2023 was a year of unexpected twists in global markets. The U.S. and Canada, initially bracing for economic downturns, witnessed robust equity performances. Asia presented a varied picture, with Japan and India thriving, but China facing continued challenges. The key takeaway from 2023 is the market’s ability to rapidly adapt and respond to macroeconomic changes, highlighting the importance of staying agile in investment strategies.
Market Review
U.S. Market Dynamics
2023 was a year of significant turnaround for the U.S. market. Earlier fears of a recession, stoked by the Federal Reserve’s largest interest rate hikes in over four decades, proved unfounded. The Fed’s unexpected dovish shift late in the year, hinting at an end to rate hikes and potential rate cuts in 2024, sparked a robust Santa Claus rally. The Russell 2000 index exemplified this resurgence, recovering remarkably from its 52-week low. This rebound was a dramatic contrast to the market’s stagnant performance for most of the year. The NASDAQ and S&P 500 indexes recorded exceptional gains, reminiscent of the dot-com era’s highs. These gains were supported by abating inflationary pressures, a consistently strong labor market, and corporate earnings that surpassed gloomy expectations. Economic data demonstrated surprising resilience, contributing to a broadly optimistic outlook. Additionally, global equity markets followed suit, buoyed by the U.S. Fed’s policy change, though the Chinese market remained an outlier with continued declines.
Canada’s Financial Market Overview
In Canada, market trends closely paralleled those in the U.S. The Bank of Canada’s aggressive rate hikes initially fostered a bearish consensus, similar to the U.S. However, the outcome was more positive than anticipated. The Canadian market benefited from the U.S. Federal Reserve’s policy changes, leading to a significant rally in Q4. In terms of equity performance, large-cap stocks outshone small caps throughout the year. The positive market sentiment was underpinned by factors similar to those in the U.S.: diminishing inflationary pressures, a robust labor market, and strong corporate earnings. The bond market also witnessed a significant upturn, with corporate bonds outperforming government securities, reflecting a surge in investor confidence. This turnaround in the Canadian market underscores the interconnectedness of global economies and the impact of major central banks’ policies.
Asia’s Market Trends
Asia’s market performance in 2023 was diverse. Japan’s Nikkei and India’s BSE Sensex notably outperformed expectations, posting remarkable gains in a challenging global economic environment. China, however, continued to struggle, with the MSCI China and Hong Kong’s Hang Seng index experiencing significant declines for the third consecutive year. The underperformance in China was attributed mainly to valuation concerns rather than earnings revisions. The fears stoked by geopolitical tensions, regulatory policies, and fund outflows from Western investors significantly impacted the market. Taiwan emerged as a regional standout, benefiting from bullish optimism in technology, particularly surrounding AI advancements. The Asian markets also reacted positively to the U.S. Federal Reserve’s dovish stance late in the year, highlighting the global influence of U.S. monetary policy. The region’s performance underscores the diverse economic landscapes and the varying impacts of global market trends.
Key 2023 Takeaways
The global markets in 2023 illustrated the complexities of financial ecosystems, with the U.S. and Canada experiencing surprising upturns despite initial pessimism, while Asia presented a mixed bag. The year was a testament to the agility of markets in responding to macroeconomic shifts and central bank policies. Going forward, investors should remain cognizant of these dynamics, as 2024 promises continued potential for market optimism amidst evolving global financial landscapes.
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 December 31, 2023).
Composite returns are calculated using the time-weighted method and presented gross of management and trustee fees and withholding taxes.
*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 the final quarter of 2023, our portfolio showcased a robust performance, recording a significant and markedly outperforming the TSX Small Cap Index. For the entirety of 2023, our portfolio’s strength was even more pronounced. These achievements our strategy’s effectiveness. Our investment approach, primarily centered on discerning stock selection and capitalizing on companies with unique growth attributes, proved resilient amidst the significant market volatility. This strategy aligned well with our investment style, which prioritizes identifying companies with specific drivers for growth and potential. In Q4, despite a market trend that de-emphasized company-specific fundamentals—a scenario often termed as a “junk rally”—our adept security selection skillfully mitigated the majority of the adverse impacts.
Notably, our portfolio’s relative returns in Q4 also benefitted from our lack of exposure to the underperforming Energy sector, which was among the few sectors to post negative returns. Conversely, our significant holdings in the Information Technology, Financial, and Industrial sectors, which were among the top performers in this period, contributed notably to our portfolio’s success. This broad-based rally across most sectors in our market underscored the effectiveness of our diversified yet focused investment approach. Our consistent track record of alpha generation over the past 31 years is rooted in our investment philosophy: a commitment to high-quality, reasonably-valued small-cap companies. This approach has consistently yielded superior returns through various market conditions, characterized by lower volatility and reduced risk profiles. The cornerstone of our success lies in our team’s deep research process, enabling us to gain and maintain comprehensive knowledge of each investment. This expertise allows us to capitalize on frequent market inefficiencies and mispricing opportunities, which can lead to superior long-term returns.
Our significant contributors to performance:
- Lumine Group (+48.6%) due to the announcement of two acquisitions and strong financials post-spinout from Constellation Software.
- Goeasy (+49.1%), benefiting from strong , market share gains in non-prime leasing and lending and favourable interest rate conditions.
- Colliers International Group (+29.7%), due to a rebound in investor sentiment towards commercial real estate.
- Computer Modelling Group (+19.8%), due to accelerating organic growth under new leadership and the announcement of an acquisition.
- Jamieson Wellness (+31.0%), driven by strong Q3 results, including continued international growth in the U.S. and China.
The stocks that detracted from performance:
- Canada Goose Holdings (-21.0%) due to reduced guidance amid a challenging discretionary spending environment.
- Altus Group (-10.0%), impacted by weaker than expected Q3 results and investor concerns over a recent acquisition.
