In Q3 2023, global economic uncertainty prevailed. The U.S. experienced modest growth with inflation and interest rate concerns. Canada faced similar challenges. Asia had a turbulent ride, with India outperforming. Q4 remains uncertain, highlighting the need to take a disciplined investing approach to identifying high-quality stocks with strong fundamentals.
Market Review
The third quarter of 2023 brought a complex and ever-evolving economic landscape across the United States, Canada, and Asia, leaving investors in search of clarity amid a mix of positive and concerning indicators.
In the United States, Q3 was anticipated to provide insights into the country’s economic trajectory. However, it primarily delivered a continuation of the mixed macroeconomic environment from the previous quarter. The focus remained on the Federal Reserve’s rate hike cycle, with headlines dominated by inflation data and central bank actions.
The U.S. economy maintained modest growth, supported by steady consumer spending and a robust labor market. Yet, concerns mounted around macro pressures, particularly regarding consumer spending. Factors like dwindling pandemic savings, rising housing and other major expenses, surging oil prices, and persistent inflation created a precarious financial situation for many Americans.
Bold predictions of interest rates rising to 7% added to the uncertainty. The surge in various interest rate benchmarks in September triggered a market downturn, resulting in the worst month for U.S. equities in over a year.
Both 10-year and 30-year Treasury rates reached levels unseen since 2007, and real yields hit their highest point since 2009. Remarkably, cash investments began to outperform the S&P 500 earnings yield by the widest margin in 23 years, while U.S. bonds experienced a significant 15% decline over the last three years, a historical drop.
Canada experienced a similar narrative. The mixed macroeconomic environment persisted, with a focus on the Bank of Canada’s rate hikes and inflation data. Both Canadian and U.S. economies saw modest growth, but rising interest rates and factors like soaring oil prices and stubborn inflation strained consumer finances.
The “higher for longer” scenario dominated most of the third quarter, suggesting a prolonged period of high interest rates beyond what the market previously expected. This became an insurmountable concern for investors, driving down U.S. and Canadian stocks and risk assets towards the end of the quarter.
In this risk-off environment, small-cap stocks in both the U.S. and Canada faced challenges, although optimism remained for a potential resurgence due to historically low relative valuations and expectations of stronger earnings growth in 2024.
Chinese markets began Q3 optimistically but soon encountered challenges related to geopolitics, real estate uncertainties and weak macroeconomic data. The pattern of punishing bad news while ignoring encouraging signs drew comparisons to the 2008/2009 crisis.
In Q3, the underweighting of China by foreign investors reached historic lows, driven by concerns over U.S.-China relations and Beijing’s regulatory crackdown. With China’s poor market performance stemming from valuation contractions rather than deteriorating fundamentals, good results often failed to translate into stock performance as risk aversion took hold.
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, 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 Q3, our portfolio slightly underperformed the TSX Small Cap Index. The reason behind this temporary setback was our limited exposure to the energy sector, which experienced a remarkable surge during Q3, driven by a substantial increase in oil prices. This sector’s exceptional performance created a significant headwind, resulting in a relative performance drag.
However, when we look at our performance for the year up to this point of +11.4%, the picture becomes much brighter. We’ve achieved solid returns, significantly outperforming the TSX Small Cap Index, which posted a negative return of -1.1%. This substantial value-add of 12.5% underscores the effectiveness of our investment approach. Our success in 2023 can be attributed to our distinct investment style, which prioritizes meticulous stock selection and focuses on companies with unique attributes and growth drivers. This approach served us well, especially given the substantial volatility prevalent in the market. The current market backdrop, marked by ups and downs, played favorably into our strategy, allowing us to deliver strong absolute performance compared to our small-cap peers.
While we certainly hoped for better performance in Q3, the headwinds from the energy sector proved challenging to overcome within a short three-month period. Nonetheless, our overall performance for the year, including the past 12 months and more extended periods, remains noteworthy and demonstrates the resilience of our investment style. Our consistent ability to generate alpha, particularly since the fourth quarter of the previous year, speaks volumes about the strength of our investment approach. It showcases our ability to adapt and excel across varying market conditions and throughout complete market cycles. This consistency highlights the merits of our investment style and reaffirms our commitment to maintaining a balanced portfolio approach.
Our significant contributors to performance:
- MDA Ltd. (+41.1%) due to its $2.1B Telesat contract, strong backlog and attractive value.
- Computer Modelling Group (+27.6%) due to its revenue growth, energy transition focus and high growth potential.
- Badger Infrastructure Solutions (+29.0%) due to its rebound (record revenues) and growth plans.
- CWB Financial Group (+13.8%) due to improved risk calculations, stable margins and valuation.
- Lumine Group Inc. (+10.7%) due to an impressive Q2 post-spinout and M&A potential.
The stocks that detracted from performance:
- Aritzia Inc. (-35.8%) due to slowing revenue growth and the impact of supply chain investments on margins.
- Trisura Group Ltd. (-19.8%) due to disappointing share price performance, despite good financial results.
- Tucows Inc. (-24.6%) due to an interest-induced valuation contraction and missed transaction expectations.
- Pet Valu Holdings Ltd. (-19.5%) due to huge investments in its distribution network and the entry of Chewy (a major player).
- Sleep Country Canada Holdings (-18.1%) due to a softening consumer environment, negative organic growth and margin improvement plans.
