Although small caps saw much milder declines in the third quarter, this period ended under very challenging market conditions after central banks made it clear that their priority is fighting inflation and raising rates.
Market Review
After very painful first and second quarters, it would have been reasonable to expect reprieve in the third quarter from the dramatic declines across asset classes and categories.
At the end of the second quarter, world equity markets looked oversold, with stock prices seemingly discounting a rapidly worsening macroeconomic conditions and significantly compressed valuation multiples. The third quarter, as a result, got off to a great start. After a rally in July, however, U.S., Canadian and Eurozone equities (and many other risk assets) slide back into negative territory due to an ever-deteriorating geopolitical and macro climate.
As investors became almost unanimously convinced that the economic cycle would not escape a dire fate, sentiment quickly soured, pushing down stocks, bonds, commodities and currencies in unison. The third quarter, as a result, saw steep declines for U.S., Canadian and Eurozone equities and most other asset classes.
Although both U.S., Canadian and Eurozone large caps and small caps saw much milder declines in the third quarter (relative to the second quarter), this period ended under very challenging market conditions.
Due to relentless and sustained high inflation data, the U.S. Federal Reserve, Bank of Canada, European Central Bank and Bank of England had to maintain a hawkish stance to fight and tame inflation. Investors, as a result, had to digest another round of significant benchmark interest rate hikes, with clear signals that more rate hikes were on the way. The spectre of a more significant recession started to loom larger, dampening sentiment further and hitting risk assets hard.
In the third quarter, the new fiscal plan released by the U.K. government added more fuel to the fire, causing the British pound to collapse to a 37-year low against the U.S. dollar. As British interest rates soared to shore up the currency and market confidence, fears escalated that this region’s ills could spread to financial markets worldwide.
Chinese stocks were also on solid footing in July, with investors redeploying cash to the region and the global liquidity situation waning.
By late August, sentiment soured quickly, turning prior gains into losses for the quarter. For China, Nancy Pelosi’s trip to Taiwan reignited concerns of a war in the South China Sea, dampening sentiment toward the region. In September, the strong U.S. dollar and the Fed’s outlook led to fears of another emerging market crisis, prompting intervention by the Bank of Japan for the first time since 1998 in support of the Yen and policy interest rate hikes by Asian Central banks to shore up the yuan, Taiwan dollar and Korean won.
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 September 30, 2022).
*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 : 06/30/1992
Portfolio Positioning
In the third quarter, we posted a positive gain, outperforming the TSX Small Cap Index and adding solid value—despite significant market volatility, souring investor sentiment and a heavy risk-off environment. This backdrop was favourable to our investment style and our positioning into high-quality small-cap stocks, offsetting even more of our year-to-date shortfall in our relative returns from earlier this year.
While company-specific fundamentals did not matter much to investors in a year plagued by major, very painful macro events, we believe that our positions in some of the very best small-cap companies in our universe have ultimately been the key driver of our recent strong relative returns and our ability to withstand this very challenging backdrop.
The dramatic Q1 energy sector rally stalled and reversed in Q2 and Q3, alongside a pullback in energy prices. Despite this reversal in performance, the energy sector still managed to significantly outperform the broader small-cap market YTD, supported by very healthy oil and gas prices. Hence, our continued lack of exposure to energy remains a headwind to our relative performance YTD, although we are gradually closing the gap in terms of relative performance.
Ultimately, our careful stock selection saved the day once again, generating significant value-add and excess returns in the third quarter. Our investments in high-conviction, high-quality small-cap stocks with vastly superior fundamentals proved to be a winning strategy. Once again, most of our portfolio companies coped quite well despite ever-growing inflationary pressures, exhibiting both strong pricing power and substantial cost efficiencies and, in turn, delivering solid financial results.
