"Know what you own and know why you own it."

Peter Lynch, One Up On Wall Street, 1989

Long-term investment success requires differentiated thinking supported by genuine conviction. At Canopy, we believe conviction cannot be borrowed or assumed; it must be built through detailed research and a deep understanding of the businesses we invest in. When markets turn volatile and uncertainty reigns, the strength of our conviction can be the difference between seizing opportunity and capitulating at precisely the wrong moment.

The challenge of maintaining conviction

Maintaining conviction through market volatility is one of the toughest challenges investors inevitably face. As shown in the charts below, even the largest and highest quality companies can experience significant price declines that test investor resolve. Amazon's share price fell 93% between December 1999 and September 2001, took eight years to regain its prior high, and then dropped more than 50% again during the Global Financial Crisis. Similarly, Apple, Netflix and NVIDIA have each weathered multiple declines exceeding 70% on their paths to becoming some of the world's most valuable companies.

^{Source: FactSet, Canopy Investors.}

This pattern isn't limited to a few notable exceptions. In a study of the top 100 most successful companies of each decade since 1950, Bessembinder (2020) found that even these exceptional investments experienced average drawdowns of 32.5%, lasting 10 months.

Volatility has real consequences for realized investment returns. A long-running analysis by market research firm DALBAR (2022) found that, over the last three decades, the average US equity fund investor has underperformed the S&P 500 by 3-4% annually - primarily because of buying high and selling low during volatile periods. When share prices decline and negative sentiment builds, many investors abandon sound investments precisely when they should maintain or increase their positions. As Cullen Roche put it, "The stock market is the only store where, when everything is on sale, people run away."

At the root of this behaviour is what we call 'borrowed conviction' - investment theses adopted from respected investors, the financial media or popular sentiment rather than developed through independent research. When negative headlines accumulate and prices fall, borrowed conviction can crumble in the face of mounting pressure to sell. Only by developing one's own conviction - built on a deep understanding of a business, its competitive advantages, its long-term prospects and cash flow generation - can investors maintain confidence in the face of market pessimism or temporary setbacks.

Being different and right

"To achieve superior investment results, you have to hold views that are different from the consensus and be right." - Howard Marks. Being different alone is not sufficient; contrarianism without insight typically leads to poor results.

Detailed research reveals opportunities where the market's understanding is incomplete or incorrect. These opportunities often arise in several ways:

• Misjudged growth runways: The market frequently underestimates how long high-quality companies can sustain growth.

• Overreaction to temporary setbacks: Markets often overreact to short-term challenges that don't impair long-term business value. Thorough research can often distinguish between genuine competitive threats and transitory issues.

• Misunderstood business models: Complex or evolving business models are frequently misvalued.

• Overlooked structural advantages: Some companies possess durable competitive advantages that are not immediately apparent from financial statements or superficial analysis.

Strong conviction must be balanced with intellectual flexibility. As Charlie Munger observed, "Part of what you must learn is how to handle mistakes and new facts that change the odds." This balance helps distinguish between appropriate persistence and mere stubbornness - knowing when to hold firm in your thesis and when to adapt to new evidence.

Our approach

At Canopy, we have developed a structured research process designed to build knowledge, test assumptions and size positions based on conviction levels:

• Comprehensive business analysis: We analyse competitive dynamics, industry structure, management capability and disruption risks through extensive primary research, including interviews with management teams, customers, competitors and industry experts. The resulting quality and valuation assessment forms the foundation of our conviction.

• Thesis articulation and testing: For each investment we develop a clearly articulated investment thesis that identifies the key drivers of future value creation, recorded in a central database. These are continuously tested against new information, allowing us to distinguish between normal business volatility and genuine challenges to our core assumptions.

• Team collaboration: Our flat team structure ensures multiple perspectives on each investment, with every position covered by both primary and secondary analysts. This collaborative approach creates natural checks and balances, strengthening conviction by subjecting ideas to rigorous debate and diverse viewpoints.

• Conviction-based decision making: Our research directly informs position sizing, which evolves as our understanding deepens or circumstances change. This framework helps maintain conviction through periods of underperformance while ensuring we remain responsive to invalidating evidence.

Investing with conviction

We believe conviction built on detailed research is essential for long-term investment success. Our structured research process develops this conviction through comprehensive business analysis, clear investment theses, collaborative team input and systematic position sizing. This disciplined approach enables us to identify opportunities amid volatility and maintain positions when others capitulate.

February marked a shift in Australia's housing market, with national home values rising 0.3%, ending a three-month downturn. Gains were widespread, with Melbourne and Hobart leading at +0.4%, while regional markets continued to outperform, rising 0.4% for the month and 1.0% over the quarter.

This renewed momentum aligns with improving buyer sentiment, supported by tighter housing supply and a slowdown in new listings, which remain 4.7% lower year-on-year. Auction clearance rates have also strengthened, reflecting growing confidence in the market.

While affordability remains a challenge, supply constraints and positive sentiment could support continued price growth in the coming months. Investors monitoring market trends should note the shifting dynamics, particularly in premium housing markets, which have historically been the first to respond to changing economic conditions.

Property Values
as at 28th of February 2025

Median Dwelling Values
as at 28th of February 2025

Quick Insights

What rising property price trends are revealing

For investors, the modest drop in interest rates serves to signal market stability and clearer future direction in the near to medium term, helping to remove any destabilising fears of rapidly escalating interest rates.

Source: Australian Financial Review

Australians make a record median profit reselling their property

CoreLogic's Head of Research Eliza Owen said: "Despite mixed market conditions, declining capital growth and lower clearance rates, Australian property continues to deliver strong profitability."

Source: Corelogic

February Edition

Debt size doesn't seem to matter!

