Source: Morningstar Research Inc., as of December 23, 2022.
POSITIONING AND OPPORTUNITIES
Looking into 2023, we are fully invested with <1% cash across our small cap mandates. As bottom-up investors, we believe there are numerous opportunities to buy wide-moat, growing and profitable small cap companies at attractive discounts to our assessment of intrinsic business value. We believe buying these businesses today offers compelling rates of return for discerning, long-term investors.
We have been underweight the consumer discretionary sector, with a particular focus on avoiding larger ticket discretionary purchases as we believe consumers will continue to feel the squeeze of inflation into 2023 and we will continue to see consumption of larger ticket items slow. We are also underweight consumer staples and utilities. While these sectors offer a high degree of stability, we believe these sectors have become expensive relative to faster growing areas of the market that enjoy wider competitive moats.
We have selectively added to energy exposure but remain underweight-to-market-weight across our strategies. We typically avoid taking direct commodity exposure, but we have been increasing weights in service companies where we believe pricing power is beginning to re-emerge after years of under-investment in capacity. We have added significantly to our position in Enerflex (TSX: EFX), a natural gas compression manufacturer and rental business. Enerflex recently completed the acquisition of its largest competitor, Exterran, for a very attractive price relative to the replacement cost of its equipment base, and we believe the deal is well-timed, ahead of a significant upcycle in demand for natural gas compression equipment.
We continue to see value in technology businesses that are trading at attractive free cash flow yields relative to their growth. These businesses benefit from secular tailwinds and the scalable, capital light nature of software products allows for high cash operating margins as the businesses mature. We believe the compounding nature of reinvestment in these businesses will drive meaningful outperformance over the longer term. We believe rates may remain elevated throughout 2023 and, as a result, have avoided exposure to unprofitable businesses that cannot self-fund their growth.
We have been adding to financials exposure but have been avoiding taking on additional consumer credit risk. We have maintained a large position in specialty insurer Trisura (TSX: TSU), which has continued to post strong growth and will see benefit to the float from higher interest rates.
In our global small cap strategy, we are getting more positive on European small cap equities. German equities have been hit very hard by the Russia-Ukraine conflict and ensuing inflationary pressures, and we have been devoting more attention to this market. Additionally, we continue to see ample opportunities in the Nordics and the UK. We believe equity markets in these countries are pricing in a very negative outcome and have been selectively adding exposure.
GLOSSARY OF TERMS:
Correlation: A statistical measure of how two securities move in relation to one another. Positive correlation indicates similar movements, up or down, while negative correlation indicates opposite movements (when one rises, the other falls).
Credit rating/risk – An assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payment.
Drawdown: Measures the peak-to-trough decline of an investment or, in other words, the difference between the highest and lowest price over a given timeframe.
Duration – A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).
Leverage – An investment strategy of using borrowed money – specifically, the use of various financial instruments or borrowed capital – to increase the potential return of an investment.
Return (absolute) – The measure of what an investment returned over a given time period. An investment that rose from $1,000 to $1,100 would have an absolute return of 10%.
Return (relative) – The performance of one investment versus another. The most commonly reported relative returns are mutual fund returns relative to their benchmark indexes.
Volatility – Measures how much the price of a security, derivative or index fluctuates. The most commonly used measure of volatility when it comes to investment funds is standard deviation.
Yield Curve - A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. A normal or steep yield curve indicates that long-term interest rates are higher than short-term interest rates. A flat yield curve indicates that short-term rates are in line with long-term rates, whereas an inverted yield curve indicates that short-term rates are higher than long-term rates.