- Ag Growth International (-4.8%) due to cautious investor sentiment around the agricultural cycle.
- GDI Integrated Facility Services (-5.0%), grappling with normalization of post-Covid margins and high working capital investment.
- Mattr Infrastructure Technologies (-4.6%) following Q3 results and growth initiative costs.
Portfolio Changes
This quarter, we actively adjusted our model portfolio to enhance its quality and long-term positioning.
We increased holdings in high-conviction companies:
- MDA: Added due to solid organic growth prospects and free cash flow inflection in 2024-2025.
- Mattr Infratech: due to solid organic growth prospects and cash flow redeployment optionality post sale of a division.
- ATS Corporation: due to attractive valuation relative to growth prospects.
We scaled back positions in well-performing stocks for valuation and weight management:
- Computer Modelling Group
- Colliers International Group
- Goeasy
We initiated a new position:
- AutoCanada, a leading North American multi-location automobile dealership group, with significant share price upside given its new strategic plan (‘Project Elevate’) aimed at expanding margins through efficiency improvements.
We divested from certain positions to reallocate capital to more promising opportunities:
- AirBoss of America
- Boyd Group Services
- Stantec
These changes reflect our commitment to a focused, high-conviction, and well-researched investment approach.
Outlook
As we begin 2024, the market’s outlook is cautiously optimistic yet uncertain. The recent rally, influenced by moderating inflation and the potential for rate cuts by central banks, presents both opportunities and challenges.
Moderating inflation data and prospects for lower interest rates are positive signs. A healthy labour market and consumer spending, along with the wealth effect from recent market gains, suggest potential for economic growth and improved corporate profits. However, the impact of high interest rates on the economy remains a concern.
Consumer spending resilience is under scrutiny, especially with persistent inflation in essential categories and the depletion of savings. This raises questions about the sustainability of consumer-driven growth in the near term.
The potential for corporate profit rebound in 2024 is uncertain. Companies may face challenges in enhancing earnings and cash flows due to cautious spending and economic uncertainty.
Despite the late-year surge in stock markets, it’s uncertain if this momentum can be sustained without significant corporate profit growth, especially given the current high valuation multiples. In addition, the global geopolitical landscape remains tense, adding another layer of uncertainty to market forecasts.
Amid these uncertainties, we advocate a strong focus on small-cap stocks for investors with a long-term horizon. Small caps currently show a relative valuation at a more than 20-year low versus large caps. Historically, small caps have outperformed large caps in environments with moderating but still high inflation and during periods of rate cuts by central banks.
Historically, the most substantial excess returns for small caps versus large caps are achieved early in an economic cycle, making this an opportune time for investment in small caps. While the economic landscape presents mixed signals, we remain confident in our ability to navigate these complexities and continue delivering strong results for our clients. Our focus remains on high-quality small-cap stocks, leveraging our time-tested investment philosophy and integrating ESG considerations into our decision-making process.
We scaled back positions in well-performing stocks for valuation and weight management:
- Computer Modelling Group
- Colliers International Group
- Goeasy
We initiated a new position:
- AutoCanada, a leading North American multi-location automobile dealership group, with significant share price upside given its new strategic plan (‘Project Elevate’) aimed at expanding margins through efficiency improvements.
We divested from certain positions to reallocate capital to more promising opportunities:
- AirBoss of America
- Boyd Group Services
- Stantec
These changes reflect our commitment to a focused, high-conviction, and well-researched investment approach.
Outlook
As we begin 2024, the market’s outlook is cautiously optimistic yet uncertain. The recent rally, influenced by moderating inflation and the potential for rate cuts by central banks, presents both opportunities and challenges.
Moderating inflation data and prospects for lower interest rates are positive signs. A healthy labour market and consumer spending, along with the wealth effect from recent market gains, suggest potential for economic growth and improved corporate profits. However, the impact of high interest rates on the economy remains a concern.
Consumer spending resilience is under scrutiny, especially with persistent inflation in essential categories and the depletion of savings. This raises questions about the sustainability of consumer-driven growth in the near term.
The potential for corporate profit rebound in 2024 is uncertain. Companies may face challenges in enhancing earnings and cash flows due to cautious spending and economic uncertainty.
Despite the late-year surge in stock markets, it’s uncertain if this momentum can be sustained without significant corporate profit growth, especially given the current high valuation multiples. In addition, the global geopolitical landscape remains tense, adding another layer of uncertainty to market forecasts.
Amid these uncertainties, we advocate a strong focus on small-cap stocks for investors with a long-term horizon. Small caps currently show a relative valuation at a more than 20-year low versus large caps. Historically, small caps have outperformed large caps in environments with moderating but still high inflation and during periods of rate cuts by central banks.
Historically, the most substantial excess returns for small caps versus large caps are achieved early in an economic cycle, making this an opportune time for investment in small caps. While the economic landscape presents mixed signals, we remain confident in our ability to navigate these complexities and continue delivering strong results for our clients. Our focus remains on high-quality small-cap stocks, leveraging our time-tested investment philosophy and integrating ESG considerations into our decision-making process.
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 December 31, 2023).
Portfolio performance returns are calculated using the time-weighted method and presented gross of management and trustee fees and withholding taxes.
* Note : June 30, 2000
Portfolio Positioning
Our U.S. small-cap strategy in 2023 navigated a dynamic market environment, characterized by significant shifts in investor sentiment and market trends. Despite challenges, the strategy maintained its strong performance record, reflecting our deep research capabilities and commitment to quality investments. In Q4 2023, our small-cap portfolio witnessed remarkable performance, led by cyclical stocks sensitive to interest rates.
Until the Federal Reserve’s pivot in mid-December, our small-cap strategy was on track to outperform the small-cap benchmark, benefiting from a risk-off environment. However, the year-end rally, driven by lower interest rate expectations, favored lower quality stocks, impacting our relative performance.