Portfolio Changes
Over the past quarter, we diligently adjusted our model portfolio to elevate its quality and long-term positioning through diligent research and purposeful portfolio activity.
Amidst notable price fluctuations within the small-cap market, the past quarter was marked by dynamic activity in our model portfolio as we made strategic investment decisions.
Our adjustments were focused primarily on augmenting the long-term alpha potential within the portfolio:
- We fortified positions in high-conviction holdings such as Pet Valu Holdings, Mattr Infratech, and Trisura Group, recognizing their growth potential and undervaluation.
- We pruned positions in well-performing assets, like Badger Infrastructure Solutions, Colliers International Group and Stantec, due to valuation and allocation considerations.
- No new positions were initiated, nor were any fully divested during this period.
- Our most significant purchases include Pet Valu Holdings, Mattr Infratech, Trisura Group, Enghouse Systems and Sleep Country Canada.
- Our most significant sales include Badger Infrastructure Solutions, Colliers International Group, Stantec, Canadian Western Bank and GDI Facility Services
Going forward, our investment philosophy will continue to revolve around maintaining a concentrated, well-researched portfolio to achieve optimal results for our investors.
Outlook
As we enter the year’s final quarter, investor unease prevails, characterized by the ongoing debate over a soft or hard economic landing.
A seemingly favourable summer, marked by lower inflation, robust job markets, healthy corporate profits, and strong consumer spending, initially bolstered confidence in the Canadian and U.S. economies avoiding recession. However, historical patterns suggest optimism often precedes downturns.
While certain sectors like manufacturing and housing show signs of stabilization or growth, their response time to rate hikes is brief. Conversely, sectors such as the labor market experience longer lag periods. Consequently, the full impact of the Bank of Canada’s 475 basis points rate hike, implemented since spring 2022, won’t manifest until late 2023 or early 2024.
Prematurely declaring a soft landing appears unjustified, and the “higher for longer” scenario could persist if the Bank of Canada enacts another rate increase, a likely scenario given the economy’s resilience.
Should the Canadian and U.S. economies succumb to mounting macroeconomic pressures, investors may need to wait for Bank of Canada support, historically averaging eight months from the last hike to the first cut. In the interim, market participants must prepare for a mixed macroeconomic environment, keeping equities directionless amid offsetting forces.
Given this uncertainty, adhering to a disciplined investment approach, exclusively favoring reasonably valued high-quality stocks, is advisable. Amidst uncertain demand and challenged industry outlooks, well-managed, strong business models remain best-equipped to deliver consistent financial results, capture market share, and position for economic recovery.
Our Canadian small-cap strategy comprises market leaders with sustainable competitive advantages, proven resilience across economic cycles, high profitability, robust balance sheets, and attractive valuations. Notably, 18 of our 37 holdings trade at over a 20% discount to intrinsic value.
Company-specific fundamentals will continue to drive stock performance, differentiating active asset managers. Our portfolio aims to deliver value relative to benchmarks and peers, supported by strong fundamentals. Furthermore, Canadian small-cap stocks currently trade at a 22-year discount relative to large caps, suggesting potential outperformance in the years ahead.
Our adjustments were focused primarily on augmenting the long-term alpha potential within the portfolio:
- We fortified positions in high-conviction holdings such as Pet Valu Holdings, Mattr Infratech, and Trisura Group, recognizing their growth potential and undervaluation.
- We pruned positions in well-performing assets, like Badger Infrastructure Solutions, Colliers International Group and Stantec, due to valuation and allocation considerations.
- No new positions were initiated, nor were any fully divested during this period.
- Our most significant purchases include Pet Valu Holdings, Mattr Infratech, Trisura Group, Enghouse Systems and Sleep Country Canada.
- Our most significant sales include Badger Infrastructure Solutions, Colliers International Group, Stantec, Canadian Western Bank and GDI Facility Services
Going forward, our investment philosophy will continue to revolve around maintaining a concentrated, well-researched portfolio to achieve optimal results for our investors.
Outlook
As we enter the year’s final quarter, investor unease prevails, characterized by the ongoing debate over a soft or hard economic landing.
A seemingly favourable summer, marked by lower inflation, robust job markets, healthy corporate profits, and strong consumer spending, initially bolstered confidence in the Canadian and U.S. economies avoiding recession. However, historical patterns suggest optimism often precedes downturns.
While certain sectors like manufacturing and housing show signs of stabilization or growth, their response time to rate hikes is brief. Conversely, sectors such as the labor market experience longer lag periods. Consequently, the full impact of the Bank of Canada’s 475 basis points rate hike, implemented since spring 2022, won’t manifest until late 2023 or early 2024.
Prematurely declaring a soft landing appears unjustified, and the “higher for longer” scenario could persist if the Bank of Canada enacts another rate increase, a likely scenario given the economy’s resilience.
Should the Canadian and U.S. economies succumb to mounting macroeconomic pressures, investors may need to wait for Bank of Canada support, historically averaging eight months from the last hike to the first cut. In the interim, market participants must prepare for a mixed macroeconomic environment, keeping equities directionless amid offsetting forces.
Given this uncertainty, adhering to a disciplined investment approach, exclusively favoring reasonably valued high-quality stocks, is advisable. Amidst uncertain demand and challenged industry outlooks, well-managed, strong business models remain best-equipped to deliver consistent financial results, capture market share, and position for economic recovery.
