Pathfinder Small Cap Quarterly Report

Rob Ballard, CFA | Portfolio Manger

Mark Ouellette | Trader

Gary Sidhu, MBA | Analyst

Jared Fehr, P.Eng | Analyst

JUNE 30, 2022

The Pathfinder Small Cap mandates invest in high-torque, early-stage companies that have the potential to generate superior returns.

Pathfinder Partners’ Fund

The Partners’ Fund had a net return of -17.1% in the second quarter of 2022.  This compares to the TSX Venture Exchange which had a return of –30.8%.  Our annualized 7-year return is 13.3% compared to the TSX Venture Exchange’s return of -1.2% over the same period.  The table below provides a performance summary.

Our top contributor for the quarter was F-Star Therapeutics (NDX:FSTX) which contributed +3% to gross returns.  Our main detractors were Spectra7 Microsystems (TSXv:SEV) at -3%, Trevali Mining (TSX:TV) at    -2.3% and Itafos (TSXv:IFOS)  at -1.8%.

The second quarter saw broad-based market declines.  Fears of a potential recession have grown as inflation remains high and the Federal Reserve continues raising interest rates.  As we’ve discussed before, when the market adjusts in response to future economic weakness, we see some of the best opportunities to become shareholders of great companies at reduced valuations.  Due to the fortunate timing on an acquisition announcement on one of our core biotech holdings (more on this below), we are well capitalized to take advantage of this market pullback and are busy negotiating deals to add to holdings at bargain basement prices.  Despite the unpleasantness of market declines, we firmly believe that volatility in the market increases our ability to generate strong returns by providing opportunities to trim holdings when they get too high and to add them when they get oversold beyond reason.

Throughout the second quarter, we have continued to allocate capital to the biotech sector and believe that our investment thesis is starting to play out.  The biotech industry is ripe for consolidation as access to capital dries up for smaller companies forced to consider strategic alternatives to preserve shareholder value.  There has been an exodus of capital in the space and stocks are trading at heavily discounted levels, yet major pharma companies are sitting with flush balance sheets and have numerous patent expiries coming throughout the decade. This suggests a need for M&A to rebuild their drug pipelines. For example, Invox Pharma (a subsidiary of Sino Biopharmaceutical) is buying F-Star Therapeutics for $7.12/share, a 79% premium to the previous close. F-Star therapeutics is an immune-oncology drug development company focused on creating bispecific antibodies with their flagship drug being FS118, a LAG-3/PD-L1 dual inhibitor in head and neck cancer as well as non-small cell lung cancer and large B-Cell lymphoma. The company has a robust pipeline of drugs in a mix of Phase 2 and Phase 1, and multiple partnerships with the likes of Janssen, Denali, and Merck. This acquisition helps validate our strategy of identifying companies with strong underlying assets, partnerships with big pharma, and low valuations.

Redishred Capital Corp. (TSXv:KUT) is a paper shredding company that operates out of the US. Paper shredding isn’t the most glamourous industry, but there exists an opportunity to capture significant market share in an overlooked segment.  Redishred is proving to do just that, led by an exceptional management team that has grown revenue at roughly 25% CAGR over the last 4 years while improving overall margins. A chunk of their success is driven by their acquisition strategy that looks at their own franchisees first, which provides a significant advantage since Redishred is privileged to the inner workings of their operations. In 2021, the company grew sales 54% and improved EBITDA margins to 25%, demonstrating that the $8M in acquisitions the company made in 2021 were done at prices that are accretive to the company’s value. The company is just getting started in a fragmented paper shredding market where acquisitions focusing on route density and good operators can add meaningful value. We think the company is flying under the radar of the market, but at their growth rates and high margins, we don’t see that lasting for very long.

Currency Exchange International (TSX:CXI) had another record quarter with revenue up 108% YoY as travel continues to open up and new corporate clients are onboarded with their payments software. Their next quarter, Q3, is usually their strongest due to the seasonality of travel and we are anticipating continued strong results.

Trying to determine the exact length of a bear market is difficult.  While there is risk of a prolonged contraction, much of the damage has already been priced in and our portfolio holdings are trading at very low valuations. We will take advantage of these conditions to add well-run companies that have exciting prospects, low valuations, and access to cash to safely navigate the current liquidity-tight capital market environment.