Our portfolio benefitted from a lack of exposure to the underperforming Energy sector and had higher weights in the Consumer Discretionary and Financials sectors, the best-performing areas in Q4. However, the rally’s focus on lower-quality stocks in these sectors didn’t align with our emphasis on established, high-quality investments.
The broad market recovery in Q4 presented challenges for active managers, particularly those with a quality bias. Nevertheless, our diversified sector exposure allowed us to participate actively in the market upswing. For the full year 2023, our small-cap strategy maintained the alpha generated in the first three quarters, culminating in meaningful excess returns relative to the Russell 2000 index. This marks the eighth year of outperformance in the past nine years, demonstrating our ability to navigate diverse market conditions effectively.
In a nutshell, our U.S. small-cap strategy’s performance in 2023 is a testament to our robust investment process and team’s expertise. We continue to leverage these strengths to deliver superior long-term returns for our clients, even amidst market uncertainties and shifting investor preferences.
Significant contributors to performance in Q4 2023:
- Installed Building Products (+47%) excelled as our top performer, driven by its resilient business model and effective pricing strategies.
- Armstrong World Industries (+37%), demonstrated strong pricing power and market share gains despite a slowing commercial construction sector.
- Bank OZK (+35%), benefiting from robust financials and positive investor sentiment towards the banking sector in anticipation of lower interest rates.
- Federal Signal, Qualys, Shake Shack, Hamilton Lane and DoubleVerify (all more than +25%), due to solid fundamentals, strong competitive positionings and healthy growth rates.
Stocks that detracted from performance in Q4 2023:
- Fox Factory (-31%), following its unexpected acquisition of Marucci and disappointing Q3 results.
- Marriott Vacations Worldwide (-15%)y, due to operational challenges.
- Iridium Communications (-9%), affected by delays and a terminated partnership with Qualcomm.
Portfolio Changes
In the December quarter, our portfolio underwent significant changes to capitalize on new opportunities and adjust to market movements.
New additions:
- Planet Fitness: Initiated a position following a ~40% pullback in share price. The company’s large scale in the HVLP gym industry, consistent same-store sales growth, and high market share offer a compelling long-term growth opportunity.
- Paylocity: Added this leading SaaS provider of HCM solutions. Its strong market position, high retention rate, and significant growth potential in the SMB sector present an attractive investment.
Exited positions:
- Paycor: Liquidated to reallocate funds to Paylocity, considering Paylocity’s longer operating history, profitability, and current undervaluation.
- Avantax: Sold after a binding acquisition offer from Cetera Financial Group, realizing full value from the investment.
Increased holdings:
- Charles River Laboratories: Added to the position due to its recent underperformance, which led to an attractive valuation.
- Envestnet: Increased holdings following a period of significant stock underperformance.
- Iridium Communications, Cerence, Grocery Outlet, Fox Factory, Silicon Laboratories, Ormat Technologies: Enhanced positions in these companies due to their underperformance and subsequent undervaluation.
Reduced positions:
- Qualys, Grand Canyon Education, Installed Building Products, Federal Signal, FTI Consulting, Blackbaud, Armstrong World Industries, StoneX Group, Hamilton Lane, DoubleVerify: Trimmed holdings due to strong performance and valuation expansion, leading to reduced upside potential and increased risk.
These portfolio adjustments reflect our proactive strategy to leverage market dynamics and maintain a balance of growth, value, and risk across our investments.
Outlook
As we enter 2024, our U.S. small-cap strategy faces a market influenced by significant recent rallies and evolving economic indicators. Our outlook is cautiously optimistic, yet we recognize the complexities ahead.
The easing of inflation and potential for rate cuts by the Federal Reserve signal positive developments. However, the full impact of previously high interest rates on the economy is yet to be realized. Consumer spending has been resilient, but ongoing inflationary pressures and depleted savings may limit future consumer-driven growth. The ability of companies to enhance earnings and cash flows in this challenging environment remains uncertain. Despite recent market surges, the need for a rebound in corporate profits is critical for sustained stock market performance.
2024 being a U.S. election year historically introduces some market volatility but often yields positive equity returns. However, the recent spike in valuation multiples across U.S. equities raises questions about the market’s ability to maintain its momentum without a significant improvement in corporate earnings. The current geopolitical environment adds another layer of uncertainty, potentially impacting market dynamics. Despite these challenges, we advocate a strong focus on small-cap stocks, particularly given their relative undervaluation versus large caps and historical outperformance in similar economic conditions.
Small caps currently present a more than 20-year low in relative valuation versus large caps, following one of the worst 5-year relative return periods through 2023. Historically, small caps have outperformed large caps in periods of moderating inflation and when the Federal Reserve begins reducing interest rates.
We start the year with a strong model portfolio, characterized by high-quality fundamentals and reasonable valuation, despite the strong returns in 2023. We are confident in our ability to sustain outperformance in 2024 and beyond, leveraging our expertise and time-tested strategies.
Exited positions:
- Paycor: Liquidated to reallocate funds to Paylocity, considering Paylocity’s longer operating history, profitability, and current undervaluation.
- Avantax: Sold after a binding acquisition offer from Cetera Financial Group, realizing full value from the investment.
Increased holdings:
- Charles River Laboratories: Added to the position due to its recent underperformance, which led to an attractive valuation.
- Envestnet: Increased holdings following a period of significant stock underperformance.
- Iridium Communications, Cerence, Grocery Outlet, Fox Factory, Silicon Laboratories, Ormat Technologies: Enhanced positions in these companies due to their underperformance and subsequent undervaluation.
Reduced positions:
- Qualys, Grand Canyon Education, Installed Building Products, Federal Signal, FTI Consulting, Blackbaud, Armstrong World Industries, StoneX Group, Hamilton Lane, DoubleVerify: Trimmed holdings due to strong performance and valuation expansion, leading to reduced upside potential and increased risk.