Our Canadian small-cap strategy comprises market leaders with sustainable competitive advantages, proven resilience across economic cycles, high profitability, robust balance sheets, and attractive valuations. Notably, 18 of our 37 holdings trade at over a 20% discount to intrinsic value.
Company-specific fundamentals will continue to drive stock performance, differentiating active asset managers. Our portfolio aims to deliver value relative to benchmarks and peers, supported by strong fundamentals. Furthermore, Canadian small-cap stocks currently trade at a 22-year discount relative to large caps, suggesting potential outperformance in the years ahead.
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, 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
In the last quarter, our U.S. small-cap portfolio navigated two distinct market phases: an initial risk-on period followed by a shift to risk-off sentiment in August and September. Despite these fluctuations, our portfolio closely tracked the Russell 2000 benchmark.
In July, relative underperformance occurred as low-quality, speculative stocks surged amid a stable to improving macro environment, challenging our high-quality, concentrated portfolio during earnings season. However, a notable sentiment shift in August and September led to a significant pullback in U.S. small-cap stocks. Our focus on high-quality, reasonably valued small-cap stocks helped our portfolio outperform the benchmark during this period.
While our third-quarter return mirrored the benchmark’s performance, we achieved strong security selection across sectors, generating positive alpha in Consumer Discretionary, Healthcare, and Industrials, partially offset by negative selection in Information Technology.
Sector allocation played a role; our lack of exposure to the Energy sector had a significant negative impact, but larger allocations to Financials and lower exposure to Healthcare helped offset these challenges. Despite the quarter’s difficulties, we are content with our performance, emphasizing the consistent alpha generated across market conditions through our investment style, prioritizing high-quality small-cap stocks, and maintaining a balanced portfolio to capture opportunities in diverse market scenarios.
Significant contributors to performance in Q3 2023:
- YETI Holdings led the pack, surging 26%, rebounding from earlier concerns.
- Qualys gained nearly 20% due to its consistent financial results and robust cybersecurity solutions.
- Laureate Education and Grand Canyon Education both rose around 17%, benefitting from their distinct growth drivers and competitive advantages.
- StoneX Group climbed 17%, driven by the higher interest rate environment and organic growth initiatives.
- Avantax was acquired by Cetera Financial Group at a 30% premium, a favorable outcome for our investors.
Stocks that detracted from performance in Q3 2023:
- Euronet Worldwide was the biggest detractor, down over 20%, impacted by changing consumer habits in payments, even though the company’s diversified operations and strong management make it undervalued at current levels.
- DigitalOcean also struggled, falling nearly 40% due to reduced revenue growth expectations and a change in leadership, affecting its valuation multiples.
Portfolio Changes
In response to the recent market challenges, our portfolio has undergone strategic adjustments to optimize holdings and seize promising opportunities. These strategic portfolio changes position us to navigate market dynamics and actively pursue high-quality opportunities for sustainable growth.
New initiatives:
- We initiated a position in Paycor, a leading SaaS provider specializing in human capital management solutions for SMEs, tapping into the transition from legacy payroll services to modern HCM platforms.
- We capitalized on Grocery Outlet’s slight pullback to complete our position in Grocery Outlet, given its strong financial results and fundamentals.
Increased holdings:
- We reinforced our holdings in Iridium Communications, a consistent performer in our portfolio with solid fundamentals.
- We increased our position in Euronet Worldwide, believing the stock is undervalued and misunderstood by investors.
- We boosted our positions in Cerence, DoubleVerify, Silicon Laboratories, Envestnet, FTI Consulting, and Ormat Technologies, leveraging strong fundamentals and unwarranted valuation contractions.
Portfolio optimizations:
- We completed the liquidation of our investment in Virtu Financial due to multiple contractions and escalating regulatory risks.
- We reduced our YETI Holdings position as the stock became our best performer, experiencing expanded valuation multiples amid an uncertain macro environment.
- We trimmed our holdings in Hamilton Lane, Tempur Sealy International, Laureate Education, HealthEquity, Primoris Services Corp. and StoneX Group, prompted by robust performance (resulting in elevated valuations and portfolio weights).
Outlook
As we enter the final quarter of this challenging year, investors are grappling with uncertainty, and the debate over a soft or hard landing for the economy rages on. While favorable indicators, such as lower inflation, robust employment, healthy corporate profits, and consumer spending, have supported the notion of a smooth economic transition, historical patterns suggest caution as optimism often precedes downturns.
However, significant headwinds loom on the horizon, including surging interest rates, escalating financing costs, depleted pandemic savings, rising oil prices, resuming student loan repayments, and sluggish global growth. Recent developments like the United Auto Workers union strike further complicate the economic landscape. While some sectors like manufacturing and housing have shown signs of recovery, the lag time between interest rate hikes and their real-world impact varies across industries. The full effect of the Federal Reserve’s 525 basis points increase since Spring 2022 won’t materialize until late 2023 or early 2024, casting doubts on a soft landing without recession.
The “higher for longer” rate scenario may persist, with the possibility of additional rate hikes. If the economy succumbs to these mounting pressures, investors may have to wait for Fed support, as history shows an eight-month gap between the last hike and the first cut.
In this uncertain environment, a disciplined investment approach centered on high-quality, reasonably valued stocks is paramount. Amid mixed macro indicators and offsetting forces, focusing on well-managed businesses with sustainable competitive advantages is key. Our U.S. small-cap strategy’s model portfolio comprises market leaders with strong track records across economic cycles.