Against a backdrop of soaring interest rates, our portfolio remains very well positioned, with low levels of leverage and no directly negative exposure to higher rates. With the portfolio currently trading almost 20% below intrinsic value, we will likely add significant absolute and relative value when the geopolitical, economic and commodity environments normalize.
Significant contributors to performance in Q3 2022 (in terms of bps) include: IBI Group (+35.3%), Aritzia (+35.0%), Boyd Group Services Inc. (+27.1%), Element Fleet Management Corp. (+22.5%) and Richelieu Hardware (+12.2%).
Stocks that detracted from our portfolio’s performance in Q3 2022 (in terms of bps) include AirBoss of America Corp. (-41.7%), CAE (-30.3%), SYZ (-16.6%), CWB Financial Group (-11.2%) and Colliers International Group (-8.1%).
Portfolio Changes
We continued to enhance the quality and long-term positioning of our model portfolio through our research on very promising, high-quality investment candidates and our targeted portfolio activity. As a result, our portfolio changes were focused on adding long-term alpha to the portfolio:
- We added to our positions in some of our high-conviction holdings, where the current valuations no longer fairly reflected the long-term organic and acquisition growth potential of these companies.
- We trimmed our positions in some of our long-term winners, such as Pet Valu Holdings, due to valuation and weight management considerations.
- We initiated three new positions: Spin Master Corp., Uni-Select and goeasy Ltd.
- We sold off three positions: CCL Industries, IBI Group and Definity Financial Corporation.
- We recycled the proceeds from the sale of CCL Industries, IBI Group and Definity Financial Corporation in other smaller-cap names with a more attractive risk-reward.
Outlook
Given a backdrop of high inflation and rising interest rates, It looks almost impossible for the Bank of Canada and other central banks worldwide to tame inflation without significantly dampening consumer and business demand and hurting the economy in the process. Under any realistic scenario, investors should brace for a probable recession in Canada and elsewhere in the coming months.
Investors also should not be surprised to see some steady downward revisions to corporate profits for this year and 2023—for Canadian companies of all sizes. The one saving grace is the weak Canadian dollar, which will likely be a tailwind for both small and large caps (and many of our holdings). Since no major components of the economy seem to be seriously impaired or structurally damaged and the labour market has remained stubbornly healthy, we should see a relatively modest or “normal” recession by historical standards.
We strongly believe that, after what’s been a meaningful bear market in our small-cap universe, most of the impending or forthcoming economic downturn is already priced into our portfolio stocks and many other small-cap companies. High-quality small-cap companies, as a result, have already assumed a meaningful cut to their earnings estimates and are now trading at very appealing valuations.
For all the gloom and doom in our market, our positions in high-quality, reasonably valued, profitable small-cap companies should lead to robust long-term returns and significant alpha over our benchmark. In fact, our portfolio is currently trading at a 20%+ discount to its intrinsic value based on conservative assumptions, a level seen only twice in the past 15 years (in 2008 and 2020).
While we are not attempting to find a bottom in this challenging market environment, we are convinced that investors with multi-year investment horizons should see very attractive returns from the current highly attractive valuation levels of our small-cap portfolio.
- We added to our positions in some of our high-conviction holdings, where the current valuations no longer fairly reflected the long-term organic and acquisition growth potential of these companies.
- We trimmed our positions in some of our long-term winners, such as Pet Valu Holdings, due to valuation and weight management considerations.
- We initiated three new positions: Spin Master Corp., Uni-Select and goeasy Ltd.
- We sold off three positions: CCL Industries, IBI Group and Definity Financial Corporation.
- We recycled the proceeds from the sale of CCL Industries, IBI Group and Definity Financial Corporation in other smaller-cap names with a more attractive risk-reward.
Outlook
Given a backdrop of high inflation and rising interest rates, It looks almost impossible for the Bank of Canada and other central banks worldwide to tame inflation without significantly dampening consumer and business demand and hurting the economy in the process. Under any realistic scenario, investors should brace for a probable recession in Canada and elsewhere in the coming months.