Major government borrowing events have typically been triggered by one-off crisis like the Global Financial Crisis (GFC) and COVID-19, not by interest rates. Before 2008, debt-to-GDP ratios were stable or even declining in many economies, suggesting governments borrow based on necessity, not borrowing costs.

Looking at the US, Australia, Germany, and the UK (refer Chart 1), debt levels have risen, yet interest rates haven't followed suit. Germany, for instance, has kept debt-to-GDP in check, yet its bond yields have moved in line with other developed economies.

Chart 1 - Debt-to-GDP vs. 10-year yields

Source: IMF, Bloomberg, Yarra Capital Management.

What does matter?

The rate of change in debt-to-GDP, rather than its size, has a stronger link to the slope of the yield curve (the difference between the 10-year and 2-year yield). When debt rises, 10-year yields trend higher than 2-year yields, steepening the yield curve. When debt growth stabilises or falls, the curve flattens (refer to Chart 2).

Since the GFC in 2008, this pattern has been distorted by central Quantitative Easing (QE). As QE is unwound, we expect this relationship to reassert itself. With debt-to-GDP projected to rise through 2029, yield curves are likely to steepen, keeping longer-term bond yields elevated even If cash rates fall.

Chart 2: Debt-to-GDP vs. yield curve slope (US, Australia, Germany and UK)

Source: IMF, Bloomberg, Yarra Capital Management.

Why it matters for investors

Active bond managers can adjust portfolio positioning based on shifts in the yield curve, potentially generating excess returns compared to passive strategies. Index funds, by design, follow fixed bond weightings and lack the flexibility to exploit relative value opportunities, meaning they may miss out on potential excess returns.

The recent wave of tariffs imposed by President Trump, along with retaliatory measures from affected nations, has created a complex environment for businesses worldwide.

While these trade disputes pose risks, they also present unique opportunities for certain US small-cap companies.

At the core of Trump's tariff policies is the goal of protecting American industries and reducing trade deficits. Measures that will undoubtedly disrupt global supply chains, drive up the cost of imported goods, and create challenges for businesses reliant on foreign materials. They are expected to, however, incentivize domestic production, potentially benefitting small-cap companies that can step in to replace diminished imports.

While not all firms will benefit, we believe companies with resilient business models, pricing power, and strong balance sheets will be best positioned to navigate these economic shifts.

Reshoring and supply chain reconsiderations

One of the primary ways tariffs could benefit small-cap companies is through the reshoring of manufacturing capacity. As tariffs make foreign goods more expensive, many US firms are adapting supply chain strategies to increase domestic sourcing and production. This shift presents new opportunities for smaller companies across a variety of sectors.

For instance, reshoring projects will drive demand for local construction crews, concrete suppliers, and equipment rental firms. Regional banks will play a key role in financing these initiatives. Meanwhile, new semiconductor facilities will require specialised HVAC systems with nearby maintenance and repair services. By positioning themselves within these expanding domestic supply chains, small-cap companies stand to benefit from stronger revenue and earnings growth.

Tariff-driven innovation and efficiency

Additionally, tariffs have spurred innovation and efficiency improvements among small-cap companies. Many businesses are investing in automation, advanced manufacturing techniques, and other innovations to offset rising material costs to enhance productivity. These efforts help maintain margins and better position small-cap companies for long-term success. This is especially relevant for technology and industrial companies leveraging innovation to reduce dependence on foreign inputs and strengthen their competitive position.

Reshaping the competitive landscape

Counter-tariffs imposed by other nations in response to Trump's policies have also played a role in shaping the competitive landscape.

Countries like China have targeted US exports, impacting industries such as agriculture and automotive. While some small-cap exporters face headwinds, others have successfully pivoted to alternative markets. We believe companies that can adapt to shifting trade dynamics and diversify their customer base will be best positioned to thrive.

The economic environment remains supportive

While we are mindful of the risks associated with recent policy actions, the broader economic environment remains supportive of high-quality small-cap stocks.

Despite geopolitical uncertainty, GDP growth is expected to remain in positive territory. Also, many companies have already strengthened operations in response to past disruptions, such as the pandemic and volatility during Trump's first term. These efforts, such as diversifying supply chains and implementing efficiency initiatives, have better-positioned businesses to navigate potential tariffs and raw material inflation.

Overall, the US economy is expected to continue expanding, albeit at a more modest pace. This environment allows resilient small-cap companies to capitalise on the new administration's 'America First' agenda while leveraging recent operational enhancements to mitigate near-term risks.

... Along with earnings growth

As we move through 2025, small-cap stocks are gaining attention for several reasons. Investors are increasingly looking to diversify, given the growing concentration of "Big Tech" in large-cap indices. The shift is timely, as small-cap companies are expected to deliver stronger earnings growth relative to their large-cap counterparts (Chart 1). This is an important development as small-cap growth rates have lagged large-caps for several years.

Chart 1. Russell 2000 Index (RTY) vs. S&P 500 Index (SPX) positive EPS growth

... And attractive valuations

Furthermore, small-cap stocks are trading at attractive valuations, with their discount to large-caps near historic lows (Chart 2).

Chart 2. Small cap relative to large cap forward price/earnings (PE) ratio

While multiple factors have contributed to this valuation gap, earnings growth differentials have been key drivers. As small-cap earnings accelerate, this discount should begin to narrow, presenting a compelling opportunity for investors.

Final thoughts...

Trump's latest tariffs and the retaliatory measures from affected nations are reshaping the competitive landscape for US small-cap companies. While risks remain, the push towards domestic production, supply chain diversification, and innovation can drive earnings growth for many firms over the long term. Coupled with resilient economic conditions and historically attractive valuations, high-quality small-cap stocks present a strong investment opportunity for those looking to capitalise on evolving trade dynamics.