These portfolio adjustments reflect our proactive strategy to leverage market dynamics and maintain a balance of growth, value, and risk across our investments.
Outlook
As we enter 2024, our U.S. small-cap strategy faces a market influenced by significant recent rallies and evolving economic indicators. Our outlook is cautiously optimistic, yet we recognize the complexities ahead.
The easing of inflation and potential for rate cuts by the Federal Reserve signal positive developments. However, the full impact of previously high interest rates on the economy is yet to be realized. Consumer spending has been resilient, but ongoing inflationary pressures and depleted savings may limit future consumer-driven growth. The ability of companies to enhance earnings and cash flows in this challenging environment remains uncertain. Despite recent market surges, the need for a rebound in corporate profits is critical for sustained stock market performance.
2024 being a U.S. election year historically introduces some market volatility but often yields positive equity returns. However, the recent spike in valuation multiples across U.S. equities raises questions about the market’s ability to maintain its momentum without a significant improvement in corporate earnings. The current geopolitical environment adds another layer of uncertainty, potentially impacting market dynamics. Despite these challenges, we advocate a strong focus on small-cap stocks, particularly given their relative undervaluation versus large caps and historical outperformance in similar economic conditions.
Small caps currently present a more than 20-year low in relative valuation versus large caps, following one of the worst 5-year relative return periods through 2023. Historically, small caps have outperformed large caps in periods of moderating inflation and when the Federal Reserve begins reducing interest rates.
We start the year with a strong model portfolio, characterized by high-quality fundamentals and reasonable valuation, despite the strong returns in 2023. We are confident in our ability to sustain outperformance in 2024 and beyond, leveraging our expertise and time-tested strategies.
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 December 31, 2023).
Portfolio performance returns are calculated using the time-weighted method and presented gross of management and trustee fees and withholding taxes.
* Note : December 31, 2011
Portfolio Positioning
The final quarter of the year brought significant geopolitical upheavals that, along with ongoing global uncertainties, reinforced the perception of U.S. markets as a safe haven, prompting increased fund flows out of Asia and into the U.S. This shift resulted in a marked decline in Asian markets.
Despite these challenges, our outlook on China remains cautiously optimistic. Critics have likened China’s current situation to Japan’s prolonged economic stagnation, but such comparisons may be premature. China is actively restructuring its property sector responsibly, avoiding excessive monetary stimulus. The country is also focusing on higher-quality growth, as evidenced by its leadership in green energy, its burgeoning high-end exports, and efforts to rebalance wealth inequality. These initiatives suggest a strategic shift to break free from the middle-income trap. Amidst this backdrop, we have identified compelling investment opportunities in high-quality companies at attractive valuations. Our portfolio, now streamlined to 45 names, reflects a focus on companies with strong growth prospects both within and outside China. Our selection process is designed to identify companies with robust strategic resources and DNA that can thrive regardless of economic cycles or geopolitical tensions. Our top 10 holdings now constitute 39.7% of the portfolio, down from 36.2% in the previous quarter. This concentration effort includes significant positions in companies like Geely, Techtronic, Kulicke, Trip.com, and Samsonite. Additionally, we adjusted our exposure in sectors affected by regulatory measures and geopolitical issues, shifting from CICC and Bank of China Aviation to Kerry Logistics and Techtronic. We also increased our stake in the healthcare sector, particularly in CSPC, following a settling of anti-corruption initiatives.
Morgan Stanley’s analysis of the MSCI China as a historically mean-reverting asset class underscores the potential for a positive shift in sentiment and performance in 2024. Despite current challenges, we remain committed to leveraging these market dynamics, focusing on robust stock selection and strategic portfolio management to navigate the less synchronized global economies in the coming decade.
Our portfolio saw significant contributions from five top performers in the quarter, cumulatively adding 4.4% to overall performance. iFAST excelled with a 52% increase, driven by a rebound in margins and promising prospects from its Hong Kong retirement plan IT platform. Techtronic, up 23%, benefited from misconceptions about its market focus and dispelled negative sentiment with strong guidance reaffirmation. Largan surged 42%, gaining momentum from periscope lens penetration and an uptick in high-end smartphone sales in China. Chicony Electronics, with a 60% rise, impressed investors with robust margins and growing interest in AI PCs and keyboards. New Oriental, up 17%, continued its strong performance, recognized for its dominant market position in education despite reduced competition, leading us to trim the position from over 4% to 2% as it surpassed our DCF valuation.
Portfolio Changes
In Q4 2023, our portfolio underwent strategic shifts to optimize performance:
- Exited holdings: We sold shares in CICC, Coli Prop, Li Ning, New Oriental, Viva China, and Bank of China Aviation. These sales were driven by a need to rebalance and capitalize on other emerging opportunities.
- New investments: Proceeds from the sales were redirected into promising sectors and companies. Key investments include CSPC in the healthcare sector, Kerry Logistics, Galaxy, Techtronic, and Yum China.
- Strategic buy: Kerry Logistics was purchased at around $7 HKD after a previous sale at $11.50, capitalizing on overly bearish sentiment about the company’s fundamentals. An unexpected special dividend from their Thailand subsidiary further underscored our decision.
- A new addition: Weichai, a leader in Automotive Engine and Parts Manufacturing, was added to our portfolio in both A-share and H-share forms. Weichai’s diverse product range, market leadership in heavy-duty trucks, and advanced technologies make it a strong competitor in the Chinese market.
These portfolio changes reflect our ongoing commitment to seeking high-quality investments with strong growth potential and aligning with broader market trends and opportunities.
