Overall economic divergence continued between the U.S. and the rest of the world given structural tailwinds implicit in the U.S. market. This caused a change in market sentiment towards the U.S. interest rate regime to one that participants view as “higher for longer.” Coupling this with an increase in treasury issuance resulted in yields rising across the interest rate market that pressured major equity market valuations (Canada included) lower. An increase in energy prices however helped to protect Canadian markets to some degree over the period. Both Canadian and U.S. equity markets experienced notable decline in the months of August and September, resulting in negative overall returns in Q3 2023.
Holdings that contributed to absolute performance:
Celestica Inc (Celestica)
Celestica beat analyst estimates during the period on higher year-over-year sales and better year-over-year operational efficiency. Their Advanced Technology Solutions (ATS) segment saw the strongest revenue growth despite softness in the Semiconductor Capital Equipment market.
Eli Lilly and Company (Eli Lilly)
Eli Lilly experienced continued strong performance during the quarter. August 8th marked a significant day of that outperformance. Not only did Eli Lilly report stellar earnings fueled by its successful diabetes (and potentially weight loss) drug Mounjaro but perhaps more significantly, its peer in the obesity space, Novo Nordisk released long awaited results of a study showing that its own anti-obesity drug, Wegovy, reduced the risk of cardiovascular problems such as strokes and heart attacks. It is believed that evidence of this nature strengthens the case for anti-obesity drugs to garner health insurance reimbursement thereby expanding the potential total addressable market.
Holdings that detracted from absolute performance:
Trisura Group Ltd. (Trisura)
Trisura sold off over the period due largely to write downs on reinsurance recoverables and losses associated with their run-off program. The latter was driven by the potential for outsized weather events during the coming peak storm season.
Microsoft Corporation. (MSFT)
MSFT has sold off following a very slight expectations miss on its June quarterly results. While the much-scrutinized Azure cloud growth of 27% was at the high end of the company’s 26-27% guidance range, it seemed to come in shy of investor expectations of closer to 28%. Equally, if not more importantly, MSFT indicated that AI revenue impacts would be more second half of the fiscal year weighted as Azure Open AI and Co-Pilot ramps begin. Lastly, MSFT’s lack of FY24 revenue guidance despite hopes for a double-digit growth outlook has likely weighed on sentiment.
Small Cap Spotlight
We would like to highlight our position in Badger Infrastructure (BDGI) – Badger Infrastructure Solutions Ltd is the North American leading provider of non-destructive excavating services. Within the last twelve months Badger has hired a new CEO and CFO who are currently in the midst of driving positive operational change within the company. One such example of change is adding a commercial strategy in the organization, which is building out relationships with large national contractors executing infrastructure related projects. Over time we believe this should lead to a larger share of customer work and a less seasonal revenue stream. In addition, over the past 5-10 years Badger’s end market exposure has shifted dramatically from being mostly Oil and Gas related, to now being heavily exposed to utility and infrastructure spend which has multi-year tailwinds from government spending bills including the Infrastructure Investment and Jobs Act and the Inflation Reduction Act. Despite these positive changes, Badger is currently trading near an all-time low valuation, carries little leverage, and has positive margin and revenue tailwinds behind them. We view shares of Badger favourably and believe there is significant upside from current levels.
Outlook and Opportunities
According to the historic playbook, we believe economic indicators continue to flash warning signs for the road ahead. Historical markers such as the continued inverted yield curve and diminishing industrial production seem to continue to hint at a recessionary trajectory that is further reinforced by tightening corporate lending standards across much of developed markets. We acknowledge that the U.S. economy remains resilient vs. its global peers (Canada included) and has likely dodged the “imminent” recession call earlier this year. Tailwinds that have benefited the U.S. include low corporate bankruptcy levels, a resilient US consumer (given pandemic stimulus) as well as continued fiscal spending. These trends have increased the divergence against the rest of the world where economies now seem to be rolling over. This coupled with a U.S. Federal Reserve that is committed to “higher for longer” has and continues to lead to a stronger U.S. dollar which in our view further increases the probability of a financial market accident. Given our view on equities, at this time we are currently waiting for better opportunities before increasing equity market risk.
