multiples, further improving their attractive risk/reward profile.

To fund our fourth quarter buying activity, we decreased certain positions:

• We reduced our position in Thermon Group, which had started to better reflect the company’s much improved fundamentals.
• We reduced our positions in Grand Canyon Education, RLI Corp. and Iridium Communications, three outstanding core holdings that had outperformed significantly and, as a result, had become much larger positions at slightly less attractive valuations.
• We trimmed our weight in NMI Holdings, as the stock had held up quite well despite a rapidly deteriorating housing market and a cloudy outlook for the mortgage industry that could negatively impact the company’s financial performance.

Outlook

To be sure, most of the macro challenges and pressure points that annihilated major financial markets and eroded investor sentiment did not suddenly magically vanish at the stroke of midnight on December 31. In fact, inflation levels are still alarmingly high and showing little sign of dwindling and, before 2022’s relentless cycle of interest rate hikes is complete, more are inevitable. In the first quarter of 2023, this perfect storm of negative macro conditions may lead to the major economic downturn and, most likely, the global recession that many investors fear. Corporate earnings will undoubtedly be under significant pressure due to this exceptionally challenging macroeconomic outlook, and growth, at least for some industries, is expected to slow and even be negative. As a result, despite the substantial downward revisions that already had started last year, we may very well see further downward pressure on earnings projections.

Nevertheless, as bottom-up, long-term investors, we are fairly positive about the risk/reward profile of our small-cap category for investors with long-term investment horizons. We believe that almost all small-cap stocks, particularly high-quality names trading at very reasonable valuations, are already heavily discounting the near-term possibility of a recession, minimizing any additional significant downside risk, should a recession officially occur.

Moreover, historically, small-cap stocks have generally outperformed large caps and other asset classes coming out of bear markets similar to the one that we experienced in 2022. Most of the excess returns that small-cap stocks deliver (relative to large caps and other asset categories) tend to be early in the cycle. Historical data indicates that small caps perform quite well, both in absolute terms and relative to large caps, when inflation levels are high but lower than the previous year.

Also, relative to large caps, after a record six consecutive years of lower relative returns versus the average under-performance cycle of just over four years, small-cap stocks currently trade at a substantial discount to their historical averages and are in bullish territory at these levels.

Given high interest rates, high inflation levels, anemic economic growth and pressure on earnings, we also believe that only high-quality, well-managed, attractively priced names with outstanding business models, sustainable competitive advantages and robust growth will be the top performers.

If fundamentals rule the day in 2023—as we expect—our portfolio will be well positioned to shine with its best-in-class financial metrics. In addition, our small-cap portfolio is still trading at a meaningful 17% discount to its intrinsic value, a very reasonable valuation despite the rally in our market and the strong portfolio returns we delivered in Q4.

In the fourth quarter, opportunities continue to be abundant from a valuation standpoint, keeping our team extremely busy. One of the keys to our long-term investment success is ensuring that we pick the right companies in the right sectors—in other words, sectors aligned with the new China of sustainable, quality growth versus the past’s of “growth at all costs” mentality. As a result, we also made these portfolio changes:

• We also added some US ADR exposure for the first time—namely, DADA (+47%) and VIPS (+62%)—with the expectation that the ADR delist risk will soon be off the table.
• We trimmed our Consumer Sector weight from 39% to 35.8% as we took profits from our travel stocks, now that markets are pricing in the impact of China’s reopening.
• We increased our technology exposure from 17% to 19.2% on improved performance, ADR delist risk dissipating and the run of anti-trust measures for the sector to tail off.

Outlook

In the fourth quarter, Asian investors were less concerned about China compared to their counterparts in Europe and North America. Despite a year-end rally, many investors are in denial and continue to remain underweight in China. The rapid reopening of China presents a strong case of for more consumption and pent-up demand.

From an economic perspective, the earlier timing of Chinese New Year holidays in 2023 will lessen manufacturing breakdowns since most of the country already shut down production lines. In theory, the “good news” is that the virus will likely run through China quicker than anybody ever imagined and get China back to its feet faster than expected.

Earnings growth expectations range from 10% to 20%, although most estimates see a minimum of 10% growth for 2023. Negative revisions have also been baked in due to China’s COVID-19 lockdowns. The nation’s monetary and fiscal policies also have room to support its economy. Although China today deserves some valuation discount due to its unpredictable anti-trust policy responses over the last two years, its efforts to expand the middle-income class should not be ignored. In the end, we certainly are not trying to predict what China will do in 2023 or whether there is more downside risk from here. However, for investors with a long-term horizon, we believe that this point in the cycle should prove to be an excellent entry point, with very attractive long-term prospects from the current depressed valuations.

We strongly believe that only the stocks of high-quality with superior management will continue to outperform— despite all the policy uncertainties in China. Last year, we actively purchased outstanding companies in the services-led and consumption space, paving the way for continued strong stock returns.

Going forward, our investors will continue to benefit from our institutional knowledge local perspective and time-tested approach to investing in high-quality, well-managed companies with solid business model. Our portfolio, which is currently trading at 15.7x forward earnings on a 20% long-term growth rate, should reward our investors well into the long term. Despite all the doom and gloom, Asian stocks are close to entering a bull market as China’s reopening and a weakening U.S. dollar lure investors back to the region with, as history has shown, trough-to-peak returns in excess of 70%—in no fewer than seven out of 10 times after a major emerging market trough.