Outlook
As we navigate through the current macroeconomic landscape, our outlook remains focused on identifying long-term compounders despite the challenging environment, particularly in relation to China. The negative sentiment and macro narrative against China have reached an extreme, with the MSCI All Country Asia Pacific index reflecting an all-time low in Chinese exposure, which we interpret as a contrarian bullish signal. Despite skepticism about Chinese policy responses, our commitment is unwavering in finding companies with strong growth potential both within and outside China.
Our approach doesn’t involve predicting Federal Reserve rate cycles or forecasting the implications of a potential US recession in an election year. Instead, we concentrate on building a portfolio of the best 45 alpha opportunities in the Asia region. With the anticipated Federal Reserve easing potentially weakening the US dollar, we expect fund flows to return to Asia. Additionally, emerging market central banks possess more levers to stimulate their economies compared to developed countries, providing a supportive backdrop.
Interestingly, the broad money growth acceleration in the US (M2) was at 18% from February 2020 to December 2020, while China’s growth was more modest at 1.3%. Other countries like Korea, Japan, and Taiwan also showed lower growth rates, in the low single digits. This disparity in monetary expansion underscores the different fiscal approaches and potential impacts on the markets.
Looking ahead, 2024 holds significant potential for shifting narratives around Chinese stocks, influenced by four key factors: a weaker US dollar boosting the renminbi, post-COVID savings increases aiding retail sales recovery, additional government property support, and the low valuations of Chinese stocks signaling capitulation. These factors, individually or collectively, could rapidly change the investment landscape.
Moreover, stock buyback activities have been notable in the market, with room for growth, given the cash-rich positions and strong balance sheets of many companies in Asia. The year 2023 posed substantial challenges, even exceeding those of the 2008 credit crisis, as we selected strong companies but faced disappointing returns and client hesitancy towards the region. However, embracing Winston Churchill’s ethos of not wasting a crisis, our team diligently scoured various countries for fitting opportunities to enhance our portfolio across Asia.
Our resolve is to persevere with our time-tested approach in discovering exceptional investment opportunities and maintaining them for the long haul. While acknowledging the complexities of the current macroeconomic environment, particularly with regard to China and the broader Asian markets, we remain steadfast in our strategy. Our focus is on uncovering high-quality investments that can withstand and thrive amid market fluctuations, thereby positioning our portfolio for continued success.
These portfolio changes reflect our ongoing commitment to seeking high-quality investments with strong growth potential and aligning with broader market trends and opportunities.
Outlook
As we navigate through the current macroeconomic landscape, our outlook remains focused on identifying long-term compounders despite the challenging environment, particularly in relation to China. The negative sentiment and macro narrative against China have reached an extreme, with the MSCI All Country Asia Pacific index reflecting an all-time low in Chinese exposure, which we interpret as a contrarian bullish signal. Despite skepticism about Chinese policy responses, our commitment is unwavering in finding companies with strong growth potential both within and outside China.
Our approach doesn’t involve predicting Federal Reserve rate cycles or forecasting the implications of a potential US recession in an election year. Instead, we concentrate on building a portfolio of the best 45 alpha opportunities in the Asia region. With the anticipated Federal Reserve easing potentially weakening the US dollar, we expect fund flows to return to Asia. Additionally, emerging market central banks possess more levers to stimulate their economies compared to developed countries, providing a supportive backdrop.
Interestingly, the broad money growth acceleration in the US (M2) was at 18% from February 2020 to December 2020, while China’s growth was more modest at 1.3%. Other countries like Korea, Japan, and Taiwan also showed lower growth rates, in the low single digits. This disparity in monetary expansion underscores the different fiscal approaches and potential impacts on the markets.
Looking ahead, 2024 holds significant potential for shifting narratives around Chinese stocks, influenced by four key factors: a weaker US dollar boosting the renminbi, post-COVID savings increases aiding retail sales recovery, additional government property support, and the low valuations of Chinese stocks signaling capitulation. These factors, individually or collectively, could rapidly change the investment landscape.
Moreover, stock buyback activities have been notable in the market, with room for growth, given the cash-rich positions and strong balance sheets of many companies in Asia. The year 2023 posed substantial challenges, even exceeding those of the 2008 credit crisis, as we selected strong companies but faced disappointing returns and client hesitancy towards the region. However, embracing Winston Churchill’s ethos of not wasting a crisis, our team diligently scoured various countries for fitting opportunities to enhance our portfolio across Asia.
Our resolve is to persevere with our time-tested approach in discovering exceptional investment opportunities and maintaining them for the long haul. While acknowledging the complexities of the current macroeconomic environment, particularly with regard to China and the broader Asian markets, we remain steadfast in our strategy. Our focus is on uncovering high-quality investments that can withstand and thrive amid market fluctuations, thereby positioning our portfolio for continued success.
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 (as of December 31, 2023).
Portfolio performance returns are calculated using the time-weighted method and presented gross of management and trustee fees and withholding taxes.
* Note : September 30, 2017
Portfolio Positioning
In 2023, our U.S. small-cap strategy experienced a dynamic year marked by strategic portfolio adjustments and notable stock performances:
The final quarter of 2023 saw allocation driving two-thirds of our outperformance, a deviation from the norm where selection typically prevails. The energy sector’s underperformance, where we had no investments, significantly contributed to this. IT and Industrials sectors were key selection contributors, while Consumer Discretionary, particularly FOX Factory, was the primary detractor.
Installed Building Products (IBP) delivered a standout Q4 with a 47% return, culminating in a 113% annual return. Its resilience in the face of high mortgage rates and substantial demand for new construction led to robust revenue growth and margin leverage. We anticipate strong performance in 2024, driven by a significant backlog in multi-family homes.
On an annual basis, stock selection was paramount, contributing over 200 basis points to outperformance, complemented by allocation contributing around 130 basis points. The portfolio yielded a return of over 21%, with Consumer Discretionary and IT being significant contributors, and no exposure to Energy, Materials, and Real Estate. Industrials sector underweight was a slight drag despite strong stock returns within the sector.
