ClearBridge Canadian Small Cap Strategy Q4 2024 Commentary

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

Energy Reversal Concludes Strong 2024 – Fourth Quarter 2024

Market Overview

North American equity markets ended a strong 2024 on a high note. The S&P 500 and S&P/TSX Composite Indexes produced positive total returns of 9.1% (CAD) and 3.8% respectively in the fourth quarter of 2024. Both indexes again set all-time highs in December prior to fading into the holidays.

While both major indexes moved higher, the underlying economic backdrop for Canada and the U.S. continues to diverge. In the U.S., the re-election of Donald Trump and a Republican sweep of both houses of Congress clear a path for a slate of pro-business polices that have invigorated the market’s animal spirits. Strong GDP and employment growth, and inflation persistently above target, resulted in the Federal Reserve taking a more hawkish tone in their December policy release, reflecting the robust state of the U.S. economy.

In contrast, the Canadian economy continued to show signs of slack in 2024, as both GDP and employment growth remained sluggish. The threat of tariffs from the incoming U.S. administration combined with a slowdown in population growth as the federal government attempts to ease the burden on strained public services creates diverging outlooks for the Canadian and U.S. economies.

The differing outlooks manifested in a very weak quarter for the Canadian dollar. The loonie declined by 6%, reflecting a combination of differing expected paths of monetary policy — a more hawkish Fed versus a more dovish Bank of Canada — and the threats to the Canadian economy in 2025. The loonie ended 2024 below $0.70/USD — its weakest level outside of the pandemic since 2015.

The S&P/TSX Small Cap Total Return Index trailed its large cap peers in the fourth quarter, increasing by just 0.7%. The small cap index was led higher by financials (+13.8%) and energy (+12.6%) while the more interest-rate-sensitive utilities (-15.2%) and real estate (-12.9%) significantly trailed the benchmark. Weaker gold prices — due in part to the higher interest rates — resulted in the heavily weighted materials sector (-4.8%) moving lower.

In a reversal of the previous quarter, the energy sector was the largest contributor and materials was the largest detractor to the benchmark’s overall performance in the fourth quarter. Energy was supported by a firming in WTI crude, up 5.2% during the quarter to US$71.72/bbl, and NYMEX natural gas pricing, up 24.3%, albeit from a low base, to US$3.63/mmbtu. The oilfield services subgroup continued to perform well despite North America rig count moving largely sideways during the quarter.

The interest-rate-sensitive utilities and real estate sectors underperformed the benchmark. Despite lower policy rates from both the Bank of Canada and Federal Reserve, longer-term interest rates moved higher during the quarter. The Canadian government 10-year yield ended the quarter at 3.23%, up 28 bps, and the U.S. 10-year Treasury ended the quarter at 4.57%, up 84 bps.

Exhibit 1: Small Cap Performance by Sector

The ClearBridge Canadian Small Cap Strategy outperformed its benchmark during the quarter. An overweight position in energy and financials, underweight in materials, and strong stock selection in energy, consumer staples and materials were the primary sources of outperformance.

In energy, a very strong quarter from Enerflex (EFXT), Parex Resources (OTCPK:PARXF) and Kelt Exploration (OTCPK:KELTF) resulted in a meaningfully positive selection effect. Enerflex had an exceptional quarter, up 78% as a positive natural gas macro backdrop, combined with steadier operations, debt reduction, a modest dividend bump and a deeply depressed valuation, laid the foundation for outsize equity returns. Parex partially recovered from a very weak third quarter while Kelt benefited from higher natural gas prices.

The only material detractor from relative performance in the quarter was the information technology (IT) sector. Shares of Converge Technology Solutions (OTCQX:CTSDF) declined 29%, pressured by uneven third-quarter results and outlook for 2025, while Sylogist (OTCPK:SYZLF) was also a notable underperformer.

Portfolio Positioning

Volatility allowed us to be active during the quarter. We eliminated two positions and added two new names to the portfolio and were active in adjusting weights as opportunities presented themselves.

After a strong run, we eliminated our position in Secure Energy Services. Secure had successfully repositioned the business away from its traditional oilfield services valuation toward an industrial valuation, which we believe fairly reflects its combination of energy volatility and earnings stability in its waste-oriented business lines. We also eliminated our position in Dexterra Group (OTCPK:HZNOF) with better risk-reward opportunities in other equities.

We added two new materials investments to the portfolio during the quarter — Hudbay Minerals (HBM) and Capstone Copper (OTCPK:CSCCF) — and added to our position in Lundin Mining (OTCPK:LUNMF). Both Hudbay and Capstone are mid cap copper producers with substantial existing operations and growth potential, with appropriate balance sheets and improving free cash flow profiles.

With respect to Capstone, the business combination with Mantos Copper has created a rapidly growing copper company with a strengthened management and operating team. Hudbay, meanwhile, has recently shown improved operating performance as it continues to advance its Copper World project. Both companies trade at attractive levels with respect to our assessment of the intrinsic value of the business and have excellent optionality to the secular theme of accelerated electrification.

We trimmed several positions into strength and reallocated the proceeds to other opportunities. These included Bird Construction (OTCPK:BIRDF), Enerflex and Transcontinental (OTCPK:TCLAF), all of which capped a series of positive operating results and earnings updates during the quarter, pushing the equities to recent highs, as well as Canadian Western Bank (OTCPK:CBWBF), which we trimmed following its strong performance.

We added to positions in Richelieu Hardware (OTCPK:RHUHF), Parkland (OTCPK:PKIUF), Converge Technology Solutions, InterRent REIT (OTC:IIPZF), and Headwater Exploration (OTCPK:CDDRF). We view these as a collection of high-quality companies that have been negatively impacted by a range of circumstances and where current valuations do not reflect the fair value of the businesses.

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, enjoy structural competitive advantages, can generate high-quality growth and do so under appropriate capital structures.

We believe that high-quality growth companies — with appropriate capital allocation policies and capital structures — should be well-prepared to weather the uncertainty associated with tariffs and adapt to the pace and direction of monetary policy. Moreover, we believe that these companies should be well-positioned to be proactive in improving their competitive positions in volatile markets.

Portfolio Highlights

The ClearBridge Canadian Small Cap Strategy meaningfully outperformed its benchmark in the fourth quarter. On an absolute basis, the Strategy generated gains in five of the nine sectors in which it was invested (out of 11 total). The primary contributors to absolute returns were energy and financials while real estate was the main detractor.

Relative to the benchmark, overall security selection and sector allocation were both positive. The Strategy was positively impacted by an overweight in the energy sector and underweight in the materials sector. It also saw positive stock selection in energy, utilities, materials and consumer staples. On the negative side, stock selection in IT and financials and an overweight to utilities were drags on performance.

Among individual securities, the leading absolute contributors were Enerflex, Parex Resources, Propel Holdings (OTCPK:PRLPF), Methanex (MEOH) and Descartes Systems Group (DSGX). Individual detractors included Converge Technology Solutions, Real Matters (OTCPK:RLLMF), Sylogist, InterRent REIT and Boralex (OTCPK:BRLXF).

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.