Investors also should not be surprised to see some steady downward revisions to corporate profits for this year and 2023—for Canadian companies of all sizes. The one saving grace is the weak Canadian dollar, which will likely be a tailwind for both small and large caps (and many of our holdings). Since no major components of the economy seem to be seriously impaired or structurally damaged and the labour market has remained stubbornly healthy, we should see a relatively modest or “normal” recession by historical standards.
We strongly believe that, after what’s been a meaningful bear market in our small-cap universe, most of the impending or forthcoming economic downturn is already priced into our portfolio stocks and many other small-cap companies. High-quality small-cap companies, as a result, have already assumed a meaningful cut to their earnings estimates and are now trading at very appealing valuations.
For all the gloom and doom in our market, our positions in high-quality, reasonably valued, profitable small-cap companies should lead to robust long-term returns and significant alpha over our benchmark. In fact, our portfolio is currently trading at a 20%+ discount to its intrinsic value based on conservative assumptions, a level seen only twice in the past 15 years (in 2008 and 2020).
While we are not attempting to find a bottom in this challenging market environment, we are convinced that investors with multi-year investment horizons should see very attractive returns from the current highly attractive valuation levels of our small-cap portfolio.
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 September 30, 2022).
* Note : June 30, 2000
Portfolio Positioning
Low-quality small-cap stocks, surprisingly and significantly, led the way in the third quarter, despite considerable market volatility, souring investor sentiment and heavy risk-off environment. As a result, the stocks of low-ROE, low-quality, unprofitable and speculative companies outperformed during this period, creating a steep headwind for our investment style.
Within our small-cap market, our portfolio companies with a higher percentage of total revenue from outside the U.S. generally underperformed in the third quarter, due to worrisome geopolitical developments and the significant weakening of most foreign currencies against the U.S. dollar.
Investors were also much more focused on macro events than company-specific fundamentals, significantly reducing the ability of investors to generate differentiated and excess returns through security selection. Sector allocation, however, was slightly favourable to us during this period.
While our lack of direct exposure to the energy sector, the best-performing area of our market, was once again a clear negative to our relative returns this past quarter, healthy relative returns from our much larger relative exposure to the consumer discretionary sector and our underexposure to the underperforming real estate, materials, consumer staples and utilities sectors offset this shortfall.
Although we underperformed significantly early in the quarter, we recovered most of the shortfall in our relative returns in September, when small caps experienced a meaningful pullback and the environment became much more favorable to our portfolio positioning.
Our strategy, despite its modest underperformance in the third quarter, remains well ahead of its benchmark for the year-to-date period. Although company-specific fundamentals did not matter much to investors plagued by very difficult macro conditions, our positions in some of the very best small-cap companies have ultimately been the key driver of our strong relative returns and our ability to withstand this very challenging backdrop.
Significant contributors to performance in Q3 2022 (in terms of bps) include: NMI Holdings (+22%), DoubleVerify (+21%) and Iridium Communications (+19%).
Stocks that detracted from our portfolio’s performance in Q3 2022 (in terms of bps) include YETI (-38%), Euronet Worldwide (-26%) and Blackbaud (-24%).
Portfolio Changes
Throughout the quarter, our investment team continued to identify very promising and high-quality investment candidates with attractive valuations due to this very difficult market, which should favorably position our model portfolio for even stronger long-term returns.
- We initiated a new position in Armstrong World following a ~30% pullback in its share price amidst the global equity selloff, allowing us to build a position in this high-quality company at valuation multiples well below their historical averages and at a significant discount to its intrinsic value.
- We also built a new position in DigitalOcean Holdings at an attractive valuation – 15x FY23 EBITDA – which is well below its historical averages and fair value.
- We also took advantage of the significant weakness in the stock of YETI to add to this small position.
- The broad pullback in our market also allowed us to add to our positions in some of our core holdings that have underperformed in the short term without any meaningful changes to their long-term fundamentals.