Throughout 2023, we reduced overweight positions in Consumer Discretionary and Financials, taking profits and exiting certain stocks. Industrials sector, where finding attractively valued stocks has been challenging, saw a gradual increase in investment.
Seven new stocks were added, including First Advantage, FTI Consulting, Grocery Outlet, Paylocity, Planet Fitness, PTC, and BioTechne. Conversely, six stocks were exited: BOKF, Digital Ocean, Thermon, Take Two Interactive, Marriott Vacations Worldwide, and Virtu Financial. This activity brought the total portfolio holdings to 42 by year-end, maintaining our strategy of one in, one out, and a consistent number of holdings since inception.
Our approach remains focused on quality over macro or tactical outlooks, with turnover driven primarily by market opportunities or acquisitions. The minor sell-off in late Q3 and early Q4 allowed us to introduce three new high-quality stocks at attractive valuations.
Entering 2024, our balanced and well-constructed portfolio is poised to navigate the evolving market landscape, leveraging our disciplined investment approach and commitment to high-quality small-cap investments.
Portfolio Changes
In the fourth quarter, our portfolio experienced notable changes, reflecting our ongoing commitment to optimizing investment opportunities.
Sold stocks:
- DigitalOcean: Decision to sell was based on concerns about the CEO’s departure and ongoing challenges in the company’s balance sheet and competitive positioning.
- Marriott Vacations: Sold due to challenges in recovering profitability, including issues with sales associates, difficulties in member upgrades, and rising default rates in timeshare purchases.
New additions:
- First Advantage: Chosen for its leading role in the employment screening industry, offering integrated services with Human Capital Management software. Strong financial model with high cash flow and returns on equity.
- Planet Fitness: Added for its dominance in the HVLP fitness club market and robust marketing strategy. The company’s mission focuses on non-intimidating, affordable fitness experiences, contributing to its significant market share.
Completed initiation:
- Paylocity: Finalized our position in this cloud-based HCM solutions provider, attracted by its extensive market opportunity, robust growth, and effective management team. Its focus on mid-market businesses and high market potential were key factors.
These strategic moves reflect our diligent approach to navigating the evolving market landscape, aiming to balance growth potential with risk management and maintain a diverse, high-quality investment portfolio.
Outlook
As we embark on 2024, the financial landscape presents a complex yet cautiously optimistic outlook. The Federal Reserve’s recent decisions hint at a soft-landing scenario, shifting from a recessionary stance to a more stable economic forecast. This change aligns with our consistent approach of focusing on high-quality, low-leverage, and attractively valued stocks, regardless of macroeconomic fluctuations.
Economic growth in 2024, as per FOMC projections, is expected to moderate to 1.4% GDP growth, slightly down from 2023’s 2.6%. Inflation, a key economic factor, is showing signs of easing, particularly in the Federal Reserve’s preferred core Personal Consumer Expenditure (Core CPE) measure. The deceleration in durable and non-durable goods inflation is notable, attributed largely to supply chain normalization. The primary concern for 2024 revolves around service inflation, closely tied to labor market dynamics and worker compensation.
The Federal Reserve’s Dot plot anticipates a series of rate cuts starting as early as the first quarter of 2024, indicating a potential easing of monetary conditions. This scenario supports a soft-landing outlook, fostering a conducive environment for market growth. Additionally, the 2024 presidential election in the U.S. adds a layer of complexity, historically bringing positive market returns regardless of the election outcome.
In this context, small and mid-cap stocks are poised for a positive trajectory in 2024. The late 2023 rally in these sectors, driven by multiple expansion, sets the stage for continued growth, especially as rates begin to decline. A shift in investment from large-cap and money market funds to broader markets is anticipated, benefiting small and mid-cap stocks due to their higher sensitivity to domestic economic changes.
The current market conditions suggest a limited downside risk. With substantial cash reserves in large-cap stocks and an economy expected to maintain stability, the stage is set for rate reductions from Q1 2024 onwards. This backdrop, combined with the historical market uplift during election years, indicates a promising year ahead for indices like the Russell 2000 and Russell 2500.
Our strategy remains unwavering: we continue to prioritize resilience and quality in our portfolio selections. The potential for rate changes does not alter our approach. Our portfolio has demonstrated robustness through challenging rate environments. Our focus is on continually enhancing the portfolio with top-tier candidates, ensuring we are well-positioned to capitalize on opportunities that 2024 may present.
Completed initiation:
- Paylocity: Finalized our position in this cloud-based HCM solutions provider, attracted by its extensive market opportunity, robust growth, and effective management team. Its focus on mid-market businesses and high market potential were key factors.
These strategic moves reflect our diligent approach to navigating the evolving market landscape, aiming to balance growth potential with risk management and maintain a diverse, high-quality investment portfolio.
Outlook
As we embark on 2024, the financial landscape presents a complex yet cautiously optimistic outlook. The Federal Reserve’s recent decisions hint at a soft-landing scenario, shifting from a recessionary stance to a more stable economic forecast. This change aligns with our consistent approach of focusing on high-quality, low-leverage, and attractively valued stocks, regardless of macroeconomic fluctuations.
Economic growth in 2024, as per FOMC projections, is expected to moderate to 1.4% GDP growth, slightly down from 2023’s 2.6%. Inflation, a key economic factor, is showing signs of easing, particularly in the Federal Reserve’s preferred core Personal Consumer Expenditure (Core CPE) measure. The deceleration in durable and non-durable goods inflation is notable, attributed largely to supply chain normalization. The primary concern for 2024 revolves around service inflation, closely tied to labor market dynamics and worker compensation.
