Institutional investor thrives on small caps

Ian Soutar isn’t patient by nature. But he knows a long-term approach to investing pays off.

“I’m definitely regarded as the most irresponsible and the risk-taker of the whole team,” admits Soutar, founding partner and vice chair of Pembroke Private Wealth Management.

Another co-founder, Scott Taylor, reminds him to take the long view, and other partners also help temper his risk-taking inclinations. They’re not afraid to caution him at weekly meetings.

The firm, which opened in 1968, still has the first two institutional clients it landed. The GBC American Growth Fund joined Pembroke in 1968, and a private Montreal pension plan came in 1974. The GBC fund has had an 11.4% compound annual growth rate over the past 45 years—nearly twice its benchmark indexes, says Soutar.

Pembroke invested the private pension fund’s assets when the market was low, and it has a 16.5% average compound return, he notes. “Over 38 years, $1 million accumulates to about $325 million invested with us, versus $37 million invested in the TSX. It’s a huge difference in returns.”

Pembroke manages assets of about $2.7 billion, which is invested in Canadian and American small- and mid-cap companies. Its partners—Canso Investment in Toronto, and Chicago’s William Blair—handle about $250 million in fixed and foreign investments.

“Large investment organizations that are managing tens or hundreds of billions of dollars of assets cannot invest in some of these smaller companies,” says Soutar, noting there sometimes aren’t enough shares of smaller companies for large funds to purchase. “That’s where we feel the real opportunities for outsized returns come,” he says, explaining Pembroke’s managers believe these companies will offer investors greater returns, compared to established companies, as they expand.

Soutar, who received a career achievement award at the 19th annual Morningstar awards in November 2013, adds, “We want to make our money the same way that our clients make their money, and that is to get good investment returns over the long-term. We are human and when we do make mistakes, people know that it’s hurting us as well.”

So how do you choose companies to invest in?

The first part of due diligence is sitting down and reading a lot of reports about these companies, to find out whether they’ve been successful in growing their revenues and earnings per share.

We don’t necessarily look for consistent growth. Instead, we look for average annual growth on the top line of at least 15%, and hopefully a little more than that on the bottom line for earnings per share.

We visit the senior people who run these businesses, and find out what their philosophy is, what they’re attempting to do and what their personal lives are like. We look for big insider ownership. We believe that the people who are running these businesses should have a lot of skin in the game.

One or two people can make a huge difference in potential long-term returns. We like to find out whether the people who live in the communities where these companies operate are also investors, because they’ll know an awful lot.

How long do you hold investments?

Usually three years, although our desire is to own them forever. But for many reasons, that doesn’t always work out: for instance, we’ve misjudged, overestimated the growth potential, or didn’t pick something up in our due diligence, which reduced the long-term attractiveness of the company.

Sometimes we underestimate the competitive landscape, or overestimate management’s competitive strengths or market opportunity. This is why new investments are more risky than time-proven older ones, and are typically smaller weightings in the portfolio. Recent holdings that have not worked out include home soda maker brand Sodastream and venture capitalists Liquidity Holdings.

But some companies we’ve owned for more than 20 years. If we find something we like, and it does well, it’ll get recognized in the marketplace and sometimes the valuation will get to be excessive. When that happens, we reduce our exposure.

For instance, O’Reilly Auto Parts hasn’t grown wildly, but it’s grown consistently and turned out to be a phenomenal investment. We bought in 1997 and still hold it today. It’s a company that’s approaching $10 billion in market cap. Due to its size and the fact that it’s already done well for us, we’ve cut it back as a percentage holding in our portfolios.

Also, for 20 years, SNC-Lavalin was a wonderful investment for us. We sold the last of our holdings in May 2010, when the company had a market cap of $7 billion. This is above our preferred market cap size of $100 million to $1.5 billion. The law of large numbers usually works to slow growth. So as companies reach multibillion-dollar revenues, we like to substitute larger-cap investments for smaller ones capable of faster growth.

What’s your sector outlook?

The portfolio has a lot of exposure to technology, technology services, financial services, healthcare, and industrial, mining and even petroleum companies. Especially in the U.S., there’s a huge industrial renaissance because of the success of hydraulic fracturing. This has led to a big increase in both oil and natural gas production. That’s bringing a lot of foreign and American manufacturing jobs back to the U.S. This is a trend that’s going to go on for the next five- to 10-years and result in better economic growth, job creation and investment opportunities.

It’s hard for us to find banks that can grow their top and bottom lines faster than 15%. Canadian large-caps have been phenomenally successful long-term investments. But they’re too big for us and they’re not growing fast enough. In the U.S., we look for smaller regional banks that have an edge. For instance, we like local banks in Texas, which are enjoying unusual economic growth because of the fracking revolution.

We’ve also owned Bank of the Internet for almost two years. [Editor’s note: Between January 2012 and January 2014, the stock more than tripled in value.] We like this company because it’s located in California, and is now providing online banking services throughout the U.S.

Youngsters are into Internet banking, so I think this is a great growth opportunity. And a branchless bank has enormous cost advantages over those with regional offices.

What’s your advice for retail investors?

Often, investors will change a manager if he’s underperforming, but doing this will hurt long-term returns. Most managers go through these periods because they can’t always outperform; perhaps there’s been a loss of key personnel, or there’s been rapid growth of assets under management, which takes time away from managing portfolios to service new clients.

However, if a manager controls his growth, it’s only a matter of time before performance will improve.

So if a manager’s underperforming, give him more money. If he’s outperforming, then take a little bit of money away. Leaving a proven successful manager for one who is outperforming is usually a costly mistake.

Also, the biggest mistake investors make is to panic at the bottom of the market. But trying to figure out what the market is going to do in the next year is impossible, so be patient.