To fund our third quarter buying activity, we exited or reduced certain positions:
- We sold off Purple Innovation due to deteriorating fundamentals that capped additional upside.
- We also decided to exit our investment in Frontdoor due to multiple headwinds that eroded the company’s profitability and pointed to a long and uncertain road to recovery for its underlying business.
- We significantly reduced our position in Acushnet to take significant profits in this somewhat expensive stock.
- We also took some profits in overly expensive stocks such as Installed Building Products, Federal Signal, StoneX, Qualys and Iridium Communications.
Outlook
It appears to be extremely difficult for the U.S. Federal Reserve to control inflation without seriously harming the economy, given a backdrop of high inflation and rising interest rates. Investors should be prepared for a possible U.S. recession in the upcoming months under any plausible scenario. Additionally, investors should not be shocked to see consistent downward revisions to corporate profits for both this year and 2023. Since the labour market has remained persistently strong and no major economic sectors appear to be significantly or structurally weakened, we should see a relatively mild or “typical” recession by historical standards.
We are confident that most of the upcoming economic downturn has already been factored into the valuations of our portfolio stocks and many other small-cap companies, following what has been a significant bear market in our small-cap universe. In comparison to the typical decrease for this asset class during the first half of a recession, this persistent bear market has been more severe. As a result, high-quality small caps have already anticipated a significant reduction in their earnings estimates and are currently trading at highly attractive valuations.
Despite all the doom and gloom in our market, our investments in high-quality, fairly valued, profitable small-cap companies should produce strong long-term returns and a sizable alpha premium over our benchmark. In fact, our portfolio is currently trading at a level that has historically been quite attractive: a 25%+ discount to its intrinsic value based on conservative assumptions.
Although we are not looking for a bottom in this difficult market climate, we are certain that investors with long-term investment horizons will likely see attractive returns from the currently compelling valuation levels of our small-cap portfolio. Our high-conviction model portfolio is well-positioned for long-term growth in a difficult macro environment that should strongly favour the stocks of our high-quality portfolio companies.
- The broad pullback in our market also allowed us to add to our positions in some of our core holdings that have underperformed in the short term without any meaningful changes to their long-term fundamentals.
To fund our third quarter buying activity, we exited or reduced certain positions:
- We sold off Purple Innovation due to deteriorating fundamentals that capped additional upside.
- We also decided to exit our investment in Frontdoor due to multiple headwinds that eroded the company’s profitability and pointed to a long and uncertain road to recovery for its underlying business.
- We significantly reduced our position in Acushnet to take significant profits in this somewhat expensive stock.
- We also took some profits in overly expensive stocks such as Installed Building Products, Federal Signal, StoneX, Qualys and Iridium Communications.
Outlook
It appears to be extremely difficult for the U.S. Federal Reserve to control inflation without seriously harming the economy, given a backdrop of high inflation and rising interest rates. Investors should be prepared for a possible U.S. recession in the upcoming months under any plausible scenario. Additionally, investors should not be shocked to see consistent downward revisions to corporate profits for both this year and 2023. Since the labour market has remained persistently strong and no major economic sectors appear to be significantly or structurally weakened, we should see a relatively mild or “typical” recession by historical standards.
We are confident that most of the upcoming economic downturn has already been factored into the valuations of our portfolio stocks and many other small-cap companies, following what has been a significant bear market in our small-cap universe. In comparison to the typical decrease for this asset class during the first half of a recession, this persistent bear market has been more severe. As a result, high-quality small caps have already anticipated a significant reduction in their earnings estimates and are currently trading at highly attractive valuations.
Despite all the doom and gloom in our market, our investments in high-quality, fairly valued, profitable small-cap companies should produce strong long-term returns and a sizable alpha premium over our benchmark. In fact, our portfolio is currently trading at a level that has historically been quite attractive: a 25%+ discount to its intrinsic value based on conservative assumptions.