Pathfinder Resource Fund

The Resource Fund had a net return of -28.1% in the second quarter of 2022.  This compares to the benchmark which was down by -17.7%.  Since inception (July 16, 2018), the Resource Fund has returned 15.9% annualized versus the benchmark of 5.2%. The table below provides a performance summary.

The main detractors this quarter were Itafos Inc (TSXv:IFOS) at -6.8%, Fox River Resources Corp (CSE:FOX) at -3.1%, Sprott Physical Uranium Trust (TSX:U.UN) at -2.2% and Trevali Mining (TSX:TV) at -2.1%.

After a strong initial start to the year, commodities had a broad decline in the second quarter as increasing inflation and higher interest rates led to fears of slower economic growth and a potential recession.  The world has a supply chain crisis caused by a lack of physical infrastructure alongside shortages in energy and food, which is a key cause of this inflation in our opinion.  This supply chain crunch can be eased by either decreasing demand or increasing supply. Currently, the US is trying to control inflation by raising rates to create demand destruction, but that does not create a long-term solution.  Unfortunately there is little appetite for increased capital investment to increase supply of these real-world physical resources.  A recession may decrease demand and alleviate inflation over the short term, but over the long run, we will need higher food, energy, and metal prices to incentivize capital investment and produce the required amounts of energy, food and raw materials necessary for the infrastructure required to control longer-term inflation.

The world has under-invested in these capital intensive industries over the last decade for two main reasons that we can see.  First, the market has favoured ‘capital-light’ companies such as software over ‘old-economy’ stocks and industrials. Second, capital-intensive companies generally score poorly on ESG related metrics which limits capital availability and increases the cost of funding such investments. The last decade of under investment into commodities has resulted in structural supply shortages and higher prices in metals, energy, and fertilizers which are inevitable to overcome the supply constraints already being experienced, in our opinion. Below we share a quote that we enjoyed in a recent podcast hosted by Smarter markets.

“Get long, buckle your seatbelt and hang on for the ride, because ultimately higher prices are going to be needed to solve these issues” – Jeff Currie, Goldman Sach’s Global Head of Commodities Research,

In response to a difficult environment, we have focused on companies with strong management teams that have top-tier assets, low operating costs and a track record of allocating capital efficiently. Two such companies we would like to highlight are Cleveland-Cliffs Inc (US:CLF) and Ero Copper Corp (TSX:ERO).

Cleveland-Cliffs is the largest producer of iron ore pellets and flat-rolled steel in North America. CLF controls all aspects of their steelmaking chain from the raw iron ore and scrap steel to primary downstream steel production. The company was able to achieve this through acquisitions of two major steelmakers in 2020, Arcelor Mittal and AK Steel, when steel prices were very low.  By vertically integrating its pre-existing iron ore business with steel production, the company increased exposure to the automotive end market and decreased reliance on global suppliers. Many manufacturers that adopted the “just in time” manufacturing philosophy, have been exposed to the vulnerabilities of this method as we continue to experience ongoing global supply chain issues. Cliffs, however, has positioned itself to be less reliant on suppliers allowing the company the advantage to control their input costs and raw supply material. Another very important acquisition recently completed was that of the Ferrous Processing and Trading Company (FPT) in 2021. Prior to this transaction, Cliffs used iron ore from their facilities to manufacture steel. The FPT acquisition secures a new source of raw material (scrap metal) for Cliffs which can be processed in a much more environmentally friendly manner than traditional methods.

Through these acquisitions, Cliffs has become the largest steel manufacturer and the primary supplier for the major auto manufacturers in the US. Cliffs has the only facility in the US that can supply the quality of steel required for the transformers and charging stations required to build out the network for the upcoming electric vehicle wave. Furthermore, auto manufacturers are behind on production because of the ongoing semi-conductor chip shortage. As this gets resolved and demand returns, we expect steel demand to surge as these companies look for domestic sources of steel to reduce lag time.