These holdings exhibit robust fundamentals: high profitability, strong balance sheets, an 18% median ROE, 11% 5-year median earnings growth CAGR, and reasonable valuations. Our thorough DCF methodology reveals a 16% discount to intrinsic value.
We believe that company-specific fundamentals will drive stock performance in this environment, differentiating active asset managers and positioning us for continued outperformance against our benchmark and peers. In this climate of uncertainty, resilience and focus on quality are our guiding principles for the future.
Increased holdings:
- We reinforced our holdings in Iridium Communications, a consistent performer in our portfolio with solid fundamentals.
- We increased our position in Euronet Worldwide, believing the stock is undervalued and misunderstood by investors.
- We boosted our positions in Cerence, DoubleVerify, Silicon Laboratories, Envestnet, FTI Consulting, and Ormat Technologies, leveraging strong fundamentals and unwarranted valuation contractions.
Portfolio optimizations:
- We completed the liquidation of our investment in Virtu Financial due to multiple contractions and escalating regulatory risks.
- We reduced our YETI Holdings position as the stock became our best performer, experiencing expanded valuation multiples amid an uncertain macro environment.
- We trimmed our holdings in Hamilton Lane, Tempur Sealy International, Laureate Education, HealthEquity, Primoris Services Corp. and StoneX Group, prompted by robust performance (resulting in elevated valuations and portfolio weights).
Outlook
As we enter the final quarter of this challenging year, investors are grappling with uncertainty, and the debate over a soft or hard landing for the economy rages on. While favorable indicators, such as lower inflation, robust employment, healthy corporate profits, and consumer spending, have supported the notion of a smooth economic transition, historical patterns suggest caution as optimism often precedes downturns.
However, significant headwinds loom on the horizon, including surging interest rates, escalating financing costs, depleted pandemic savings, rising oil prices, resuming student loan repayments, and sluggish global growth. Recent developments like the United Auto Workers union strike further complicate the economic landscape. While some sectors like manufacturing and housing have shown signs of recovery, the lag time between interest rate hikes and their real-world impact varies across industries. The full effect of the Federal Reserve’s 525 basis points increase since Spring 2022 won’t materialize until late 2023 or early 2024, casting doubts on a soft landing without recession.
The “higher for longer” rate scenario may persist, with the possibility of additional rate hikes. If the economy succumbs to these mounting pressures, investors may have to wait for Fed support, as history shows an eight-month gap between the last hike and the first cut.
In this uncertain environment, a disciplined investment approach centered on high-quality, reasonably valued stocks is paramount. Amid mixed macro indicators and offsetting forces, focusing on well-managed businesses with sustainable competitive advantages is key. Our U.S. small-cap strategy’s model portfolio comprises market leaders with strong track records across economic cycles.
These holdings exhibit robust fundamentals: high profitability, strong balance sheets, an 18% median ROE, 11% 5-year median earnings growth CAGR, and reasonable valuations. Our thorough DCF methodology reveals a 16% discount to intrinsic value.
We believe that company-specific fundamentals will drive stock performance in this environment, differentiating active asset managers and positioning us for continued outperformance against our benchmark and peers. In this climate of uncertainty, resilience and focus on quality are our guiding principles for the future.
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, 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
Throughout the quarter, US interest rates continued their ascent, culminating in a robust September following the Fed’s “higher rates for longer” guidance. The strengthening US dollar has adversely affected emerging markets, particularly Chinese equities trading in Hong Kong, which have borne the brunt of short-term volatility, despite brighter long-term prospects.
Historically, rising rates and a stronger dollar have heightened market sentiment volatility, impacting growth stocks as investors turn to defensive plays like telecoms, banks, and state-owned enterprises. However, our observations within China reveal signs of marginal economic recovery, suggesting there’s no need for undue pessimism. The Chinese economy is shifting towards domestic consumption, bolstered by increased consumer spending. For instance, notable European luxury brands are expanding their presence in China, reflecting rising consumer demand. Passenger travel has rebounded, indicating growing consumer willingness to spend.
Our portfolio maintains a significant focus on consumer sectors within China, including positions in Yum China, New Oriental, and travel-related stocks like Samsonite, Tongcheng, and Trip.com. Yum China, the owner of KFC and Pizza Hut in China, continues its impressive growth trajectory. Despite already boasting a 13,000-store base, they plan to expand to 20,000 stores within three years, primarily targeting tier 3 cities and lower, where tremendous growth potential exists. Additionally, they anticipate returning $3 billion to shareholders in the next three years. We also anticipate the rise of China’s EV export industry, with Geely maintaining a top position due to its diverse portfolio, including Volvo, Zeeker, Polar and local Geely brands. China’s exports of higher-value goods like EVs have increased, surpassing Japan in the first half of the year.
We remain bullish on our chosen stocks acquired during the market’s recent weakness. Apart from transitioning from Bilibil to Kuashiou, few substantial changes were warranted. Our portfolio consists of 47 quality companies, focusing on high barriers to entry, strong competitive advantages, and growth prospects. Certain specific circumstances, such as regulatory changes or management shifts, led to minor reductions in exposures to companies like Hua Hong, Country Garden, and Sunevision. However, these funds were efficiently reallocated to similar sector holdings.
