Pathfinder Small Cap Quarterly Report
SEPTEMBER 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 -1.2% in the third quarter of 2022 and -20.9% YTD. This compares to the TSX Venture Exchange which had a return of –3.7% in the third quarter and -36.7% YTD. Our annualized 7-year return is 15.3% compared to the TSX Venture Exchange’s return of 1.8% over the same period. The table below provides a performance summary.
Our top contributors for the quarter were Eupraxia Pharmaceuticals Inc (TSX:EPRX) which contributed +2.4% to gross returns, and Imaflex Inc (TSXv:IFX) which contributed 1.0%. Our main detractors were Spectra7 Microsystems Inc (TSXv:SEV) at -1.6% and Neoleukin Therapeutics Inc (Nasdaq:NLTX) at -1.1%.
The TSX Venture ended the third quarter at an 18-month low, resulting in the loss of all the gains from the recent bull run. The index in now sitting at pre-COVID levels as recession and inflation worries continue to dominate news headlines. Investor sentiment is strongly negative, and “doom & gloom” has taken over. While there are many worrisome developments occurring all over the world, there will always be mispriced opportunities to take advantage of, perhaps even more so in a tumultuous market. Amidst this backdrop, we are seeing a distinct disconnect between stock prices and the underlying fundamentals in our portfolio. While share prices are weak, several of our largest holdings have recently reported record quarters and their underlying businesses look strong.
In particular, Currency Exchange International (TSX:CXI), Redishred Capital Corp (TSXv:KUT), and Imaflex Inc (TSXv:IFX) all reported record revenues and profits for the quarter with a strong outlook. Currency Exchange grew revenues by over 100% and doubled operating income versus their previous best quarter (pre-pandemic). Redishred grew revenue by 68% (40% organic) with record operating margins, and Imaflex grew revenue by 24% and profits by 71%. While these are outstanding results, the value of the business is only a partial consideration in picking a stock; the other part is the price you pay. Luckily, all three of these businesses were priced at bargain levels, suggesting future business deterioration. These stocks were cheap for a purported reason, be it the end of physical cash, elimination of paper in the workspace, or reduced usage of plastics in flexible packaging. Yet despite these fears, each company reported record results which we believe will eventually lead to a re-rating and rising stock price.
From the results of the above companies, we would expect to see significant appreciation in their respective share prices, but the reaction has been lackluster. Over time, our strong cash flowing companies can take advantage of weak market conditions by investing to gain market share or by acquiring struggling competitors. The market may be declining, but as good companies get caught in the sell-off, we see the opportunity for their valuations to sling-shot once negative conditions begin to reverse.
We firmly believe that times like this present the best opportunities, either from new ideas, former positions, or stocks within the current portfolio. During the quarter, our activity in new positions was limited as we saw greater value in current holdings and stocks we had previously sold. As we have written before, volatility is a feature not a bug. During the quarter, we were able to add to three holdings at a 50-80% discount to where we had sold last year. Over time, we believe this activity, enabled by volatility, creates significant value. Our investment companies sometimes see similar opportunities, sensing a deal in their own shares and deploying capital to buy back stock. That has occurred in fund holdings Microbix Biosystems Inc (TSX:MBX) and Pivotree Inc (TSXv:PVT).
Rarely have we seen a small cap market this bad, which conversely means that the opportunity has rarely been better for finding great deals. The Partners’ Fund has strong return potential going forward. In these risk-off environments, it sometimes feels like stocks have no floor in how low they go as capitulation and forced selling takes place. This is painful in the short-term but will reverse in due course, creating opportunities on the buy side for us in the meantime. Other market participants are playing defense, with a focus on larger companies that have predictable business models and are profitable. We have shifted from defense to offense, going against the herd and diving into the smallest companies that are currently losing money. The lower the stock price, the greater the upside potential if the business opportunity is still intact. By investing in these companies via private placements, we can eliminate the financing overhang that is often the cause of the stock price decline itself and pick up substantial positions in the next cohort of lucrative opportunities.
Pathfinder Resource Fund
The Resource Fund had a net return of -3.9% in the third quarter of 2022 and -19.3% YTD. This compares to the benchmark which had a return of +0.1% in the third quarter and +2.2% YTD. Since inception (July 16, 2018), the Resource Fund has returned 13.8% annualized versus the benchmark of 4.9%. The table below provides a performance summary.