The Federal Reserve’s Dot plot anticipates a series of rate cuts starting as early as the first quarter of 2024, indicating a potential easing of monetary conditions. This scenario supports a soft-landing outlook, fostering a conducive environment for market growth. Additionally, the 2024 presidential election in the U.S. adds a layer of complexity, historically bringing positive market returns regardless of the election outcome.
In this context, small and mid-cap stocks are poised for a positive trajectory in 2024. The late 2023 rally in these sectors, driven by multiple expansion, sets the stage for continued growth, especially as rates begin to decline. A shift in investment from large-cap and money market funds to broader markets is anticipated, benefiting small and mid-cap stocks due to their higher sensitivity to domestic economic changes.
The current market conditions suggest a limited downside risk. With substantial cash reserves in large-cap stocks and an economy expected to maintain stability, the stage is set for rate reductions from Q1 2024 onwards. This backdrop, combined with the historical market uplift during election years, indicates a promising year ahead for indices like the Russell 2000 and Russell 2500.
Our strategy remains unwavering: we continue to prioritize resilience and quality in our portfolio selections. The potential for rate changes does not alter our approach. Our portfolio has demonstrated robustness through challenging rate environments. Our focus is on continually enhancing the portfolio with top-tier candidates, ensuring we are well-positioned to capitalize on opportunities that 2024 may present.
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 December 31, 2023).
Portfolio performance returns are calculated using the time-weighted method and presented gross of management and trustee fees and withholding taxes.
* Note : July 31, 2022
Portfolio Positioning
It was a December to remember. The quarter commenced with the ongoing uncertainty in the market that had persisted throughout the year. As previously mentioned, some regions experienced an unprecedented valuation gap between small-cap and large-cap stocks. However, while engaging with companies from various sectors and geographical areas, it became evident that there was a disparity between the resilient fundamentals and the prevailing bearish market sentiment. Amidst this uncertainty, we adhered to our process and leveraged the market sell-offs to acquire positions in high-quality companies at discounted prices. We were fortunate to be in a position of strength as two takeouts in our portfolio during the quarter gave us room to redeploy capital.
Just as we were wondering what would trigger a mean reversion, the Federal Reserve pivoted. Within a few weeks in December, the portfolio, which had been range-bound all year, roared back to life.
The suddenness and magnitude of the rally reminded us once again 1) attempting to time the market is a futile endeavor; 2) fundamentals matter. We are pleased to end the quarter with 374 bps alpha and even more pleased that the portfolio once again performed in line with the intended design.
One noteworthy area of outperformance stemmed from European small-cap stocks. Throughout the year, we witnessed substantial sell-offs in European small-cap names, irrespective of their underlying fundamentals. Some of this can be attributed to fund flows, while others are driven by specific events.
Despite a 21% rally in Q4 for the European small-cap within our portfolio, as a group, they are still trading significantly below their intrinsic value. This suggests ample room for further upward revaluation. In cases where the disparity is substantial, private market players tend to step in, as seen with Musti, which received a management buyout offer at a 27% premium to its previous day trading price.
In the United States, the Federal Reserve’s indication of an end to rate hikes led to an impressive year-end rally, particularly benefiting the cyclical stocks in our portfolio, especially in the financial and consumer discretionary sectors. However, we maintain a cautious stance towards overly optimistic outlooks.
While the fundamentals have improved to some extent, the economic landscape is far from operating at full capacity. Consumer sentiment remains subdued, and the impacts of inflation and interest rates on businesses continue to be a concern. We believe that while the worst may be behind us, the path to a full-fledged economic boom is far from straightforward.
In Asia, the quarter was relatively benign, with China continuing to grapple with economic challenges. My recent travels to the region, including China, Hong Kong, Taiwan, and Japan, reaffirmed that the structural issues facing the greater China region will require years, rather than quarters, to rectify.
However, this sentiment is largely reflected in the depressed valuations. Interestingly, Japan is viewed as a more attractive market than China for the first time in decades, and local authorities and market participants are poised to capitalize on this opportunity. We anticipate further market-friendly reforms in the near future.
Significant contributors to performance in Q4 2023 include:
- Musti (52.03%)
- SES Imagotag (28.3%)
- Federal Signal (28.7%)
Stocks that detracted from our portfolio’s performance in Q4 2023:
- Marlowe (-23.1%)
- Inmode (-26.46%)
- Marriott Vacation Club (-14.88%)
Portfolio Changes
Through the quarter, we had two portfolio companies that announced they will be acquired (Avantax, Musti). We took advantage of the opportunity to rotate the capital into new names from our approved list which contributed to a higher than normal turnover of the portfolio. New additions are the following:
- SMS Co: A leading platform focused on the placement of senior care and medical professionals in Japan. SMS also offers medical marketing, clinical decision support, and health care recruiting globally.
- Technopro: A specialized engineering outsourcing and consulting firm in Japan with 20,000+ engineers with expertise in a range of fields such as software, manufacturing, and chemicals. These engineers are deployed to TechnoPro’s clients on a non-permanent basis to drive or assist with scaling up R&D and operational projects.
- MDA: A technology company focused on space robotics, satellite, and geointelligence systems. It designs, manufactures, and services key systems and components for applications in national security, climate change monitoring, maritime surveillance.
- Cerence: A tier one supplier to automotive OEMs focused on voice-controlled applications in the mobility sector. It offers a conversational Ai platform integrating edge and cloud-connected components, and is tailored for specific transportation verticals.
- Samsonite: A global luggage company with a portfolio of brands (Samsonite, American Tourister, Tumi, etc) with growing market share and dominant distribution channels.
- Paylocity: A cloud-based payroll and human capital management company focused on medium-sized organizations. It offers among others, payroll, tax, and talent management solutions.
We exited AVTA, MUSTI from acquisition and Inmode at the onset of the conflict in the Middle East.
