First Quarter Market Discussion
After pushing the major indexes into record territory early in the quarter, investors pivoted to a wait-and-see stance and the markets moved mostly sideways to close out the period. The lack of traction reflected a mixed macro backdrop. Positive economic data and stronger than expected job growth were balanced against political discord in Washington and already elevated valuations for many stocks.
Investors remained generally constructive on equities but hedged some of their bullishness about the economy by favoring growth-oriented businesses and less-volatile names. This renewed focus on top-line increases is a reversal from the previous several months when valuations drove performance. We think this move could be short-lived, with value stocks returning to close the performance gap versus their growth counterparts. As shown, that disparity has been in place for several years.
A Rough Stretch for Value
Russell 3000® Value Index Less Russell 3000® Growth Index
Source: Furey Research Partners and Russell®, 3/31/2010 to 3/31/2017
Additional information for indexes shown at end of commentary.
Past performance does not guarantee future results.
The Federal Reserve Board’s mid-March interest hike was widely expected and viewed as another step on the road to normalized rates. Commentary by the board was viewed as signaling the Fed’s willingness to take a slow and steady approach to tightening. As a result, bond proxies such as Utilities remained steady as investors saw them as a safe place for yield in the near term.
Security selection was mixed, and the Fund modestly lagged its Russell Midcap® Value benchmark. Holdings in Materials and Industrials were strong on both an absolute and relative basis. The portfolio’s Information Technology (IT) names were down moderately and drove underperformance. Allocation decisions were mostly positive, with a significant underweight to Real Estate boosting results.
A material contributor. The portfolio’s Materials holdings were a key source of strength with Olin Corporation (OLN), the world’s largest chlor-alkali producer, leading the way. The company continued its impressive run from late 2016. The business has made progress in raising prices for its products, and the industry continues to benefit from expectations for increasing demand and decreasing capacity both domestically and in the European Union (EU).
EU regulations scheduled to take effect this year will require older facilities to cease production of chlor-alkali. The shuttering of plants, we believe, will reduce supply and provide additional pricing strength for Olin.
Western woe. IT holdings hurt performance, and the group contained a key detractor. The Western Union Company (WU) was down after it agreed to pay $586 million in fines stemming from an investigation into its anti-money laundering program. The issue was previously disclosed, but the size of the fine was higher than expected and dwarfed the amount the business had set aside to cover the penalty.
The settlement is a serious matter; however, the company began addressing problems when investigators first raised issues and we believe shortcomings have been adequately addressed.
We remain constructive on the name and believe its free cash flow generation will offset additional costs associated with enhanced compliance. Additionally, with the stock trading at 11x earnings per share, investors appear to be overlooking the early traction Western Union has gained from its digital efforts.
All the right ingredients. Bunge Limited (BG) was a standout in Consumer Staples. The multi-line food and agribusiness company was up after reporting better than expected revenue and earnings. Management also provided a clearer outlook for its core lines as well as its smaller sugar business. The top- and bottom-line growth reflects progress the company has made in cutting costs and focusing its operations.
Management remains committed to selling, spinning off or forming strategic partnerships of its sugar operations, which have an estimated value of as much as $1.5 billion. The company has a robust asset base that should allow it to capitalize on a strong macro environment in agribusiness and food and ingredients.
The Fund continues to seek high-quality companies as measured by balance sheet strength, free cash flow generating capabilities and returns on capital. Given that much of the late 2016 run up in stocks was driven by expanding valuation multiples, we believe highly levered businesses have downside potential that is not fully reflected in market prices.
Banking on tech. Recent addition Diebold Nixdorf, Incorporated (DBD), a banking technology company, is an example of a business with an improved balance sheet and steady cash flow generation that could offer investors attractive compensation for risk. We were early advocates of the name but sold our position in the first half of 2016 as the sales outlook for the U.S. and India became clouded and prospects in China and Brazil were weak.
We continued to believe in the company’s management team, but valuations didn’t adequately reflect the business’ elevated debt or uncertain sales. Since that time, Diebold’s market share abroad has stabilized, cash flow generation is improving and there is greater clarity on progress undertaken to cut costs and improve efficiency following its acquisition last year of a large competitor.
With balance sheet and sales clarity concerns addressed, we returned to the name and have been encouraged by early signs that Diebold is gaining traction in the high margin areas of its business related to bank branch automation and retail point of sales opportunities.
Outlook and Positioning
Our outlook remains tempered. Market advances appear to have paused as investors look for signs that the economy still has room to grow.
Against this backdrop, we are focused on striking a balance between great companies at moderate discounts and average businesses at deep discounts. Our efforts have resulted in a portfolio with compelling upside that trades at a discount based on the valuation multiples we track versus its benchmark, the Russell Midcap® Value Index.
We continue to seek idiosyncratic factors that provide our businesses with the greatest opportunity to succeed. As always, balance sheets are a key focus in our analysis. Companies with favorable liquidity and strong, consistent free cash flow should be in a healthy position to succeed. Additionally, companies that can drive earnings growth—whether through cost savings or increased sales—should be well positioned to keep pace with heightened investor expectations.
Thank you for the opportunity to manage your capital.