Although we are not looking for a bottom in this difficult market climate, we are certain that investors with long-term investment horizons will likely see attractive returns from the currently compelling valuation levels of our small-cap portfolio. Our high-conviction model portfolio is well-positioned for long-term growth in a difficult macro environment that should strongly favour the stocks of our high-quality portfolio companies.
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 September 30, 2022).
*Note: Dec. 31, 2011
Portfolio Positioning
Concerns about China’s covid measures, weak macro conditions, anti-trust issues, common prosperity, U.S. export bans and global inflation delinked the stock prices of all Chinese companies.
Six out of our top 10 stocks starting the quarter outperformed and dropped less than half of what the market did. Our four disappointing stocks in the top 10 are Geely, Country Garden Services, Coli Overseas Property and Sunevision. All four stocks declined due to political forces outside of their own company’s control and, in Sunevision’s case, the interest rate hike. Policy and politics hurt stocks like Geely, Country Garden Services and Coli Overseas Property.
We firmly believe that our core positions in the portfolio continue to follow the policy tailwinds. We are in good shape with our management since we have initiatives in place to reach our goals, even though the operating environment has grown more complex. In summary, we continue to bulk up the business and earnings quality of our portfolio during this government’s policy storm.
Our top 10 weights moved up to 39.6% vs. 37.1% QoQ. Our consumer sector exposure expanded due to the outperformance of our travel stocks from the re-opening of economies or the prospect of it inside China.
Our top five contributors attributed 1.5% to the portfolio in the third quarter:
- AK Medical (+31%)
- Samsonite (+22%)
- Lotus (+0.6%)
- Formosa Intl Hotel (+8%)
- Straits Trading (+10%)
Our bottom five stocks detracted -7.8% from the portfolio in the third quarter:
- Country Garden Services (-67%)
- Geely (-39%)
- Weimob (-48%)
- Bilibili (-41%)
- Sunevision (-30%)
Portfolio Changes
In the third quarter, opportunities continue to be abundant from a valuation standpoint. One of our keys to success is to ensure that we pick the right people in sectors that align with the new China of sustainable-quality growth versus the old “growth at all costs” school of thought.
Over the past three months, we made these portfolio changes:
- We rebalanced names such as Techtronic, Sunevision, Country Garden, Geely and CICC.
- We added a new stock: Hua Hong Semiconductor, which has grown its revenue at a 25% CAGR over the past five years and is trading at around its normal valuation range.
- We took profits in Lotus, Xinyi Electric and Straits Trading.
- We decided to fully exit our HKTV Mall position to rotate to larger-size names that are higher in quality.
In the third quarter, our portfolio valuation moved only from 16.2x to 15.2x, baking in an earnings rebound delay into 2023, now that we expect China to move away from its “zero Covid” policy in the first quarter of 2023.
Outlook
If China’s “Zero Covid” policy gets relaxed by Chinese New Year of 2023, the release of pent-up demand should make 10% growth an achievable target. These new policies may boost consumption and services dramatically, allowing China to rely less on infrastructure spending, which would only expand the country’s debt trap.
Valuation levels continue to be incrementally positive and supported by aggressive buybacks by Chinese companies and strong flows from the Stock Connect programs of Shanghai and Shenzhen.
In summary, the following factors should lessen Covid-19 fears and macroeconomic concerns in the coming months:
- G20 visit by President Xi and his meeting with Biden
- December’s Central Economic Work Conference (which should provide policy continuity for growing the economy)
- Covid relaxation news
- Positive outcome from the PCAOB audit inspection in Hong Kong
We continue to firmly believe in owning outstanding companies. Recent events have created excellent opportunities to own more of them at a discount to their long-term valuations. Our portfolio will continue to get stronger with higher-quality names as we acquire more companies with compelling fundamentals.