Our top contributors for the quarter included New Oriental Education, Samsonite, iFast, L’Occitane, and Chicony Power. New Oriental Education, in particular, stands out with its impressive growth potential. In contrast, our bottom contributors were Lotus, Country Garden Services, Hua Hong, Kulicke, and Li Ning. These companies faced challenges ranging from market sentiment corrections to regulatory shifts, affecting short-term performance.
Despite these fluctuations, our portfolio remains well-positioned, with a concentration on quality companies primed for growth in the evolving Chinese market.
Portfolio Changes
Regarding portfolio changes, there have been minimal adjustments, as we remain bullish on our chosen stocks acquired during the market’s recent weakness.
- We partially divested CGS due to headline risk and increased volatility; reallocated 10% of exposure to Yuexiu Services.
- We reduced Hua Hong, trimming exposure by 10% after a successful A-share listing at a premium valuation led to an unexpected Hong Kong stock selloff.
- We trimmed Sunevision, reducing exposure by 10% following the abrupt departure of its long-time CEO, awaiting further clarity under new management.
- We rotated Bilibili to Kuaishou, shifting 10% of exposure due to Kuaishou’s strong outperformance, better monetization, and alignment with evolving content consumption trends.
Outlook
Despite foreign investors exiting China, we find reasons for optimism. MSCI China now trades at just 10x with projected 2023/2024 earnings growth of 10%/15%. It’s premature to declare ‘peak China’ akin to Western media like the “Economist.” Historical parallels with South Korea and Taiwan, which endured crises like the 1997 Asian financial crisis, suggest resilience. China’s emphasis on quality and sustainable growth, shifting away from over-investment and excessive leverage, aligns with long-term prosperity.
Though challenges persist, China’s commitment to consumption-led growth remains prudent. Unlike the 1993 Japanese experience with massive stimulus, China has been cautious, focusing on sustainable policies. The nation still graduates 1.4 million engineers annually, fostering an entrepreneurial spirit. While calls for extensive stimulus persist, China’s measured approach and control over inflation stand out.
Incremental stimulus measures and governmental crackdowns are expected to subside. China possesses the means to reverse course. Growth rates might dip from 2022’s predictions, but quality improvement compensates. As investors recognize current challenges as manageable, capital will flow back into China. Our model portfolio offers significant returns, driven by current discounts, with potential for further growth as opportunities reemerge.
Comparisons with the U.S. post-COVID spending aren’t equitable, as China didn’t provide similar handouts. The 2024 Taiwan election holds geopolitical implications; a change in leadership could improve cross-strait relations.
Local Chinese companies maintain long-term confidence. Anticipated Hong Kong stock buybacks totaling $93 billion HKD, nearly 4x the five-year average, signal positive sentiment. Our portfolio, trading at 10.7x forward earnings with a conservative 20% long-term growth rate, promises enduring rewards. Backed by two decades of experience and an on-ground perspective, we remain dedicated to investing in excellent companies led by exceptional management teams. Our investors benefit from institutional knowledge, local insights, and our steadfast investment approach.
- We partially divested CGS due to headline risk and increased volatility; reallocated 10% of exposure to Yuexiu Services.
- We reduced Hua Hong, trimming exposure by 10% after a successful A-share listing at a premium valuation led to an unexpected Hong Kong stock selloff.
- We trimmed Sunevision, reducing exposure by 10% following the abrupt departure of its long-time CEO, awaiting further clarity under new management.
- We rotated Bilibili to Kuaishou, shifting 10% of exposure due to Kuaishou’s strong outperformance, better monetization, and alignment with evolving content consumption trends.
Outlook
Despite foreign investors exiting China, we find reasons for optimism. MSCI China now trades at just 10x with projected 2023/2024 earnings growth of 10%/15%. It’s premature to declare ‘peak China’ akin to Western media like the “Economist.” Historical parallels with South Korea and Taiwan, which endured crises like the 1997 Asian financial crisis, suggest resilience. China’s emphasis on quality and sustainable growth, shifting away from over-investment and excessive leverage, aligns with long-term prosperity.
Though challenges persist, China’s commitment to consumption-led growth remains prudent. Unlike the 1993 Japanese experience with massive stimulus, China has been cautious, focusing on sustainable policies. The nation still graduates 1.4 million engineers annually, fostering an entrepreneurial spirit. While calls for extensive stimulus persist, China’s measured approach and control over inflation stand out.
Incremental stimulus measures and governmental crackdowns are expected to subside. China possesses the means to reverse course. Growth rates might dip from 2022’s predictions, but quality improvement compensates. As investors recognize current challenges as manageable, capital will flow back into China. Our model portfolio offers significant returns, driven by current discounts, with potential for further growth as opportunities reemerge.
Comparisons with the U.S. post-COVID spending aren’t equitable, as China didn’t provide similar handouts. The 2024 Taiwan election holds geopolitical implications; a change in leadership could improve cross-strait relations.
Local Chinese companies maintain long-term confidence. Anticipated Hong Kong stock buybacks totaling $93 billion HKD, nearly 4x the five-year average, signal positive sentiment. Our portfolio, trading at 10.7x forward earnings with a conservative 20% long-term growth rate, promises enduring rewards. Backed by two decades of experience and an on-ground perspective, we remain dedicated to investing in excellent companies led by exceptional management teams. Our investors benefit from institutional knowledge, local insights, and our steadfast investment approach.
