indicatorFund Commentary

Sub Advisor Insights—Investment Strategies Q2 2021

Sub-Advisors for the Compass Portfolio program reviews the events in their underlying Investment strategies during the second quarter of 2021.

By ATB Investment Management 26 August 2021 13 min read

Canso Corporate Value Mandate

Contributed by: Canso Investment Counsel Ltd.

The portfolio returned 3.4% in the quarter, ahead of the benchmark return of 1.3% (FTSE All Corporate Bond Index). Performance was led by further recoveries in pandemic affected issuers as spreads continued to normalize. Bonds issued by Bombardier, Occidental Petroleum and Continental Resources outperformed the broader market. For the one year period, the portfolio returned 25.5% and over ten years the 8.7% return was 4.2% ahead of the Index. Since inception, the 9.8% return represents 4.5% of added value.

 

Canso Investment Grade Mandate

Contributed by: Canso Investment Counsel Ltd.

The quarterly return of 1.9% was 0.6% ahead of the benchmark (40% FTSE Canada Mid-Term Corporate Bond Index & 60% FTSE Canada Short-Term Bond Index). Performance was driven by strong returns in longer term bonds of issuers that have been affected by the pandemic such as Cenovus Energy, Heathrow and Boeing. AT&T long bonds also aided in outperformance after the announcement of the merger of their WarnerMedia business with Discovery. Higher underlying yields in the first quarter have produced negative returns year-to-date but the return is 1.0% ahead of the benchmark for that period. For the past 3 years, the 6.0% return is 1.4% ahead of benchmark and since inception the 4.8% compound annual return has added value of 1.2% per annum.

 

Cardinal Canadian Equity Mandate

Contributed by: Cardinal Capital Management Inc.

The portfolio gained 6.82% in the second quarter and 18.66% for the first half of the year. While the portfolio trailed the benchmark (S&P/TSX Index) in the quarter, the portfolio returns for the first half of the year and year-over-year, continue to beat the index. The portfolio generated 138 basis points of outperformance for the first half of the year and 533 basis points outperformance over the past year.

Inflation metrics and rising interest rates paused in the second quarter as the push/pull line between permanent and transitory price pressures remain unknown. The broad commodity rally continued in the second quarter with a few commodities lagging, such as lumber and gold. Energy prices further strengthen with WTI climbing to levels not seen since October 2018.

While inflation and interest rates are still expected to rise longer term, the pause in the second quarter, especially in June, led to change in market leadership. The growth-oriented stocks in the U.S. and Canada, namely Shopify, Inc. outperformed in the latter half of the quarter. With Shopify accounting for approximately 7% of the S&P/TSX index, its 31% price increase for the quarter and 42% increase from mid-May, accounted for the majority of the underperformance of the portfolio in June and in the quarter.

 


Cidel Canadian Total Return Mandate

Contributed by Cidel Asset Management Inc.

The Fund posted a solid 6.4% return in the second quarter while the S&P/TSX Index returned 8.5%. The largest source of underperformance compared to the S&P/TSX Index was security selection, while sector allocation was an overall positive contributor.

Negative security selection came from the Information Technology sector. In particular, Enghouse Systems declined 5%. Despite generating significant free cash flow, Enghouse’s fiscal Q2-2021 results missed expectations. The stock was weak heading into the mid-June report. We believe, with reset expectations, the outlook for the company remains very positive.
Security selection was also weak in the Energy sector, with Parkland returning only 6.9% in the quarter while the Energy sector rose 14%. Parkland is not an oil and gas producer but rather a refined fuel distributor and convenience store operator, so it did not participate in the second quarter enthusiasm for energy commodity exposed equities. It remains a top position in the Fund due to the compelling fundamental outlook as lockdown restrictions ease in Canada combined with very attractive valuation.

There was some good stock selection during the quarter from the Consumer Staples and Financials sectors. The leading positions were Loblaw (+9.1%) and Bank of Montreal
(+14.5%). From a sector allocation perspective, the timing of the investment in Chartwell Retirement Residences (see below) led to a positive contribution in the Healthcare sector. Unfortunately, partially offsetting the Healthcare sector positioning was the overweight in the outperforming Consumer Staples sector.

 

Mawer Canadian Equity Mandate

Contributed by Mawer Investment Management Ltd.

The Mawer Canadian Equity Fund (the “Fund”) returned 6.2% before management fees in the second quarter, resulting in relative underperformance against the benchmark (S&P/TSX Index). The portfolio provided a positive return in the second quarter in a continuation of the themes that drove relative performance in Q1. Areas of strength during the quarter were tied to portfolio components most exposed to re-opening. The bank stocks we owned, notably Royal Bank of Canada and Bank of Montreal, benefitted given the prospect of greater economic activity as reopening plans continue. E-commerce company Shopify posted stronger than expected quarterly earnings and continues to benefit from digital commerce tailwinds. In our energy holdings, Canadian Natural Resources performed well driven by higher oil prices and the prospect of increased demand from continued reopenings.

