Small Cap Quarterly Report
DECEMBER 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 -20.6% in 2022. This compares to the TSX Venture Exchange which had a return of –39.3%. Our annualized 10-year return is 15.0% compared to the TSX Venture Exchange’s return of -7.3% 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 +2.7% to gross returns, Currency Exchange International Corp. (TSX:CXI) which contributed 2.1%, and F-Star Therapeutics Inc. (NASDAQ:FSTX) which contributed 1.3%. Our main detractors were Spectra7 Microsystems Inc. (TSXv:SEV) at –0.8% and Affimed N.V. (Nasdaq:AFMD) at -0.8%.
We would like the Partners’ Fund to perform exceptionally each year and are disappointed with negative returns in 2022 despite outperforming the Canadian Venture benchmark. There weren’t many places to hide in 2022 – large stocks, represented by the S&P 500 Index, were down 19.5% and bonds provided little safeguarding with investment grade corporate debt down ~20% and US government debt down ~15%. This difficult investment environment has lowered valuations across the board, and we currently view our portfolio as attractively priced. We own a broad set of quality opportunities at bargain basement prices which has historically boded well for forward-looking potential returns.
The macro themes we addressed in our Q2 and Q3 notes remain mostly unchanged as worries of high inflation, rising interest rates, and a potential recession continue. High growth companies and technology stocks reversed course and generated losses in 2022 as supply constraints eased up and digitization trends cooled off. Energy remained the steadfast leader in performance for 2022 as inflation, the Russian/Ukraine war, and general supply uncertainty kept prices high.
For our part, we fine-tuned the portfolio by trimming some of our larger positions that had outperformed and grown to an oversized weighting of the portfolio. We used these funds in Q4 to enter positions we already owned at attractive valuations. We continued investing in capital-intensive businesses such as niche material and manufacturing companies. Over the last decade, businesses requiring large amounts of capital have been out of favor in the market, but we believe that higher interest rates and inflation will make it more expensive for potential competitors to add new production capacity. Our hope is that these specialty businesses will be able to increase prices based on rising replacement costs and improve margins.
We believe that our thesis on the biotech sector is playing out and with the SPDR Biotech ETF down 26%, there will be increased M&A activity in 2023 as major pharma companies seek to replenish their pipelines. In the last five years, biotech stocks have had an easy time going public with 60 IPOs in both 2018 and 2019, 100 IPOs in 2020, and a record 110 in 2021. This number cratered to roughly 20 in 2022. Two years of negative returns on pricey IPOs have made investors wary and now both public and private companies need to find other ways to raise additional funds. In a tough financing environment, our cashed-up companies are funded to complete their trials and potentially be acquired.
Eupraxia Pharmaceuticals Inc. (TSX:EPRX), one of our biotech positions, sold off for the first half of the year as they needed cash to continue their trial programs. They closed a $14.7 million overnight offering at $2.05/unit to extend cash runway until Q4 2023, and by August, the stock had begun to recover. In October, Eupraxia announced positive preliminary phase 2 safety data in Osteoarthritis, allowing patients with diabetes to now be included in the trial – this is significant as Type 2 diabetes and osteoarthritis frequently co-exist (overweight/obesity) so the inclusion of this sub-group would be more convincing to the FDA when looking for approval. Lastly, Eupraxia announced they were expanding their drug indications and launching a Phase 2 in Eosinophilic Esophagitis (EoE), effectively a disease where the esophagus swells and impacts the ability to swallow food. Eupraxia’s drug, if it works, has strong potential versus current standards of care and can be expected to capture a reasonable portion of a multi-billion-dollar market. These factors, along with an exciting readout schedule in 2023, has driven Eupraxia stock to $3.65, up 49% on the year.
Continuing with the biotech theme, Affimed NV (NASDAQ:AFMD) is a German biotech company specializing in Natural Killer (NK) Cell engagement. NK cells are a key component of our innate immune system and used to defend the body against diseases. An NK cell engager is a bispecific antibody that binds with NK cells, but it can also bind to cancerous receptors such as CD30. The idea is that the cell engager will bind an NK cell to the tumor cell, at which point the NK cell will attack the tumor.
