ClearBridge Canadian Small Cap Strategy Q1 2024 Portfolio Manager Commentary

By Garey J. Aitken, CFA, & Michael Richmond, CFA

Upgrading Portfolio Quality into Strength – Market Overview

After nearly two years of managing through steadily higher policy rates and regular prognostications of economic troubles, investors clearly expected 2024 to be a transition year. Rather than a change, the first quarter of 2024 looked much like 2023. The widely held expectations of further disinflation, a softer real economy and lower policy rates have proven largely misplaced: inflation has remained sticky and above central bank targets, the economy has been robust and forecasts for lower policy rates have been continually pushed later into the year and 2025.

North American equities have shrugged off these changing views on the economy and higher interest rates with U.S. equities, the S&P/TSX Composite and the S&P/TSX Small Cap Index all up meaningfully in the first quarter. The mega-trend trades of artificial intelligence (AI) and GLP-1s broadened out to include a wider equity participation as investors became comfortable with earnings growth and valuations across a number of sectors, regardless of the direction of interest rates.

The S&P/TSX Small Cap Total Return Index increased 7.9% in the first quarter. The index’s heavy-weight commodity sectors led the way higher, with energy (+13.6%) and materials (+8.6%) two of the three sectors to outperform the broader index. The U.S. crude benchmark price (WTI) moved from US$71/bbl at the end of 2023 to US$83/bbl at the end of the quarter. The combination of a stronger than expected global economy, muted U.S. activity/production, and OPEC+ production curtailments has tightened the supply-demand outlook for crude, pushing prices higher. Canadian oil and gas producers entered this cycle from a position of strength. Balance sheets are, on average, incredibly strong and companies have held the line on capital commitments. As a result, liquids producers are testing highs set in the summer of 2022 when crude pricing was above US$120/bbl.

Exhibit 1: Small Cap Sector Performance

Oilfield service companies also had a very strong start to the year as fears around declining North American drilling and completions activity abated with stronger commodity prices. The small cap oilfield group was up 16.4% during the quarter.

Gold prices added fuel to the commodity trade in March. Gold reached an all-time high of US$2,250/oz during the quarter and has subsequently moved higher. Interest in gold producers and developers moved down the market cap range with the metals and mining subsector increasing by over 10% in the quarter, with the move occurring entirely during March.

Interest rate sensitive sectors continued to fall behind the small cap index. Real estate (+2.9%) and utilities (+2.9%) lagged in a strong market while consumer discretionary (+2.3%) and consumer staples (+0.5%) sectors also underperformed on a mix of idiosyncratic moves within the sectors and general weakness from the Canadian consumer.

The Canadian small cap information technology (IT) sector was surprisingly weak given the broader performance of North American technology, up just 2.3%. The limited number of AI-related technology equities in the Canadian small cap index made stock selection a key driver of performance.

Health care was a standout performer in Canada (+14.3%), but it is worth stressing that performance was the result of cannabis companies that have meaningfully underperformed in recent years due to challenged long-term prospects.

Portfolio Positioning

Our portfolio actions in the first quarter were consistent with the steps taken in 2023 to improve the average quality of the holdings while remaining committed to our views on valuation. This resulted in us eliminating three positions during the quarter.

• We continued to trim equities that have performed well and are approaching, or in certain cases have surpassed, our estimate of fair value, including Celestica (CLS), DRI Healthcare (OTC:DHTRF), Bird Construction (OTCPK:BIRDF), Converge Technology (OTCQX:CTSDF), and Propel Holdings (OTCPK:PRLPF). These are a collection of high-quality business that have performed well and executed along our initial investment theses. Nonetheless, we remain disciplined in our valuation approach and have trimmed positions into strength.
• We exited our position in Neighbourly Pharmacy (OTCPK:NBLYF) following the finalizing of its take-private offer. We were disappointed by the implied valuation of the offer, but ultimately could not see an avenue to surface further value and so we moved on.
• We eliminated our position in Whitecap Resources and reallocated toward increased weights in other E&Ps: Parex Resources (OTCPK:PARXF), Headwater Exploration (OTCPK:CDDRF) and Kelt Exploration (OTCPK:KELTF). The move was made in part to increase the average quality of our E&P positions and to reduce our net exposure to Western Canadian natural gas pricing. Whitecap has progressively shifted away from its historical roots as a conventional light oil producer toward a more diversified natural gas, condensate and light oil production profile. Given the macro headwinds facing Western Canadian natural gas, we decided to shift our E&P exposure toward high-quality pure-play crude producers (Headwater and Parex) and long-resource, Montney-focused natural gas/condensate (Kelt).
• We also exited our position in Blackline Safety (OTCPK:BLKLF), a safety technology/service provider to industrial applications that had done well to grow and improve profitability, but whose pathway to sustained profitability and appropriate return on invested capital remains uncertain. In our view, the equity price during the quarter properly reflected the risked upside potential on Blackline, and we eliminated our position.

Outlook

Our investment approach is a bottom-up strategy that prioritizes identifying and capitalizing on market inefficiencies, using our proprietary research, and the time arbitrage that comes with our long-term investment horizon. This approach is supported by our patient culture, enabling us to make well-informed decisions when there are discrepancies between expectations and underlying fundamentals. We remain steadfast in our commitment to our investment style, diligently seeking out businesses that exhibit wise capital allocation practices and structural competitive advantages, can generate high-quality growth, and can do so under appropriate capital structures.

Our long-term, bottom-up investment approach is agnostic to economic cycles, but as valuations in more cyclical sectors become stretched, we continue to find opportunities in defensive areas of the market and those sectors that have been most negatively impacted by the rise in interest rates. The Strategy as a result is overweight the defensive utilities and consumer staples sectors and has reduced its relative weighting toward the more heavily cyclical sectors.

As we acknowledge the presence of risks and uncertainties, we are confident that the future will present both challenges and opportunities. We will seize on opportunities as they arise, leveraging our extensive track record of delivering superior risk-adjusted returns over the long term.

Portfolio Highlights

The ClearBridge Canadian Small Cap Strategy outperformed its benchmark in the quarter. It was a quarter marked by two halves, with very strong relative performance in January and February partially reversing in March as the materials sector posted an exceptionally strong month. On an absolute basis, the Strategy posted positive returns in eight out of the 10 sectors in which it was invested during the quarter (out of 11 total).

On a relative basis, stock selection had a positive impact on performance, and was partially offset by negative sector allocation. Specifically, stock selection in IT, health care and consumer discretionary drove results. Conversely, negative selection in materials, energy and consumer staples, overweights to utilities and consumer staples and an underweight to materials, in particular precious metals, detracted from performance.

On an individual stock basis, the largest contributors to absolute performance were DRI Healthcare, Headwater Exploration, Celestica, Converge Technology Solutions and Enerflex (EFXT). The largest absolute detractors included Jamieson Wellness (OTCPK:JWLLF), Parex Resources, Boralex (OTCPK:BRLXF), Canadian Western Bank (OTCPK:CBWBF) and Richelieu Hardware (OTCPK:RHUHF).

Garey J. Aitken, CFA, Head of Canadian Equities

Michael Richmond, CFA, Director, Portfolio Manager

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