Although we are in the longest emerging market bear market ever, bull market phases can be as dramatic as their bearish counterparts, where trough-to-peak returns have been more than 70%— seven out of 10 times after a major emerging market trough.
Over the past three months, we made these portfolio changes:
- We rebalanced names such as Techtronic, Sunevision, Country Garden, Geely and CICC.
- We added a new stock: Hua Hong Semiconductor, which has grown its revenue at a 25% CAGR over the past five years and is trading at around its normal valuation range.
- We took profits in Lotus, Xinyi Electric and Straits Trading.
- We decided to fully exit our HKTV Mall position to rotate to larger-size names that are higher in quality.
In the third quarter, our portfolio valuation moved only from 16.2x to 15.2x, baking in an earnings rebound delay into 2023, now that we expect China to move away from its “zero Covid” policy in the first quarter of 2023.
Outlook
If China’s “Zero Covid” policy gets relaxed by Chinese New Year of 2023, the release of pent-up demand should make 10% growth an achievable target. These new policies may boost consumption and services dramatically, allowing China to rely less on infrastructure spending, which would only expand the country’s debt trap.
Valuation levels continue to be incrementally positive and supported by aggressive buybacks by Chinese companies and strong flows from the Stock Connect programs of Shanghai and Shenzhen.
In summary, the following factors should lessen Covid-19 fears and macroeconomic concerns in the coming months:
- G20 visit by President Xi and his meeting with Biden
- December’s Central Economic Work Conference (which should provide policy continuity for growing the economy)
- Covid relaxation news
- Positive outcome from the PCAOB audit inspection in Hong Kong
We continue to firmly believe in owning outstanding companies. Recent events have created excellent opportunities to own more of them at a discount to their long-term valuations. Our portfolio will continue to get stronger with higher-quality names as we acquire more companies with compelling fundamentals.
Although we are in the longest emerging market bear market ever, bull market phases can be as dramatic as their bearish counterparts, where trough-to-peak returns have been more than 70%— seven out of 10 times after a major emerging market trough.
U.S. Small & Mid Cap Equity Strategy
Investment Performance
The following table shows the investment performance of the VB U.S. Small-Mid Cap Pension Fund Composite (in U.S. dollars), compared to the Russell 2500 Small Cap Index and the S&P 500 Index (as of September 30, 2022).
*Note : September 30, 2017
Portfolio Positioning
Small- and mid-cap companies with profitable growth and pricing power should continue to generate good overall returns on strong real growth, even if the broader market indices are not providing them right now.
Valuations are also very supportive for small- and mid-cap stocks, both absolute and relative to large-cap indices such as the S&P 500. The Russell 2500 is as cheap as it has ever been relative to the large cap S&P 500 Index. It is hard to believe that the faster-growing Russell 2500 should be trading at a lower multiple than large caps.
Accordingly, small-cap stocks look extremely cheap by any measure, particularly considering the inherent ability of many of Russell 2500 constituents to outgrow the broader economy.
More than ever, a longer period of higher inflation and interest rates should favour active strategies, like U.S. Small & Mid Cap Equity Strategy, which can navigate this complicated economic environment. This macro combo will also most likely limit the kind of multiple expansion that benefited growth companies before inflation started to spike.
Our portfolio lagged in the third quarter, but two stocks, Sotera Health (-62%) and Cerence (-45%), represented the entirety of the shortfall. Beyond these two names, most other underperformers were modest detractors. This demonstrates that, in a concentrated portfolio, getting most of your decisions right is sometimes not enough if you have significant falls in the price of one or two stocks. That is what happened over the past three months.
Seventy five percent of the underperformance was due to the collapse in the share price of Sotera Health following the unexpectedly large settlement awarded against the company in its first civil litigation case.
Our top 10 weights totalled 30.6% at the start of the quarter and 30.9% at the end. Our top 15 were 44% at the beginning of July and 44.9% at the end of September, so there was little change in the overall concentration of our portfolio throughout the quarter.