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, 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 Q3, our portfolio faced headwinds as rising rate expectations dampened performance, revealing the challenge of navigating a tightening cycle. While our strategy typically thrives in the mid to late cycle, rising interest rates negatively impacted businesses with limited correlation to such conditions.
Notably, our portfolio remains positioned to capture opportunities in mid to late-cycle phases, leveraging the strength of resilient businesses. Our commitment to high-quality holdings with sustainable competitive advantages has guided our decisions, even amid challenging market conditions.
Iridium saw a perplexing 16% decline following a marginally revised outlook on the as-yet unquantified contribution from Qualcomm, pushing it from Q4 2023 to 2024. This knee-jerk reaction resulted in a $1.3bn market cap reduction, undervaluing the company at 14.3x EV/EBITDA, given its minimal economic sensitivity.
DoubleVerify also faced unwarranted weakness, down 28% in the quarter despite solid results with a 22% YoY revenue increase. Priced for perfection, the stock experienced multiple contraction due to higher interest rate expectations. With a bright outlook, DV remains a strong long-term hold.
Digital Ocean raised concerns, citing a weakened SMB customer base and technological shifts. The lack of GPUaaS for AI-based apps may result in increased churn as competitors catch up. Questionable capital use, including a $1.4bn convertible note for stock buybacks, left the company vulnerable. A new CEO may need to refocus on long-term stability.
Euronet’s 20% drop on results day was exacerbated by weak Q2 and Q3 seasonality, affecting full-year earnings. Though 2024 earnings expectations fell 8%, the sell-off appeared excessive. The quarter’s total revenue and EPS were in line with forecasts, with the ATM segment’s softness likely a temporary cyclical issue.
Cerence experienced a 30% share decline but delivered solid results, reducing fixed contracts for long-term stability. Despite short-term setbacks, its guidance indicates strong 2024 growth potential. IPG Photonics suffered from softer industrial demand and provided guidance below consensus. As growth shifted away from Chinese industrialization, the stock became more reliant on global PMI trends. The EV battery business may introduce lumpiness, and the company’s revenue growth has been stagnant.
Silicon Labs, Envestnet, and Shake Shack were weak despite no material changes to their business fundamentals. Envestnet is amidst an activist campaign to enhance profitability. Despite these challenges, Yeti, Qualys, StoneX, Laureate, and Grand Canyon contributed positively. Laureate and Grand Canyon benefited from their defensive models and counter-cyclicality perception. Yeti exceeded low expectations and is poised for growth. Qualys reinvested for expansion, delivering strong results in the cybersecurity market.
In summary, Q3 posed challenges, primarily due to rising interest rates. While some stocks faced unwarranted weakness, our portfolio includes resilient performers with solid long-term prospects. We will continue to adapt to market dynamics, prioritizing stability and growth in the ever-changing investment landscape.
Portfolio Changes
In Q3, we made strategic portfolio changes to adapt to market conditions and seize opportunities. Here are the key adjustments:
- We initiated a new position in FTI Consulting, a global financial and business consulting firm. Despite a 10% drop following FTI Consulting’s second-quarter results, we saw an attractive entry point, since it offers comprehensive services and has a history of strong execution.
- We exited our five-year ownership in BOK Financial, achieving a flat return. Regulatory tightening and persistently high interest rates created uncertainty, limiting growth prospects. With a muted outlook, we decided to exit, anticipating limited returns in the next 24 months.
- We took profits in Hamilton Lane at $86 and $90, reallocating capital.
- In response to significant falls on result days, we bought Iridium and Euronet, considering them undervalued.
- The market’s early-quarter sell-off also provided us with opportunities to rebalance positions.
These portfolio changes were strategic moves to enhance our positions and capitalize on market dynamics.
Outlook
In Q3, despite the looming specter of stagflation, there are reasons for cautious optimism as we assess the economic landscape.
Interest rates are nearing their peak, with only a small margin left before further hikes could trigger a recession. While a soft landing remains elusive, avoiding a severe recession is still possible if labor market conditions improve. Corporations may need to implement workforce reductions to meet earnings targets, potentially impacting their expansion plans due to higher rates.
The bond markets continue to be a source of concern, potentially heading for another challenging year. However, there’s potential for Small Cap stocks to deliver positive returns in 2023, especially if interest rates peak in Q4. Small Cap companies often exhibit resilience, driven by growth and their ability to capture market share from larger competitors or ride adoption curves that continue during recessions.
Many of our portfolio companies are poised for growth and market share gains, even in a downturn. Our holdings maintain low leverage and limited sensitivity to rising rates, positioning them well in periods of economic decline. While weaker business models may be exposed, our investment approach focuses on solid businesses with strong financial profiles and track records, ensuring the majority of our holdings remain robust.
We anticipate the Federal Reserve stepping back from aggressive rate hikes in Q4, potentially boosting market returns. Despite the Q3 sell-off, the 12–18-month outlook is becoming more attractive.
During these challenging market conditions, we are committed to implementing our investment strategy diligently, with the aim of consistently delivering robust returns in 2024 and beyond.
Portfolio Changes
In Q3, we made strategic portfolio changes to adapt to market conditions and seize opportunities. Here are the key adjustments:
- We initiated a new position in FTI Consulting, a global financial and business consulting firm. Despite a 10% drop following FTI Consulting’s second-quarter results, we saw an attractive entry point, since it offers comprehensive services and has a history of strong execution.
