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Dear unitholders,
The Fund performed well in the first quarter of 2023 against a backdrop of overall positive results in global financial markets despite some intra-quarter volatility. The Canadian and US stock markets had positive performance, with the S&P/TSX Composite advancing 4.6% and the S&P 500 gaining 7.3%. Concerns of a regional banking crisis in the US were short-lived, but still caused a reset in interest rates and piled investors back into mega-cap technology. The six largest companies in the S&P 500, which happen to be technology firms, contributed about three quarters of the total gains to the index in the quarter.
The Federal Reserve continued on its path to cooling inflation, raising interest rates twice in the quarter with the Fed Funds target rate ending the period at 5%. Despite rising benchmark interest rates, bond yields moved lower throughout the quarter, with the benchmark 10-year yield finishing at 3.48% after starting the year at 3.88%. This reset in interest rate expectations was driven by the upheaval in regional banks, combined with cooling inflation trends and a Fed signalling the aggressive interest rate hiking campaign is nearing at an end. Overall, against the backdrop of these macro events, we were pleased with the Fund’s performance.
One of the major areas of market concern during the quarter was the meltdown of Silicon Valley Bank (SVB), and the subsequent fallout to US regional banks and fears of a possible wider contagion to the financial system. Much has been written about this latest crisis, but we feel amongst the most insightful was Oaktree’s Howard Marks’ latest memo, “Lessons from Silicon Valley Bank”. He asks if this is a one-off or a harbinger of things to come. In short, he feels SVB was something of a special case and does not see its collapse leading to widespread contagion. We do not own any U.S regional banks in the Fund, nor any other banks for that matter. We also do not hold companies that were dependent on continued financing from SVB. Direct fallout has been negligible.
Nevertheless, we own numerous companies that are categorized as “financials” despite getting most of their value from operations in other sectors. For example, the value creation machine (in our opinion) of Exor NV (BIT: EXOR) is driven by its major holdings in the consumer discretionary and industrial sectors. Likewise, Onex Corporation (TSX: ONEX) owns some financial services companies, but its intrinsic value is driven more by its core investments in the healthcare and technology sectors. Companies like Onex and Exor do not easily fit into a single “sector” classification, which is standard practice in the investment industry.
It’s like logging into your Netflix account and seeing every movie is labelled “comedy”. Just because the lead actor makes a joke in an action movie does not automatically turn it into a comedy. But if it was a stock, the folks at data analytics company MSCI, who maintain industry classification standards and determine individual sectors for each company, might label it as such. Banks are certainly “financials”, but when it comes to Exor and Onex, in Star Wars parlance, “These are not the financials you are looking for.” We view both companies as well-run collections of diverse, good-to-great businesses, which are currently trading at bargain valuations. We believe the risk/reward ratio for both stocks have seldom been more favourable.
“We believe that observing actions when it comes to share repurchases is one of the best methods to assess management rationality and shareholder alignment.”
Today, Exor is comprised of a portfolio of assets that include a wide range of companies in sectors such as automotive, construction farming equipment, media and technology. Some notable investments include large stakes in Ferrari (NYSE: RACE), Stellantis NV (NYSE: STLA), maker of car brands Chrysler, Fiat, Peugeot and others and CNH Industrial (NYSE: CNHI), maker of Case construction equipment and New Holland farming equipment. Exor owned a large reinsurer (PartnerRe) for many years—which partly explains its historical industry classification as a “financial” —but sold it for a nice gain last year.
We estimate EXOR’s NAV at the end of the first quarter was approximately €133 per share and the stock traded at 57% of the NAV. The recent market value of its holdings Ferrari and Stellantis alone exceeds the market value of the entire company. We believe this dislocation puts it deep into bargain territory, relative to its historical trading metrics.
Closer to home, Onex, one of Canada’s alternative asset firms, was the Fund’s fourth largest direct holding. Like Exor, despite being categorized as “financial services”, most of the intrinsic value of the firm is not related to its holdings in financial services, but partial ownerships of numerous private and public companies operating in the industrials, business services, and healthcare industries, plus a sizable net cash balance. Similar to most of the industry, the past year was challenging for Onex. However, management has seen numerous market storms over the decades and navigated much worse cycles in the past. Importantly, Onex management also leaned into its stock repurchase program in 2022 when its stock was cheap.
Our detractors in the quarter included energy companies ARC Resources Ltd (TSX: ARX) and Texas Pacific Land Corporation (NYSE: TPL), as well as defense contractor Northrup Grumman Corp (NYSE: NOC). These companies were among the top contributors to the portfolio in the fourth quarter but gave back some of their gains in the first quarter. The portfolio made some changes, adding Trisura Group Ltd (TSX: TSU) and selling Brookfield Asset Management Ltd (TSX: BAM) late in the quarter after a run to top up our Onex position.
Trisura is a specialty insurer in the US and Canada. It operates in niche markets, relying on specialized underwriting knowledge and structuring expertise. It has a strong history of profitability and growth, notwithstanding a write-down in the fourth quarter, which caused the stock to fall to attractive prices. Trisura is a previously owned, successful holding and we were pleased to reestablish a position after the stock sold off. We expect Trisura to leverage its fixed cost base and technology investment to demonstrate sustainable mid-teens ROE and 15%+ EPS growth.
Our small cap exposure through the Pender Small Cap Opportunities Fund (PSCOF) contributed positively to overall performance during the quarter. Small caps began the year on a positive note, bouncing back from weak capital flows and tax loss selling at the end of 2022. The strong start to the year faded, however, as stress in the US regional banking industry became evident and capital flows shifted into large companies. The banking stress and the collapse of Silicon Valley Bank highlighted again the need to focus on the balance sheet and funding sources of the companies we own, particularly smaller companies. We have been focused on owning high-quality companies in the portfolio that have long runways of growth to compound value and that are profitable or where we see a visible path to profitability. For more details on the PSCOF, see the March update here.
Our fixed income investments are mostly reflected by our position in the Pender Corporate Bond Fund (PCBF). This contributed positively to performance in the quarter, against the backdrop of a rally in corporate bonds and despite some volatility. Since 2020, PCBF has delivered an annualized return of over 8% per year, notwithstanding the fact that this period has included a dramatic rise in risk-free bond yields. PCBF ended the quarter with an average yield-to-maturity of approximately 7.9%, significantly higher than the start of last year, with a current yield of 5.6%1 and an average duration of maturity-based instruments of 3.3 years. For more details on the PCBF, see the March portfolio update here.
The portfolio ended the quarter with approximately 50.2% invested in direct equities, 6.7% allocated to PSCOF, 36.1% invested in PCBF and limited cash. The Fund also held about 6.8% across the Pender Alternative Absolute Return Fund and the Pender Alternative Arbitrage Fund. These strategies contributed positively to the quarter, while providing uncorrelated returns in this environment as we expected. Over the long term, these strategies should dampen overall portfolio volatility while delivering returns with a low correlation to the overall portfolio.
We have remained balanced in our positioning and are finding a wide range of attractive opportunities across each asset class. The impact of rising interest rates over the last year has put downward pressure on asset prices but to varying degrees. As inflation continues its retreat, economic growth will be closely watched and could lead to further volatility. Our approach will remain consistent and we will continue to target investments where we see value, and that can sustain a wide range of market scenarios.
Felix Narhi & Geoff Castle
May 1, 2023