A few positive contributors during this quarter were DoubleVerify (+21%), Iridium Communications (+20%) and BOK Financial (+18%) due to multiple tailwinds from an uptick in demand, a solid beat on revenue and a strong margin performance.
Portfolio Changes
Overall, we completely exited one position, Primoris, and added two new names, Armstrong World Industries and DigitalOcean, bringing our total number of positions up by one (to 41).
- We initiated a new position in Armstrong World following a ~30% pullback in its share price amidst the global equity selloff, allowing us to build a position in this high-quality company at valuation multiples well below their historical averages—at a significant discount to its intrinsic value.
- We also built a new position in DigitalOcean Holdings at an attractive valuation – 15x FY23 EBITDA – which is well below its historical averages and fair value.
- Upgrading the portfolio into higher-quality, attractively valued names was an opportunity to exit PRIM after what can only be described as an underwhelming period of ownership.
Other noteworthy trades were trims to the weight of Installed Building Products, Take-Two Interactive, Qualys and Sotera Health.
Most of our purchases were absorbed by the initiation of our new positions and additions to our existing positions during the third quarter.
Outlook
Higher interest rates have impacted multiples but, unlike the second quarter, we do believe that the market consensus, in the third quarter, shifted to a recession scenario, leading to very attractive absolute and relative multiples for companies that are currently profitable with steady modest growth.
With a core view that rates will remain high despite some easing as the economy reverses in the next six to nine months, our prime portfolio stocks is well-positioned. We think unprofitable growth stocks or highly levered businesses have a difficult couple of years ahead of them despite their own underperformance.
The era of easy money is over. A dose of realism has now returned to market valuations. With many retail investors now nursing significant losses, we think the likelihood is very low that meme stock investing will distort overall index returns, like in 2020.
As we enter what’s likely to be a messy earnings season, we are optimistic that the difficult and fast-moving macroeconomic events of the third quarter have brought us to the best part of the cycle for our style of investing. Although it’s frustrating to see that we are back to 2020 levels as we stare into 2023, cheap valuations for businesses with solid balance sheets, pricing power and low capital intensity are a tremendous formula for success next year.
- We initiated a new position in Armstrong World following a ~30% pullback in its share price amidst the global equity selloff, allowing us to build a position in this high-quality company at valuation multiples well below their historical averages—at a significant discount to its intrinsic value.
- We also built a new position in DigitalOcean Holdings at an attractive valuation – 15x FY23 EBITDA – which is well below its historical averages and fair value.
- Upgrading the portfolio into higher-quality, attractively valued names was an opportunity to exit PRIM after what can only be described as an underwhelming period of ownership.
Other noteworthy trades were trims to the weight of Installed Building Products, Take-Two Interactive, Qualys and Sotera Health.
Most of our purchases were absorbed by the initiation of our new positions and additions to our existing positions during the third quarter.
Outlook
Higher interest rates have impacted multiples but, unlike the second quarter, we do believe that the market consensus, in the third quarter, shifted to a recession scenario, leading to very attractive absolute and relative multiples for companies that are currently profitable with steady modest growth.
With a core view that rates will remain high despite some easing as the economy reverses in the next six to nine months, our prime portfolio stocks is well-positioned. We think unprofitable growth stocks or highly levered businesses have a difficult couple of years ahead of them despite their own underperformance.
The era of easy money is over. A dose of realism has now returned to market valuations. With many retail investors now nursing significant losses, we think the likelihood is very low that meme stock investing will distort overall index returns, like in 2020.
As we enter what’s likely to be a messy earnings season, we are optimistic that the difficult and fast-moving macroeconomic events of the third quarter have brought us to the best part of the cycle for our style of investing. Although it’s frustrating to see that we are back to 2020 levels as we stare into 2023, cheap valuations for businesses with solid balance sheets, pricing power and low capital intensity are a tremendous formula for success next year.