The company’s most exciting drug is AFM13 which is being used in combo with NK cells and Affimed will submit for the approval of two trials in the first half of 2023. The technology is cutting edge in the immuno-oncology space and is made more unique by the co-administration of genetically modified NK cells to increase the overall effectiveness. Initial results in previous trials have shown tremendous efficacy, as a Phase 1 study on AFM13 in CD30 positive Hodgkin’s lymphoma patients with NK cell therapy had 97% of 31 patients respond to the treatment and 77% of those had a complete response (i.e. no trace of cancer left). Affimed has other drugs further along the pipeline, but we think AFM13 in combo has shown the most promise so far. On the valuation side, Affimed has ~$280 million in cash, which is more than their market cap of only $175 million, potentially making it a compelling acquisition target.
Shifting gears away from biotech, Technology was out of favor this year with the iShares S&P/TSX Info Tech sector down ~34%. The headwinds here were threefold: first, we had COVID “coming to an end” and digitization that had been accelerated was now losing its tailwind. Second, rising interest rates made investors question “growth at all costs” tech companies as promised profits in 5-10 years are now worth much less than in a low-interest rate environment. These cash burning companies addressed concerns by transitioning to a “flat revenue growth and cost neutral” approach which spurred additional selling as growth evaporated. Finally, the prospect of a recession reduced business spend, ad spend, digitization spend and more. While these factors have led to a drawdown and the sector becoming out of favor, we think this makes for large upside potential for picking the right businesses that can weather the current conditions.
One tech standout we think will be Pivotree (TSXv:PVT). Pivotree is an ecommerce platform that integrates a client’s broader third-party technology software such as Enterprise Resource Planning, Client Relationship Management, Master Data Management, Point of Sale and more into a single dashboard that can be used to streamline operations and monitor business performance. Their revenue growth for 2022 will be around 50% with 2/3rds coming from acquisitions, but importantly the company is nearing cash burn neutral, which would shift the story from “M&A growth at all costs” to a “profitable tech company with high quality recurring revenue” – and this comes with great upside potential.
Going forward, it is important to focus on fundamentals while trying to anticipate how markets and businesses will try and adapt to volatility. The natural response of management teams to high inflation, high interest rates, and uncertainty on future income is to protect the balance sheet. This is typically done by slashing the workforce and prioritizing product pipelines to ensure the best ideas are being funded, resulting in slower but higher quality revenue growth with better margins on the bottom line. Essentially, growth is sacrificed for security, or in some cases survival. We’re seeing this play out not just in the small cap space but also across the board.
Here is how we view this opportunity – of the many companies cutting costs, there is a unique set who will benefit from their austerity measures by developing into lean operators that, like a coiled spring, can use leverage and scale to build explosive operational potential that can be unleashed when the market sentiment turns bullish. It is our job to find the best of those opportunities and be along for the ride when that occurs.
Pathfinder Resource Fund
The Resource Fund had a net return of -18.7% in 2022. This compares to the benchmark which had a return of +11.9%. Since inception (July 16, 2018), the Resource Fund has returned 13.2% annualized versus the benchmark of 6.7%. The table below provides a performance summary.
Our top contributors for the quarter were Ero Copper Corp. (TSX:ERO) which contributed +1.1% to gross returns, and Pan Global Resource Inc. (TSXv:PGZ) which added 1.0%. The main detractors this quarter were Itafos Inc. (TSXv:IFOS) at -2.8%, and Giyani Metals Corp. (TSXv:EMM) at -1.2%.
Our underperformance against the benchmark was due to a lack of Oil & Gas exposure; 25% of the benchmark weight is the S&P/TSX Capped Energy Index which had a 54% total return in 2022. We entered the year having trimmed many of our junior mining companies and shifted towards a more diversified and defensive portfolio. This paid off initially after the Russia-Ukraine war began and there was an initial spike in energy and agricultural commodities, but by the end of the year, most of these commodities were back to their pre-invasion levels. Unfortunately, we were unable to capitalize on this move, riding uranium and agriculture stocks up in the first half of the year, then giving it all back by the end of the year.
Despite these short-term interruptions, we remain steadfast on our supply driven thesis for agriculture and multiple other commodities such as oil, copper, and uranium. Demand for all of these will increase over the next decade, but there will be insufficient supply at current spot prices to fulfill this demand. We believe that prices need to rise to incentivize this production leading to a multi-year, multi-commodity super-cycle. This cycle paused in 2022 as liquidity was drained from the system via interest rate hikes and a strong US dollar. Base metals (such as copper, tin, nickel and steel) were particularly affected in the summer as economic concerns and recession fears took over. We took this opportunity to add to our base metal exposure. Following this move, towards the end of the year, we went back into ‘risk-on’ mode, adding junior mining exposure and participating in numerous private placements.
