At a time when investors are leaping into private markets, one Canadian small-cap fund is seeing big returns by taking a private equity approach to public markets.
That’s how David Barr, CEO of Vancouver-based PenderFund Capital Management Ltd., manages the $323-million Pender Small Cap Opportunities Fund.
Barr, who has been CEO since 2016, joined PenderFund in 2003 as the firm’s chief financial officer. He’s managed the Pender fund since its inception in 2009, posting returns of more than 18% over the fund’s lifetime.
The fund’s performance has held up over shorter periods. For the year to Nov. 30, the Series A version rose by 27.4%, compared to 16.3% for the index, and over five years that return is 15.9% (compared with 6.1% for the index).
With returns like these, Barr is a natural choice for Investment Executive’s 2021 Mutual Fund Manager of the Year.
The Pender Small Cap Opportunities Fund is “an opportunistic, concentrated portfolio,” with an emphasis on “undervalued small- and micro-cap companies with strong underlying economics, predominantly in Canada,” according to PenderFund. The market seems to have agreed with Barr’s picks: in 2021, nine of his holdings were acquired by other companies.
The fund comprises 87.3% Canadian equities and 9.9% U.S. equities, with the rest held in other assets and cash. The fund’s highest sector weightings are IT (35.5%), industrials (17.8%) and consumer discretionary (13.2%).
The fund focuses on companies with a market cap of $2 billion or less, Barr said, although its investments aren’t limited by company size. The fund also can invest directly in companies through private placements or public offerings.
PenderFund aims to invest in small caps earlier than other investors. The portfolio managers look at a company that is not yet profitable, but is growing rapidly in a relatively new market, Barr said. Indicators include general and administrative spending, an increase in sales and marketing, as well as research and development.
Barr said his background in private equity shapes his investment strategy. Prior to joining PenderFund, Barr was an investment manager at venture capital firm FutureFund Capital Corp. in Vancouver for almost three years. He then worked exclusively on PenderFund’s private equity investments until 2009, when the firm launched the Pender Small Cap Opportunities Fund.
“We take a private equity approach to public markets. What that means is really understanding the underlying economics of the business we’re investing in,” said Barr, who described himself as a “bottom-up investor all the way.”
He said that approach is necessary in private equity because “you’re buying something incredibly illiquid” and holding it for five to 10 years. You have to conduct a “deep level of due diligence” to ensure you fully understand the company you’re investing in, he added.
Barr put this philosophy into action when the Pender fund bought shares of Kanata, Ont.-based ProntoForms Corp. in 2018. That B2B software and mobile app developer had posted compound annual growth of 30%, with 90% recurring revenue, from 2013 to 2018. (Today, ProntoForms is a top 10 holding in the fund, with a 3.2% weighting.)
Barr said research revealed the company was trading at a 50% discount. “We also saw the growth opportunity for the company and realized the value of the business was going to be substantially higher five years from when we made the initial investment,” he said.
The company is one of the main players in the burgeoning field-services automation space. (Field-services automation involves using technology to schedule technicians — for example, the people who read gas meters — and monitor repairs and returns across a service network.) As a result, Barr felt ProntoForms had “a long runway.”
“There’s inherent advantages in being [one of] the biggest companies in the space,” Barr said. “We thought that positive feedback loop would kick in to help Pronto continue to accelerate its growth.”
ProntoForms stock produced a three-year return of almost 44% as of Nov. 30, which is about the same time frame as PenderFund has owned the stock.
Another pick that typifies Barr’s strategy is Markham, Ont.-based Sangoma Technologies Corp., which the fund has owned since 2010 and is its top holding today at 6.3%. Barr had been following Sangoma, a communications firm, since the mid-2000s, and had heavily researched the company’s underlying technology, growth strategy and competitive space.
Sangoma produced a 10-year return of 21.8% and a 15-year return of 11.2% as of Nov. 30.
Over the past 10 years, the Pender fund’s only year of below-category (and negative) performance was 2018, when the fund returned –16.3%, about five percentage points worse than its category.
That year was “really challenging” for small- and micro-cap stocks, Barr explained: “Throughout the year, a lot of small-cap funds actually shut down. So, when it came to year-end, there were a lot of small- and micro-cap companies being sold indiscriminately as portfolios wound up. [That] impacted everyone right across the board.”
His lesson learned? “Never measure your success in short periods,” Barr said. “Focusing longer term is a much healthier measure and more indicative of what’s actually going on.”
Barr said 2021 has been a “tweak the portfolio” year, given that nine of the fund’s holdings were acquired by other companies, representing about 20% of the fund’s weighting. In fact, the nine takeouts were an annual record for the fund amid a “historical high” for mergers and acquisition activity in general. (In 2013, the fund saw eight holdings acquired.)
The majority of the nine acquisitions were in the technology space and “were taken out at a premium,” Barr said. “It’s been a nice tailwind for the portfolio” that has driven “a large percentage of the returns.”
But Barr doesn’t usually set out to find companies that will be acquired. Instead, he buys “really high-quality businesses” in early stages of their growth and typically holds them for a long time. That said, “because of the types of companies we invest in, we end up getting companies that, due to their underlying business characteristics, become very attractive.”
According to Barr, key indicators that a company could be acquired are strong revenue growth, healthy gross margins and scalability, and high return on invested capital.
“The big companies are always worried about who’s coming along, who can eat their lunch or disrupt them, or could be a pain in their neck. As opposed to competing with these young upstarts, they generally just buy them,” said Barr, who anticipates M&A activity will remain strong next year.
“If we have another year of record M&A, we should have another really strong year of ‘takeouts’ in our portfolio,” Barr said. “There’s lots of cash on balance sheets. We’ve had stock prices do really well, [so] if a company needs to issue equity to finance a transaction, they’re able to do so. We still have really low rates. It’s a pretty prime environment for M&A to continue into 2022.”
Performance of the Pender fund
The Pender Small Cap Opportunities Fund’s (Series A) 10-year annualized return is 19.8% as of Nov. 30, well above the 3.1% for the benchmark Morningstar Canada small cap GR CAD index, according to Chicago-based Morningstar Inc.
The fund’s annual returns were in the top quartile for six of the past 10 calendar years, and the fund is poised to return to the top quartile in 2021.
The fund won a Lipper Fund Award for best Canadian small/mid-cap fund over both three- and five-year performance periods in 2015, 2016 and 2017.
The Pender fund’s risk rating is medium to high and its management expense ratio is 2.50%.
Methodology
Investment Executive (IE) uses a points-based scoring system to rate Canadian mutual funds that have a minimum record of 10 years. Points are awarded for each year of positive annual returns as well as for relative outperformance and quartile rankings. IE also assesses cumulative 10-year returns, management expense ratios and volatility. Data courtesy of Morningstar Inc.