Our top contributors for the quarter were Sprott Physical Uranium Trust (TSX:U.UN) which contributed +1.4% to gross returns, and Ero Copper Corp (TSX:ERO) which added 1.3%. The main detractors this quarter were Fox River Resources Corporation (CSE:FOX) at -1.3%, and Giyani Metals Corp (TSXv:EMM) at -0.9%.
We continue to see commodities struggling on the back of rising interest rates and a strong US dollar. We have seen a broad sell-off across most sectors and tumultuous market activity throughout the quarter. Higher interest rates have the effect of slowing global growth which in turn decreases demand for commodities, especially industrial and base metals. Eventually, the US dollar strength will reverse itself and the upturn in commodity prices will resume.
Our strategy remains steadfast on investing in high-quality defensive companies that are counter-cyclical to other commodities. Geodrill Limited (TSX:GEO) is an example of a company that is generating steady revenue and growth despite the current economic conditions. We continue to add to our Uranium positions as well as the sector will need to show growth as demand increases with additional reactor start-ups.
Geodrill is an exploration drilling company with operations mainly focused on West Africa. As companies around the world look to replenish mineral reserves, there has been an uptick in exploration budgets over the last few years, which has translated into strong growth and financial results. GEO is attractively valued, trading below a 5x P/E ratio and 2.5x EV/EBITDA. The company is also well positioned in terms of secured contracts. Since the beginning of the year, GEO has closed on three significant long-term drilling contracts with top tier mining companies and a +70% drill fleet utilization. Geodrill also announced their intention to buy back up to 5% of their outstanding shares while increasing their semi-annual dividend. With long term contracts in place and strong revenue growth outlook, we believe Geodrill offers investors an opportunity to participate in the looming commodities upcycle without exposure to inflationary costs being experienced by miners.
Despite the volatility in markets, uranium has held its value relatively well compared to other commodities. Nuclear sentiment has improved as nations grapple with the shift from fossil fuels to renewable energy sources, highlighting the need for clean base load power. The European energy crisis has been a key catalyst, sparking greater investment in nuclear energy. At the start of the year, the President of France had planned to reduce the country’s reliance on nuclear energy from 70% to 50% by 2035, but quickly shifted his position to building six new reactors by 2028 with potential for an additional eight more by 2035. Germany has also shifted its energy policy by delaying plans of phasing out nuclear energy and extending the life of two of the three remaining nuclear reactors. Belgium has followed suit by extending the life of two of their reactors an additional ten years past the original 2025 shutdown deadline and the UK has also decided to build a new nuclear power plant in a partnership with France. Although there is still division in the EU on whether nuclear energy is the path forward, demand is set to increase based on the proposed new builds. Combined with the restart of Japan’s nuclear reactors and those under construction by China and India, demand growth for uranium appears promising.
The ongoing crisis in Ukraine has pushed supply security to the forefront forcing world leaders to question their dependency on Russia, a dominant player in the uranium supply chain with significant conversion and enrichment capacity. Uranium miners produce and sell yellowcake (U3O8) by soaking ore in an acid solution to leach out the uranium which is then separated, dried, and filtered into the final product. Converters take the yellowcake and turn it into uranium hexafluoride (UF6) where it is ready to be enriched into fuel.
Enrichment is measured in separative work units (SWUs), and by processing converted uranium longer and using more SWUs, less uranium is needed to create nuclear fuel. This is known as underfeeding and occurs when electricity prices are low and there is excess enrichment capacity. With Russian supply being called into question, SWU prices have risen dramatically. Enrichers are using fewer SWUs to create nuclear fuel, which requires extra uranium. This is known as overfeeding and will add to the supply deficit. We forecast that enrichers will go from sellers of excess uranium (over the last decade) to buyers, resulting in a substantial increase in demand. We are already starting to see a shortage in converted uranium (UF6), and we expect this to trickle down into mined uranium (U3O8 or yellowcake).
The uranium market is in a dramatic deficit with mined supply estimated to be only ~135 million pounds compared to nearly ~200 million pounds of demand. This shortfall has been covered through inventory drawdowns and secondary supply (decommissioning of nuclear warheads), but at some point, new supply will be required. When this supply crunch emerges, we believe the uranium price will respond quickly due to the need to incentivize additional supply and the long time it takes to explore and build a mine (~15-20 years).
The continued weakness in the market is being felt across all sectors, leaving very few places to “hide” in terms of investing. This has led us to be selective with a focus on quality assets with strong balance sheets. Aware of the challenging conditions, the portfolio has been positioned with a greater emphasis on defensive and countercyclical positions that will allow us to withstand the current downturn and offer liquidity as sentiment improves.
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 www.paml.ca 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.