Canadian National Railway was the largest detractor over the quarter due to disappointing earnings results and concerns related to their proposed acquisition of Kansas City Southern. Lundin Mining Corp declined during the quarter on news of lowering their production guidance. The near-term production delay should not impact the total amount of ore expected to be produced over the long-term. Wood product company Stella Jones also declined over the quarter due to softening lumber fundamentals.

Looking back over the full year ended June 30th, the portfolio delivered considerably strong returns that have nonetheless failed to keep pace with the benchmark. Fundamentally, the portfolio has proven more resilient through the pandemic: the revenues and operating earnings of our portfolio companies – in aggregate – have been less volatile than those of the broader market … both on the way down and on the way up. It is this consistency, along with a risk management approach that prioritizes resilience, that explains the portfolio’s behaviour and return profile relative to that of its benchmark.

 


Mawer Canadian Small-Cap Mandate

Contributed by Mawer Investment Management Ltd.

The portfolio returned 6.0% in the second quarter, lagging the S&P/TSX Small-Cap Index’s 9.2% return. As in the first quarter, the market continued to emphasize the cyclical and commodity-focused companies which benefit most in the early stages of an economic cycle. These companies tend to have weaker competitive advantages which our philosophy shies away from, and as a result the portfolio’s lower exposure to these cyclical companies and to commodity-related businesses, such as those within the Energy and Materials sector, detracted from our relative performance. While we recognize that such companies could outperform in a recovery rally, timing when to buy these lower-quality companies, and, just as importantly, when to again de-emphasize them, is very difficult. Predicting the economy’s future is a tough task, and at Mawer we do not believe we can do so with any degree of statistically significant success. Rather, we aim to predict the future of each company our clients own by virtue of analyzing its competitive advantage, the strength of its management team, and aiming to buy these businesses at a discount to intrinsic value. While still difficult, predicting these variables on a single company basis is incrementally easier than the entire path of the economy, and we believe this bottom-up assembly of a resilient portfolio is ultimately what has allowed us to create value for our clients.

While our overweight exposure to Information Technology detracted from performance over the second quarter, select IT holdings such as Converge Technology and Dye & Durham performed well. In the case of Dye & Durham, the share price increased following news of the company exploring strategic alternatives after the CEO offered to take the company private, while Converge continued to execute on its strategy and was rewarded by the market.

Holdings such as Stella-Jones, Sleep Country and Richards Packaging all experienced increased demand over the pandemic but their stock prices have pulled back as investors emphasized companies whose earnings would show more immediate growth as the economic impact of the pandemic subsides.

 

Mawer US Equity

Contributed by Mawer Investment Management Ltd.

The Mawer U.S. Equity Fund (the “Fund”) returned 6.0%, before management fees, resulting in relative underperformance against the benchmark (S&P 500 CAD Index). The portfolio provided a strong positive return in the second quarter while lagging its benchmark in a continuation of the themes that drove relative performance in Q1.

Areas of strength were tied to technology companies as well as portfolio components most exposed to re-opening:

  • The technology stocks we owned – notably Alphabet (Google), Intuit Inc, and Microsoft – benefitted given the prospect of greater economic activity. Alphabet (Google) continued its advance from the first quarter, buoyed by elevated consumer activity online and broad based growth in advertiser revenue. Microsoft also continued to advance since the start of the year as it issued positive guidance for future earnings. Intuit Inc, a financial software firm, advanced strongly as the company reported higher revenues during the quarter.
  • Elsewhere, global professional services firm Marsh and McLennan, had strong stock performance as the company reported earnings that topped consensus estimates during the quarter
  • Waters Corporation, a laboratory instrument company, continued on its advance from Q1 as it continued to implement its strategic plan and display positive signs of execution improvement under the new CEO.

Areas of weakness during the quarter:

  • The rise in discount rates hurt longer-duration companies whose valuations are most dependent on cash flow projections further into the future. Examples we own include technology company Cognizant Technology Solutions, software company Aspen Technology, and data analytics provider Verisk. The sell-offs were more notable when coupled with results that missed lofty expectations, e.g. Verisk.
  • Hologic Inc, a global medical technology company, experienced some share price weakness over the second quarter on lower guidance from management
  • Less exposure than the benchmark to tougher, less competitively-advantaged business models such as banks, communication services, and energy companies – all of which were among the best performing parts of the market over the period.