After a constructive first half in 2022, fertilizer prices came under pressure on the back of weaker farmer demand, which offset lower Russian and Belarus potash exports (which were significantly below 2022 levels). We expect this demand to come back and level out leading into the second half of 2023. The ongoing Russia-Ukraine conflict will continue to be a challenge on the supply side, but we also view the deterioration of soil quality resulting in lower crop yields as being an overlooked driver. The International Fertilizer Association estimates that 73 percent of the world’s soils are deficient in phosphorus (phosphates) and 55 percent are deficient in potassium (potash). For farmers to take advantage of robust crop prices, they will need to increase crop yields by planting additional acreage and increasing fertilizer application.
To mitigate increasing costs due to inflation, part of our strategy last year was a pivot towards high quality, best in class, low-cost producers versus higher torque (also higher risk) early-stage exploration companies. We strengthened our positions in companies with high operational margins which were trading at a discount due to the general market malaise. Ero Copper Corp. (TSX:ERO) and Altius Minerals Corporation (TSX:ALS) were two key components of this strategy that helped preserve capital during the year, allowing us to be aggressive in adding risk in recent months at what we believe are attractive valuations.
Similar to 2018 when the Resource Fund was created, we think the sector is primed for a re-awakening. We are starting to see green shoots in the gold sector rekindling our optimism for early-stage precious metals opportunities. The US dollar has been a crucial headwind for gold commodities, and if it begins to weaken, we expect renewed support for gold assets to offset geopolitical and recessionary risks. As countries shift towards net zero carbon targets on the back of increasing electrification, we anticipate a growing demand for critical metals such as copper and nickel resulting in deficits. In terms of copper, some studies indicate potential for a supply gap as large as 9.9 Mt by 2035. To put that into context, the largest copper mine in the world produces 1.1 Mtpa and one of the best new recent discoveries, Ivanhoe’s Kamoa-Kakula, at peak will only be producing 0.32 Mtpa. Similarly, nickel is expected to be in deficit as increasing demand for battery grade nickel is the main driver along with a lack of quality projects to backfill this demand. Current pricing suggests existing tightness in the market and a potential near-term opportunity.
We would also like to point out that despite increasing exploration budgets over the last decade, demand for copper and gold is set to outpace supply due to lack of major discoveries. Thus, the largest challenge for producers is reserve replacement through new discoveries or M&A activities due to decades of underinvestment in exploration. The cost of capital continues to increase while operating margins shrink due to higher input costs further exacerbating the supply side. With insufficient access to capital, new projects will continue to be placed on hold and shortages will drive higher prolonged prices. Increased exploration budgets have been a positive read through for companies like Geodrill Limited (TSX:GEO) which has been a strong performer for us. The company delivered record revenues despite a seasonally weaker period demonstrating increased demand in the sector as exploration sentiment continues to improve.
We believe these fundamental supply and demand issues will result in a prolonged commodity cycle. However, we would like to remind investors that commodity cycles ebb and flow. As commodity prices increase, we’re likely to see the market temporarily rebalance itself driving prices down, which in turn will start the cycle over again. We view these spikes and valleys as opportunities to create as much value as possible for shareholders through our active investing approach, which allows us to pivot into more attractive commodities ahead of market volatility.
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 are presented based on the Class C Master series except prior to its inception in July 2011 when the Class A Master series was used. Inception returns include the 10 months from inception in March 2011. Returns greater than one year are annualized. Returns from the Pathfinder Resource Fund are presented based on the Class C Master series since its inception in July 16, 2018. The S&P/TSX Venture Composite Index (C$), the S&P/TSX Venture Composite Index, the S&P/TSX Capped Materials Index and the S&P/TSX Capped Energy Index provide general information and should not be interpreted as a benchmark for your own portfolio return. Further details of the Partners’ Fund are available on request.
Changes in Leverage. We are increasing the liabilities ceiling to 2.0 times the market value of equity for Pathfinder International Fund and Pathfinder Real Fund to be consistent with Pathfinder Partners’ Fund and Pathfinder Resource Fund.
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.