We believe the investment opportunity is yet to be realized with Cliffs. The company had a solid first quarter generating US$6 billion in revenue, US$801 million in net income and an adjusted EBITDA of US$1.5 billion.   Cliffs is securing long term contracts from major automakers by not only supplying steel, but also receiving scrap from the same companies to help offset increasing input costs. Management has shown strong leadership through timely acquisitions to set all the pieces in place for ongoing success and can now focus on debt reduction while purchasing shares back after announcing a one billion share buyback program earlier this year.

Ero Copper is a Brazil-focused best in class, intermediate base metals copper producer. ERO currently has two underground copper mines in production, Pilar and Vermelhos, along with Surubim which is an open pit mine (MCSA mine complex). The company is also constructing a fourth copper project, Boa Esperança, and operates a gold mine as well.

A significant advantage of ERO over many other copper producers is their low first quartile copper production cash costs. While many producers are now experiencing tightening margins due to cost inflation and decreasing commodity prices, ERO is poised to generate substantial cash flow due to peer leading cost guidance of ~$1.15/lb of copper over the next five years. The cost advantage comes from the type of copper deposit that they have which is a magmatic sulphide deposit. These are world class deposits and are known for their high grades and polymetallic nature. With the infrastructure already in place and excess mill capacity, the company has increased production through organic growth at modest incremental costs.  ERO has shown a successful track record of organic growth through exploration not only adding significant resources, but also doubling production since 2017. By 2025, ERO is guiding for further production increases with the addition of production from Boa Esperança while maintaining current cash costs.

In addition to current operating mines, ERO has significant exploration potential both near mine and regionally. Ero controls ~170,000 hectares along a 100 km belt with similar geology and mineralization as current operations. Near mine exploration at Pilar has resulted in resource growth of ~80% since 2018 and a new discovery of the “deepening extension” which has grades of over 2% Cu and remains open at depth. More importantly though, a new geologic interpretation which identifies structural traps (thick very high grade zones) has advanced the understanding of the mineralization in the region increasing the probability of additional discoveries on the property.  With all this exploration potential, we envision the installation of another standalone mill at MCSA and a further doubling of production. By leveraging their existing infrastructure, the CAPEX burden would be manageable and allow ERO to uncover a potential world class district on their property.

As readers may have noticed over the past few small cap quarterlies, there has been a shift in our investment criteria towards best-in-class commodity companies that offer exposure to longer-lived commodity cycles. Historically, commodity cycles would typically last 7-10 years due the necessary time required to develop and construct these projects versus the more recent 3-5 year cycles. Lower returns in commodities forced investors into other assets classes preventing growth and development across the sector. A shift to companies with strong management teams, top tier assets, and strong balance sheets will allow us to mitigate near-term volatility while positioning us to benefit from the pending longer-lived commodity cycles.

Pathfinder Asset Management Ltd. | Equally Invested™
1450-1066 W. Hastings Street, Vancouver, BC V6E 3X1
E | T 604 682 7312 |
Sources: Pathfinder Asset Management Limited

National Instrument 31-103 requires registered firms to disclose information that a reasonable investor would expect to know, including any material conflicts with the firm or its representatives. Doug Johnson and/or Pathfinder Asset Management Limited are an insider of companies periodically mentioned in this report. Please visit for full disclosures.

*All returns are time weighted and net of investment management fees. Returns from the Pathfinder Partners’ Fund and Partners’ Real Return Plus Fund are presented based on the masters series of each fund. The Pathfinder Core: Equity Portfolio and The Pathfinder Core: High Income Portfolio are live accounts. These are actual accounts owned by the Pathfinder Chairman (Equity) and client (High Income) which contain no legacy positions, cash flows or other Pathfinder investment mandates or products. Monthly inception dates for each fund and portfolio are as follows: Pathfinder Core: Equity Portfolio (January 2011), Pathfinder Core: High Income Portfolio (October 2012) Partners’ Fund (April 2011), Partners’ Real Return Plus Fund (April, 2013), and Partners’ Core Plus Fund (November 2014).

Pathfinder Asset Management Limited (PAML) and its affiliates may collectively beneficially own in excess of 10% of one or more classes of the issued and outstanding equity securities mentioned in this newsletter. This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor PAML can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your portfolio manager, who can assess all relevant particulars of any proposed investment or transaction. PAML and the author accept no liability of any kind whatsoever or any damages or losses incurred by you as a result of reliance upon or use of this publication.