Our biggest sale of a longer-tenured position was in Virtu Financial, where we believe that the regulatory environment is turning more negative, and the inability of the company to be rewarded for a more consistent delivery of earnings makes us believe that the public markets are not prepared to put a high multiple on the earnings.

Our pipeline of opportunities remains strong. We have approved a few new ideas in principle, but the key stumbling block with these names remains their valuation. With these candidates, we are currently waiting for the right entry point before we start building these positions. Given the volatility in today’s markets, we are confident that one or two of them will be actionable in the first quarter of 2023, but we are not prepared to sacrifice our goal of a 15% compound annual return in our investments, if it means we buy into the name at the wrong level. We still believe that our patience will be rewarded in the long run.

Outlook

In 2022, interest rate and macro themes resulted in a very sector-driven and thematic-oriented market, where we struggled due to our broadly interest rate neutral stance and our lack of exposure to commodities and energy. A market with high sector correlation and low dispersion tends to be a tough market for bottom-up investing. We think that the impact of these issues will be much lower as we get close to peak rates and energy stock prices continue their broad reversal. Ultimately, a wider dispersion of returns should bode very well for a strategy built on company-specific fundamentals.

We remain comfortable with our current positioning, where quality remains high and economic cyclicality relatively low. Rightly or wrongly, we think the interest rate theme is broadly neutral at this point and, from there, the incremental gains from playing the “rising rates” game are likely to be small. From an operational perspective, our portfolio companies have low underlying financial leverage, so few will face the headwind of rising interest rates. We are already discounting cash flows at or above where peak rates are likely to end up, so further rate hikes will likely have little impact on the intrinsic value of our holdings as we are.

All in all, we believe that the solid fundamentals of most of our names will play strongly in our favour in what’s likely to be a weak year of economic growth. The benefit of our small and mid cap equity strategy is that many of our companies are small players in very large markets that can grow even in a down market year over year. Our central scenario is one where inflation starts to decrease again and the U.S. Federal Reserve falls short of current interest rate peak expectations, causing the stock market to muddle through the next 12 months and produce positive returns. In our case, this is a formula for strong relative performance since investors will be forced to think about stock fundamentals in an environment where rates have peaked and sector rotation is less additive.

The only unknown in our scenario is how long the U.S. Federal Reserve holds rates steady before it starts to cut again. Given our experience on the way up, we think the FED will be slow to cut. However, if it quickly cuts rates, there is a chance that growth stocks will come back into favour faster than we expected, becoming a headwind for a predominantly core style portfolio.

With small caps as a class trading at very attractive valuations, both in absolute and relative terms, this could be a set-up for mid- to high-single digit returns this year. For long-term investors, buying into the market when money is expensive allows you to ride the inevitable wave of euphoria as money starts to get cheap again.

We see the following regions evolving differently over the next year:

China
We were an early believer in China’s reopening and see 2023 as a continuation of the structural recovery of the region lea by China. Fundamentally, we see significant sequential improvements from the re-opening through both the rebound of domestic consumer demand and the easing of corporate credit. We believe the change in policy stance towards the property and technology sectors will alleviate the overhang on valuation due to an improvement in sentiment. Although, in the short term, a surge in COVID cases will continue to supress productivity. For the year as a whole, the combination of improving fundamentals and market sentiment creates a very attractive outlook for the region.

Europe
We are more cautious about European fundamentals but believe there are incredible opportunities to be had. Consumer discretionary spending power is under enormous pressure and the mood is very negative, validated by our recent visit to the region. In terms of fundamentals, we noticed a consistent view across verticals and countries from our portfolio companies: we see solid numbers but a negative “feel.” A Swiss industrial company’s CFO put it nicely: “If we don’t read the papers that tell us about a looming recession and just look at our own business, we are quite positive about 2023.” Perhaps, with few positive catalysts, such as lower-than-expected energy prices or China reopening driven demand, Europe could see an upside surprise. Of course, the biggest overhang of the region remains the war in Ukraine. Until there’s a positive development on that front, valuations will remain subdued.

North America
We believe that corporate earnings in North America will face further pressure as growth decelerates and earnings are revised downward. However, after a 20% decline in small caps in 2022, the market consensus of a mild recession in 2023 seems reasonably priced in. Of course, as public equity investors, we naturally have a glass-half-empty perspective, so our model uses significantly more conservative assumptions. That said, we still see incredible value in our holdings and their ability to differentiate and generate consistent excess returns through different cycles.

Overall, we believe that 2023 will be the start of a new market environment due to a change in the interest rate regime: one where capital is expensive and liquidity is scarce. Investors across all asset classes are more discerning and tend to focus on tangible cashflow over aspirational growth. In the new regime, we believe that our investment focus on high-quality, profitable and growing companies should make our portfolio uniquely positioned to outperform.

Our portfolio companies have stronger growth than the index, are higher quality (higher ROE vs index), and possess healthier balance sheets (Net Debt to EBITDA of 0.3x vs. index 3.0). With such a strong profile, most of these names are operating from a position of strength. As a result, we expect them to capitalize on a downturn, which should strengthen their market positioning.

Finally, our proven investment process has weathered decades of different investment environments across geographies. We can pinpoint when our style should do well relative to the market and when it won’t. Therefore, despite near-term economic challenges, we are convinced that 2023 will be incredibly supportive for our investment style and our positioning in high-quality stocks.