- We exited our five-year ownership in BOK Financial, achieving a flat return. Regulatory tightening and persistently high interest rates created uncertainty, limiting growth prospects. With a muted outlook, we decided to exit, anticipating limited returns in the next 24 months.
- We took profits in Hamilton Lane at $86 and $90, reallocating capital.
- In response to significant falls on result days, we bought Iridium and Euronet, considering them undervalued.
- The market’s early-quarter sell-off also provided us with opportunities to rebalance positions.
These portfolio changes were strategic moves to enhance our positions and capitalize on market dynamics.
Outlook
In Q3, despite the looming specter of stagflation, there are reasons for cautious optimism as we assess the economic landscape.
Interest rates are nearing their peak, with only a small margin left before further hikes could trigger a recession. While a soft landing remains elusive, avoiding a severe recession is still possible if labor market conditions improve. Corporations may need to implement workforce reductions to meet earnings targets, potentially impacting their expansion plans due to higher rates.
The bond markets continue to be a source of concern, potentially heading for another challenging year. However, there’s potential for Small Cap stocks to deliver positive returns in 2023, especially if interest rates peak in Q4. Small Cap companies often exhibit resilience, driven by growth and their ability to capture market share from larger competitors or ride adoption curves that continue during recessions.
Many of our portfolio companies are poised for growth and market share gains, even in a downturn. Our holdings maintain low leverage and limited sensitivity to rising rates, positioning them well in periods of economic decline. While weaker business models may be exposed, our investment approach focuses on solid businesses with strong financial profiles and track records, ensuring the majority of our holdings remain robust.
We anticipate the Federal Reserve stepping back from aggressive rate hikes in Q4, potentially boosting market returns. Despite the Q3 sell-off, the 12–18-month outlook is becoming more attractive.
During these challenging market conditions, we are committed to implementing our investment strategy diligently, with the aim of consistently delivering robust returns in 2024 and beyond.
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 September 30, 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
The malaise pervading the global market since the beginning of the year persisted throughout the quarter. Fundamental indicators remained lackluster, and several of our portfolio companies either adjusted their guidance for the full year to the lower end or slightly revised it downward. This recalibration reflected the caution we observed during our discussions with companies in the previous quarter, now manifesting itself in the financial figures.
However, the market’s response to earnings results this quarter was far from subdued, revealing a certain nervousness among investors. Positive results that surpassed expectations and optimistic outlooks generated minimal reactions, while any hint of imperfection led to double-digit declines. Over the course of the quarter, our portfolio experienced a decline of approximately 5.67%, primarily driven by losses in Europe and subsequently in Asia.
Despite the weakness in share price performance, we were encouraged by the underlying strength of our portfolio companies. Their management teams demonstrated resilience in a challenging environment, their business models exhibited robustness, and their balance sheets remained healthy.
North America continued to serve as a global safe haven and a source of alpha for our portfolio. Despite facing their own set of domestic challenges, both the U.S. and Canadian consumer markets displayed resilience, albeit with some emerging signs of weakness. In other regions, we observed heightened volatility in Europe and Asia, driven by fund flows and geopolitical factors. Given that our European exposure often includes higher-growth or smaller market cap companies compared to the index, there was a pronounced flight to safety in the European market, resulting in the indiscriminate sell-off of growth and smaller cap stocks. Small-cap stocks now trade at a 43% discount to their 10-year average and a 60% discount to their 3-year average.
A similar trend occurred in Asia, where companies with exposure to Greater China were systematically sold off during the quarter due to escalating geopolitical tensions between the U.S. and China. August alone witnessed a record outflow of $12 billion in capital from the region. We exercise greater caution in this region, as the resolution of geopolitical issues tends to span years rather than quarters. Meanwhile, we are actively exploring opportunities within the region for new investment ideas and conducting due diligence on our existing portfolio holdings.
We view these systematic sell-offs, irrespective of underlying fundamentals, as short-term pressures that create long-term pockets of opportunity for generating alpha. This rationale led us to redeploy capital from our more defensively positioned North American holdings into European small-cap growth companies. In the Asian market, we remain vigilant due to the protracted nature of geopolitical risks. In the interim, we are diligently scouting the region for new investment prospects while maintaining a close watch on our existing portfolio companies.
Significant contributors to performance in Q3 2023 include Computer Modelling Group (25.6%), SES Imagotag (14.0%) and Avantax (14.3%). Stocks that detracted from our portfolio’s performance in Q3 2023 include Country Garden Services (-30.9%), Big Technologies (-27.1%) and Silicon Laboratories (-26.5%).
Portfolio Changes
Throughout the quarter, we added the following companies to the portfolio:
- JTC PLC: A leading provider of fund services to institutional and private clients. It offers administrative services such as multi-currency valuation, fund accounting, shareholder registration, and related services to a range of asset classes, including real estate, private equity, and alternative asset classes. The nature of its business model is highly recurring and resilient, given its linkage to the duration of funds (7 to 10 years). Moreover, the company’s growth is independent of the fundraising environment. It is linked to the activity level of the alternative assets industry, which benefits from structural tailwinds and the growth of the global high-net-worth asset space.