Looking back over the full year ended June 30th – a period of time entirely comprised of the bounce-back – the portfolio has delivered considerably strong returns that have nonetheless failed to keep pace with the benchmark. Fundamentally, the portfolio has proven more resilient through the pandemic: the revenues and operating earnings of our portfolio companies – in aggregate – have been less volatile than those of the broader market … both on the way
down and on the way up. It is this consistency, along with a risk management approach that prioritizes resilience, that explains the portfolio’s behavior and return profile relative to that of its benchmark.

 

Mawer International Equity

Contributed by Mawer Investment Management Ltd.

The Fund delivered a comparable return to that of its benchmark (MSCI EAFE CAD Index) during the second quarter.

Despite the economic recovery, pandemic-related issues continued to impact Japanese drug store chains Tsuruha and Sundrug as the bump in COVID-related sales has waned while customer traffic, particularly in urban locations, is taking time to fully recover. Two other Japanese companies – videogame developer Nexon and high-performance plastics company Sekisui Chemical – experienced declines in their stock prices after offering weaker guidance ahead. For Nexon, this may suggest that the drivers that led to strong performance during the pandemic (people staying indoors) may not be sustained as countries re-open. We had trimmed some of our exposure to Nexon back in March on valuation concerns, but continue to maintain our positions in both companies given the long-term investment theses.

Two recently-initiated Chinese companies experienced outsized negative price movements during the quarter: after-school tutoring service provider New Oriental Education and online automobile platform Autohome. Both represent below-average sized positions in the portfolio.

  • The uncertainty and potential for increased regulation has weighed on New Oriental. The timing of our initiation earlier this year was influenced by what we perceived to be excessive negative sentiment, which has subsequently gotten worse. We continue to maintain our position, as we think the odds aren’t as dire and that often policy rulings benefit larger players at the expense of smaller ones.
  • Autohome announced a long-term strategic review – both aimed at scaling back inefficient business lines and searching for new growth drivers. While we have acknowledged some greater competitive intensity, we are surprised by the degree of the pullback. We continue to maintain our position.

By contrast, two of the largest contributors to the portfolio’s positive returns were LVMH and Wolters Kluwer, and they are also among the portfolio’s largest weights.

Luxury goods conglomerate LVMH has proven both surprisingly defensive during the COVID-19 induced global recession, but has also benefited more recently as it is exposed to a post-COVID world by way of spending on luxury goods across travel destinations. Other stocks in the portfolio whose results showed they are benefitting from re-opening and increased economic activity include electrical components manufacturer Legrand and construction materials company Sika.

 

Mawer Global Small-Cap

Contributed by Mawer Investment Management Ltd.

The Mawer Global Small Cap Equity Fund (the “Fund”) returned 3.1%, before management fees, resulting in ~1% of relative underperformance against the benchmark (Russell Global Small-Cap Index). Overall, the pattern of returns in the portfolio has been consistent with our philosophy and expectations. The portfolio provided a modestly positive return in the second quarter while lagging its benchmark in a continuation of the themes that drove relative performance in Q1.

Areas of strength during the quarter were tied to portfolio components most exposed to economic re-opening. One example is Bilia AB, a Swedish company that services and sells vehicles. The company reported operational earnings that were significantly higher compared with previous year and market expectations. On a similar note, software company Bravura Solutions performed well during the quarter. Elsewhere, BayCurrent Consulting benefited from strong sales growth due to increased IT spending in Japan, our research suggests that companies in the country may be accelerating their focus on digital solutions after years of under-investment.

Conversely, areas of weakness during the quarter included less exposure to business models that we believe can be more cyclical and capital intensive on average, such as energy and real estate companies – all of which were among the best performing parts of the market over the period. CSW Industrials, an industrial component and specialty chemicals company, reported increases in revenues in key end markets during the quarter, but may have to navigate a challenging supply-chain environment as the pandemic restrictions are lifted. For On The Beach Group, a UK online holiday retailer, an uneven return of customers amid ongoing travel restrictions has dampened some of the enthusiasm around the company’s recovery. Although some holdings had relatively weak performances during the quarter, we still believe in an investment philosophy that prizes durable revenue streams. An example of these “boring” businesses that held back portfolio performance in the quarter would be Japanese drug store chain Tsuruha. While the company continues to grow at a stable rate, the bump from pandemic-related sales and traffic has waned. In our opinion this might have made the company seem less exciting for investors interested in shorter term re-opening beneficiaries.

Looking back over the full year ended June 30th – a period of time comprised of the bounce-back – the portfolio has delivered considerably strong returns that have nonetheless not kept pace with an even faster rising benchmark. That said, the portfolio has proven its relative strength through the pandemic. It is this consistency, along with a risk management approach that prioritizes resilience, that explains the portfolio’s behaviour and return profile relative to that of its benchmark over this 1yr time frame.

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