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Since the end of 2020, we have continued to believe the markets are overbought and a correction is warranted. That did not prove out to be the case this quarter. Although there appears to be a rolling correction within the sub-indices, the overall market continues to push higher with the portfolio posting a +10.0% return in the quarter, relative to a 9.2% return for the SP TSX Small Cap index. The sectors with the highest returns this quarter included Energy (+32.6%), Real Estate (+13.7%) and Financials (+12.7%). The underperforming sectors were Health Care (-8.5%), Consumer Staples (-7.4%) and Technology (-0.7%). Despite the overweight in materials, the overweight in energy kept the portfolio returns in line with the small cap index. Below is a chart showing the monthly returns and some index comparisons. Despite the positive push forward of returns in the market, we believe stocks are still susceptible to a correction with the bond market increasing in volatility and defensive parts of the equity markets beginning to show some life. Transitory inflation became the term of the quarter with many trying to decide what is the definition of transitory inflation. By the end of the second quarter there was also some concern of a growth slow down with investors attention turning to the Delta Variant.
In the second quarter the three names that detracted the most from the portfolio included Neo Performance Materials Inc., Quipt Home Medical and Talon Metals. Collectively these three names cost the portfolio -1.4% in the quarter. We continue to hold all three names but have been taking profits in Talon over the last number of months.
Neo Materials manufactures advanced industrial materials that serve as the building blocks of many modern technologies such as vehicle electrification, industrial automation, consumer electronics, energy-efficient lighting, air, and water pollution control to name a few. The products the company produces are magnetic powders and magnets, specialty chemicals, rare earth metals and alloys. The company is well funded and managed with a reasonable valuation. In the quarter we added to the position and expect good growth in an exciting space in the future.
Quipt (previously know as Protech Home Medical) is a US distributor of durable medical equipment (DME) and services for in-home management of chronic diseases, particularly respiratory disorders. The company has 48 locations in 10 states throughout the Midwest and East Coast. Quipt has built a significant regional platform with ample opportunity for consolidation and the industry has solid tail winds. We continue to hold Quipt given its reasonable valuation and growth outlook.
Talon Metals is a mining company which is busy drilling up and defining the resource of its Tamarack Nickel Property located in Minnesota. To date the team has had significant success in extending the resource in all directions and to depth with good high-grade hits throughout. The deposit is well situated with good infrastructure and in time is expected to be a domestic source of battery grade nickel for the electric vehicle industry in the USA. The stock was somewhat ahead of itself coming into 2021 and we have been reducing the weight, however we are very excited about this project and continue to hold a position.
The three names that contributed the most to the second quarter performance include Birchcliff Energy, Arizona Metals and Capstone Mining. These three names contributed +3.6% to overall performance in the quarter. Despite reducing all three names in the quarter after the significant price appreciations, we maintain a position in all three.
Birchcliff Energy is a Calgary, Alberta based intermediate oil and gas company with operations concentrated within its core area, The Peace River Arch. Its Montney/Doig Resource Play is significant in scope with over 7,000 net future potential drilling locations. We view management favourably and like its revenue tilt toward natural gas. As most energy company stocks appreciated considerably this quarter, we have taken some profits in the name but continue to hold given our longer-term positive view towards the sector.
Arizona Metals flagship 100% owned property is the Kay Mine located in Arizona. It is a VMS style deposit with a historic resource of 5.8Mt (Au, Cu, Zn, AG) delineated by Exxon in 1982. Arizona Metals did some validation drilling in 2020 and followed up this year with more exploratory drilling. They were successful in hitting gold and zinc in a new area called the Discovery Zone in which the intercepts were wide and high grade in nature, propelling the stock value and creating much excitement. They are currently in a fully funded Phase 2 Drill Program (>75,000m). We think the discovery has tremendous potential to grow and believe the majors will be interested in the deposit. We have taken profits in the position but continue to hold for further news on the drilling that is underway.
Capstone is a base-metal producer with two producing copper mines: Pinto Valley in the US and Cozamin in Mexico. Capstone also owns Santo Domingo, a large scale, fully permitted, copperiron-gold project in Chile. The company has undergone several optimization projects lowering their overall cost of production thereby enhancing returns. With the projects being largely complete and the commodity prices being elevated, Capstone has been able to significantly improve their balance sheet with the strong free cash flow. Of the mid size copper producers Capstone stands out as having good growth potential with an undeveloped property and further expansion potential on existing producing assets. With copper prices having had a significant move we have reduced the Capstone position as we expect a check-back this summer. It is one of our favorite names and we suspect we will once add to the position on a market correction.
Below are the portfolio and index sector positions:
OUTLOOK
As we are start the summer months there are a few things we continue to watch closely.
The stock markets around the world have been on a significant run with very little in the way of a pullback. The global recovery is in full swing, thereby supporting the run up in equity prices. Looking at stock valuations, the US market is historically expensive but Canada, and especially small caps, are relatively less expensive because many commodity prices have moved higher increasing earnings estimates and visibility.
As we begin this new quarter, all eyes appear to be on the Fed. Clearly the Fed has signalled that they believe the current inflation readings are transitory in nature and that they are willing to allow inflation to be elevated to ensure complete and inclusive economic recovery. The Fed has been signaling that they will keep lower rates for longer.
The bond market has recently become extraordinarily volatile with the US 10-year bond yields gyrating from 1.45 to 1.18 in a matter of weeks. At the high point, pundits arguing that inflation was too high, and the Fed would need to tighten earlier than they had guided. The following week, the bond market reversed, and yields started falling as the same group started arguing that global growth was slowing, and inflation had peaked.
With the back up in rates, the US dollar has strengthened providing some short-term head winds for commodities and is signalling a period of risk off to the market. To that end, let us also throw in some OPEC discussions where the potential for some additional supply in the face of a potential slow down has also created some uncertainty. And finally, the Delta Variant whose numbers have begun to steal some headlines adding to the growth slowdown scenario.
So, amidst all this confusion where do we land in terms of managing the portfolio? We have shifted some of our weight out of energy and back into golds. We had reduced some of our base metal exposure and purchased some of the technology stocks that had sold off earlier in the 2nd quarter. But when we look past most of the noise, we like our positioning in the cyclicals. The Fed is more focused on ensuring a complete and inclusive recovery. On multiple occasions the Fed has communicated to the market that the recovery has been unbalanced, with several disadvantaged demographics/segments needing to return to pre-COVID levels before they would remove stimulus. As the US manages this, we expect that other parts of the globe will continue recovering from the pandemic and start to grow faster than the US. This should cause the US dollar to resume the downward trajectory it was on and benefit the cyclical/commodity trade. We may need to reset valuations in the short term but the mid to long-term outlook is bright with central banks still favouring growth and stimulus.