- Intercos: A leading outsourced innovation and manufacturing partner to the global beauty industry. With a primary focus on color cosmetics and a global capability in product design and innovation, manufacturing, and R&D, the company sells to more than 720 clients worldwide, spanning from large beauty multinationals to emerging brands and retailers. The company’s full-service capabilities for brands allow it to weather the trends and cyclicality of the beauty industry. The company’s focus on value-added R&D services enables its clients to stay ahead within a changing industry.
- Pet Valu: A Canadian domestic market leader in the pet retail industry. Eighty percent of its revenue is essentially recurring. The company’s growth is driven by the increasing penetration of pet ownership in Canada and the humanization trend of pets, leading to the premiumization of pet products. Growth drivers include new stores, a higher portion of private labels, increasing e-commerce penetration, and better monetization through loyalty programs. The company was downgraded recently, along with other “discretionary” stocks, due to weakness in the macro backdrop of the Canadian economy. However, any pet parent knows that pet food/treats are anything but discretionary.
- We exited Richelieu Hardware, GDI Integrated, Sunevision, Country Garden Services and Digital Ocean based on relative opportunities to fund the new positions.
Outlook
In North America, despite the resilience displayed by consumers, we remain cautious and don’t consider them immune to economic challenges. We continue to witness painful adjustments in response to the new interest rate environment, and we anticipate that certain sectors of the economy will encounter growing difficulties. However, we take comfort in the fact that many companies in our portfolio maintain strong financial positions with low leverage and robust cash flow generation.
Turning to Europe, a recurring theme among our portfolio companies with global exposure is their preference to invest in growth in the U.S. or China rather than in Europe itself. While we understand this as a pragmatic capital allocation decision, we view the widespread negative sentiment toward the European business environment as a structural challenge.
In Asia, companies with operations in China are increasingly focused on navigating U.S. restrictions. A common solution is to establish independent entities separated from their global operations. Despite the prevailing “peak pessimism” in the market regarding China, our recent channel checks in several cities revealed robust consumer trends, particularly in services such as domestic travel, mirroring post-lockdown behaviors seen elsewhere. In the long run, we believe this represents a healthier growth pattern compared to the real estate and infrastructure-led growth observed in the pre-pandemic years.
In summary, the macroeconomic backdrop of prolonged higher interest rates and escalating geopolitical tensions is placing considerable pressure on companies, particularly small-cap firms. Those lacking strong market positioning, operational reach, and solid balance sheets will face increasing challenges. Consequently, the higher market volatility and overall weakness in small-cap stocks are understandable. However, there is a flip side to this situation: it has become more evident which companies possess dominant business models, capable operators, and robust financials. As market sentiment turns risk-averse and sells off both strong and weak performers, we find ourselves well-positioned to acquire high-quality companies at discounted prices.
- Intercos: A leading outsourced innovation and manufacturing partner to the global beauty industry. With a primary focus on color cosmetics and a global capability in product design and innovation, manufacturing, and R&D, the company sells to more than 720 clients worldwide, spanning from large beauty multinationals to emerging brands and retailers. The company’s full-service capabilities for brands allow it to weather the trends and cyclicality of the beauty industry. The company’s focus on value-added R&D services enables its clients to stay ahead within a changing industry.
- Pet Valu: A Canadian domestic market leader in the pet retail industry. Eighty percent of its revenue is essentially recurring. The company’s growth is driven by the increasing penetration of pet ownership in Canada and the humanization trend of pets, leading to the premiumization of pet products. Growth drivers include new stores, a higher portion of private labels, increasing e-commerce penetration, and better monetization through loyalty programs. The company was downgraded recently, along with other “discretionary” stocks, due to weakness in the macro backdrop of the Canadian economy. However, any pet parent knows that pet food/treats are anything but discretionary.
- We exited Richelieu Hardware, GDI Integrated, Sunevision, Country Garden Services and Digital Ocean based on relative opportunities to fund the new positions.
Outlook
In North America, despite the resilience displayed by consumers, we remain cautious and don’t consider them immune to economic challenges. We continue to witness painful adjustments in response to the new interest rate environment, and we anticipate that certain sectors of the economy will encounter growing difficulties. However, we take comfort in the fact that many companies in our portfolio maintain strong financial positions with low leverage and robust cash flow generation.
Turning to Europe, a recurring theme among our portfolio companies with global exposure is their preference to invest in growth in the U.S. or China rather than in Europe itself. While we understand this as a pragmatic capital allocation decision, we view the widespread negative sentiment toward the European business environment as a structural challenge.
In Asia, companies with operations in China are increasingly focused on navigating U.S. restrictions. A common solution is to establish independent entities separated from their global operations. Despite the prevailing “peak pessimism” in the market regarding China, our recent channel checks in several cities revealed robust consumer trends, particularly in services such as domestic travel, mirroring post-lockdown behaviors seen elsewhere. In the long run, we believe this represents a healthier growth pattern compared to the real estate and infrastructure-led growth observed in the pre-pandemic years.
In summary, the macroeconomic backdrop of prolonged higher interest rates and escalating geopolitical tensions is placing considerable pressure on companies, particularly small-cap firms. Those lacking strong market positioning, operational reach, and solid balance sheets will face increasing challenges. Consequently, the higher market volatility and overall weakness in small-cap stocks are understandable. However, there is a flip side to this situation: it has become more evident which companies possess dominant business models, capable operators, and robust financials. As market sentiment turns risk-averse and sells off both strong and weak performers, we find ourselves well-positioned to acquire high-quality companies at discounted prices.
