Contrarian Calls Can Have Big Payoffs: How We Make It Work

Investing in out-of-favour stocks can feel isolating. Operational challenges or industry setbacks often drive shareholders away in search of more promising opportunities. Even seasoned analysts familiar with these, out-of-favour companies, may advise against investment during such unpopular times. At this juncture, it’s often easier to join the exodus than to stand firm on what might be a mirage of potential.

In our view, getting things to feel more like an island paradise and less like that of Tom Hanks with a volleyball, requires conviction. What we have highlighted with this simple depiction is the dilemma faced when making a contrarian call, and the need for conviction when choosing to swim against the current. To gain conviction, it is essential to have in place a sound weighing mechanism. To our benefit – and ultimately that of our clients – we believe the Nicola Canadian Equity Income Fund (CEIF) has such a process in place, and when combined with our long-term lens it allows us to “be greedy when others are fearful.”

A Case Study: Aritzia (ATZ)

A recent example occurred with the fund’s position in Aritzia (ATZ) – a company founded 40 years ago in Vancouver, BC that has formulated success in the design and retail of women’s apparel within the category of ‘everyday luxury.’ Admittedly, our investment in ATZ has had its challenges. Firstly, the fast-paced, trend-setting fashion industry is somewhat outside of our circle of competence. Secondly, less than a year after the CEIF built its initial position (July 2022), mounting inflationary and competitive pressures led ATZ to slash its annual profit (EBITDA) margin projections twice in two consecutive quarters. Management’s expectations now called for an adjusted profit margin 600 basis points lower than what it had achieved just one year earlier. It also planned to continue spending on infrastructure to support future growth at a time when consumer weakness had led to a guide down in sales growth from low double-digits to mid-single-digits. Thirdly, the company had experienced a CEO change prior to this downturn, so a crisis of confidence in leadership circulated among investors. Shares of ATZ were punished, declining 60% from their October 2022 peak.

For a relatively new investment in the CEIF, this was a lot of negative information to digest. Did we miss something in our due diligence or was the stock now a bargain? In July 2023, we concluded that Aritzia (ATZ) presented a compelling buying opportunity despite the challenges it faced. Our conviction was based on several key factors:

1. Innovative Business Model: Aritzia’s focus on ‘everyday luxury’ and disciplined operating history positioned it well for long-term growth.
2. Fundamentals: Despite temporary setbacks, the company’s fundamentals, from our perspective, remained solid, with a strong balance sheet and relatively high insider ownership.
3. Market Mispricing: The market’s undervaluation of Aritzia due to temporary declines in consumer spending and supply chain challenges created an attractive entry point.

Indeed, we felt we were being presented with a very compelling buying opportunity that could lead to a doubling of ATZ’s share price in the next three years if our assumptions were accurate. We proceeded to increase our position in ATZ by 70%. The conviction to add while others had sold rested in our Quality Scorecard approach (an internal due diligence process), which upon review had not indicated any significant flags to alter our initial assessment of ATZ being a Quality-rated business. Scorecard in hand, we were able to overcome the challenges listed earlier by focusing on the elements that had formed our long-term thesis:

1. Management Track Record: Over nearly four decades, management had demonstrated a record of creating assortments that resonated, and brand awareness that persisted among a global customer base. We trusted ATZ’s leaders, whom we had met on several occasions.
2. Profit Margins: Over the past seven years, the company averaged 15%+ profit margin, including a low of 9% during the COVID-19 pandemic. Management’s revised guidance implied a temporary return to this low. However, the company was now making nearly three times the revenue it did during the pandemic. Additionally, ATZ’s new retail locations were experiencing the strongest payback periods in recent history, and its existing locations were sustaining sales per square foot ahead of most peers in apparel. Excluding some near-term noise, the business appeared healthy.
3. Balance Sheet: The balance sheet remained comparatively strong. Outside of real estate leases, of which it was an anchor tenant for most landlords, the company had no long-term debt.
4. Executive Alignment: Executives were well-aligned with investors. The Executive Chairman, former CEO and Founder owns 18.5% of ATZ common shares, indicating significant skin in the game and motivation to succeed.

No changes to our quality score for ATZ meant that our required rate of return could remain the same as at initiation. Only now, with the stock 30% cheaper than where we had first purchased, the potential upside to our base-case scenario far exceeded our minimum threshold. Furthermore, our margin of safety to the downside had improved considerably. A very asymmetric opportunity.

The Outcome

The ensuing events since ATZ hit its low point have been beneficial to investors with the discipline to swim against the current. The company wrapped up a relatively weak fiscal 2024, and more importantly, introduced inspiring guidance for the fiscal year ahead. This included high single-digit to low double-digit revenue growth and up to 500 basis points of improved profit margin. With confidence restored among investors, the ships quickly set sail back to “ATZ island” and at the time of writing, the stock price has more than doubled since the lows of late 2023. The result has pulled forward our three-year projection much sooner than expected, and provided our clients with a return that has outpaced the TSX by 11% since we initiated the position. While we believe there are still good things to come for ATZ, the risk-reward ratio on the stock appears less compelling today. Accordingly, we chose to take some profits and once again employ our scorecard in search of the next overlooked paradise.