Outlook
In North America, our sentiments are mixed regarding the substantial rally that transpired. While the moderation of inflation and the possibility of rate cuts offer some assurance that the worst may be behind us, we are acutely aware that the true impact of higher interest rates on both businesses and consumers has yet to fully materialize in the economy. Consequently, we maintain a cautious stance, anticipating that real profits may not experience a significant rebound in 2024 and beyond. Furthermore, with 2024 being an election year, a time historically marked by increased market volatility, albeit with a positive bias, we remain watchful of the potential market dynamics.
Turning to Europe, the year saw subdued sentiment and outlooks. Although one could argue that things are not deteriorating further, a sense of ongoing conflict fatigue has settled over the region, leading us to believe that any progress toward peace talks in Ukraine would be a welcome boost to sentiment. From a fundamental standpoint, we also discern signs of improvement, particularly as earnings expectations are conservatively set for 2024. We maintain our conviction that European small-cap stocks represent the most attractive asset class, offering asynchronous growth prospects and heavily discounted valuations. These smaller companies have the potential to outpace their larger counterparts significantly while trading at substantial discounts, a compelling proposition for us.
In Asia, we are witnessing China rapidly advancing towards technological independence from the West. In fact, their progress in this regard appears to outpace the Western world’s decoupling from the Chinese supply chain. This dynamic creates a complex situation for neighboring economies such as Taiwan (which sends a significant portion of its exports to China) and Japan (also heavily reliant on China for exports). They are faced with the challenge of complying with US regulations while also retaining their most significant client. As we witness the escalation of geopolitical tensions, we remain vigilant regarding potential impacts on the global supply chain.
While we welcomed the year-end rally, our fundamental perspective remains unchanged. We maintain an optimistic outlook but anticipate a potentially turbulent road ahead for global markets. On a positive note, fundamentals within our portfolio companies have stabilized, with signs of growth emerging through increased M&A activities. Supply chain bottlenecks are receding into the rearview mirror, inventory levels are being reduced, and wage inflation appears to be easing. We also believe that expectations have been adjusted to a more realistic outlook. However, consumer spending and sentiment continue to face pressure, and geopolitical tensions are poised to rise, especially in a year with a significant number of global elections. In sum, amidst this uncertain outlook, we remain steadfast in our belief that opportunities exist for selective investments in best-of-breed companies at reasonable prices.
- SMS Co: A leading platform focused on the placement of senior care and medical professionals in Japan. SMS also offers medical marketing, clinical decision support, and health care recruiting globally.
- Technopro: A specialized engineering outsourcing and consulting firm in Japan with 20,000+ engineers with expertise in a range of fields such as software, manufacturing, and chemicals. These engineers are deployed to TechnoPro’s clients on a non-permanent basis to drive or assist with scaling up R&D and operational projects.
- MDA: A technology company focused on space robotics, satellite, and geointelligence systems. It designs, manufactures, and services key systems and components for applications in national security, climate change monitoring, maritime surveillance.
- Cerence: A tier one supplier to automotive OEMs focused on voice-controlled applications in the mobility sector. It offers a conversational Ai platform integrating edge and cloud-connected components, and is tailored for specific transportation verticals.
- Samsonite: A global luggage company with a portfolio of brands (Samsonite, American Tourister, Tumi, etc) with growing market share and dominant distribution channels.
- Paylocity: A cloud-based payroll and human capital management company focused on medium-sized organizations. It offers among others, payroll, tax, and talent management solutions.
We exited AVTA, MUSTI from acquisition and Inmode at the onset of the conflict in the Middle East.
Outlook
In North America, our sentiments are mixed regarding the substantial rally that transpired. While the moderation of inflation and the possibility of rate cuts offer some assurance that the worst may be behind us, we are acutely aware that the true impact of higher interest rates on both businesses and consumers has yet to fully materialize in the economy. Consequently, we maintain a cautious stance, anticipating that real profits may not experience a significant rebound in 2024 and beyond. Furthermore, with 2024 being an election year, a time historically marked by increased market volatility, albeit with a positive bias, we remain watchful of the potential market dynamics.
Turning to Europe, the year saw subdued sentiment and outlooks. Although one could argue that things are not deteriorating further, a sense of ongoing conflict fatigue has settled over the region, leading us to believe that any progress toward peace talks in Ukraine would be a welcome boost to sentiment. From a fundamental standpoint, we also discern signs of improvement, particularly as earnings expectations are conservatively set for 2024. We maintain our conviction that European small-cap stocks represent the most attractive asset class, offering asynchronous growth prospects and heavily discounted valuations. These smaller companies have the potential to outpace their larger counterparts significantly while trading at substantial discounts, a compelling proposition for us.
In Asia, we are witnessing China rapidly advancing towards technological independence from the West. In fact, their progress in this regard appears to outpace the Western world’s decoupling from the Chinese supply chain. This dynamic creates a complex situation for neighboring economies such as Taiwan (which sends a significant portion of its exports to China) and Japan (also heavily reliant on China for exports). They are faced with the challenge of complying with US regulations while also retaining their most significant client. As we witness the escalation of geopolitical tensions, we remain vigilant regarding potential impacts on the global supply chain.
While we welcomed the year-end rally, our fundamental perspective remains unchanged. We maintain an optimistic outlook but anticipate a potentially turbulent road ahead for global markets. On a positive note, fundamentals within our portfolio companies have stabilized, with signs of growth emerging through increased M&A activities. Supply chain bottlenecks are receding into the rearview mirror, inventory levels are being reduced, and wage inflation appears to be easing. We also believe that expectations have been adjusted to a more realistic outlook. However, consumer spending and sentiment continue to face pressure, and geopolitical tensions are poised to rise, especially in a year with a significant number of global elections. In sum, amidst this uncertain outlook, we remain steadfast in our belief that opportunities exist for selective investments in best-of-breed companies at reasonable prices.
