First Quarter Market Discussion
Optimism that drove the markets at the end of last year continued into 2017 but lost steam as the quarter wore on. Stronger than expected job growth was offset by political fighting in Washington and elevated valuations for the major indexes.
Investors responded by buying large-cap names and renewing their chase of momentum and growth stocks. Adding to the effect was a continued flocking into passive funds that don’t look at valuations—just market cap. When investors en masse disregard valuation measures such as price-to-earnings (P/E) or price-to-book (P/B), it can lead to near-term frustration for those of us unwilling to overpay for a company. But experience has shown that in the long run, buying at the right price is what ultimately leads to success.
The Fund’s holdings were mixed on a relative basis, with allocation decisions contributing positively to performance. Stock selection in Materials, Consumer Discretionary, and Real Estate boosted returns. However, Industrial names detracted and caused the portfolio to mildly lag its benchmark, the Russell 2000® Value Index.
A no-frills approach, priced at a single-digit P/E
LGI Homes (LGIH) is one of the nation’s fastest growing homebuilders and operates in 10 states in the south and western U.S. The company focuses on the entry-level market with an average selling price of just over $200,000. To keep costs down and margins up, LGIH builds standardized homes and uses an aggressive sales and marketing program to target renters.
The no-frills approach has helped the company grow from startup in 2003 to $818 million in sales for 2016. LGIH has made a profit every year since opening and boasts a gross margin the envy of the industry. This trend should continue, we believe, as homeownership has hit a 50-year low and should revert back to historical averages in the coming years.
Despite projecting growth in the mid-teens during the next few years, LGI is trading at only 8x this year’s estimated earnings per share (EPS). The business also pays a 34% tax rate and should be a clear beneficiary of any tax cuts from Washington. Based on our estimates, internal revenue code changes could contribute an additional $1 in EPS.
Long-time holding Barrett Business Services Inc. (BBSI) was a key detractor. The Industrials company provides outsourced human resources services including staffing and benefits management to small- and medium-sized companies. Record rains in California, snow days in Portland Oregon (a major market), hurt expected revenue growth for the quarter; additionally, an increase in the effective tax rate for the company from 25% to 34% resulted in earnings not meeting expectations.
As long-term investors, we are able to look past temporary blips that may pop up during a single quarter. Management has performed well over the years and revenue has climbed more than 13% in the past year to $841 million in 2016. Shareholders have reaped the rewards of this strong growth, thus we believe the company will be able to continue to deliver top-line growth in the mid-teens—much faster than the expected low single-digit growth of the economy as a whole.
Furthermore, the stock trades at a significant discount to some of its larger peers. For example, BBSI, which has no analyst coverage, is priced at only 13.9x this year’s estimated earnings compared to 20x for Insperity Inc. (NSP). Therein lies the opportunity. We continue to hold Barrett and would view it as an attractive “buy” candidate on any pullback.
A lift in Health Care
Our holdings in Health Care lagged the benchmark but also included a top contributor—a leading provider of air medical emergency transport services and systems in the U.S. We took a stake in the business late last year based on attractive mix of valuations and expected double-digit earnings growth.
Shares appreciated smartly after the company announced it was taking itself private at a premium to current valuations. We view this as an example of the appeal of small, specialized businesses. Improved business and investor confidence should be a catalyst for more take outs in the small-cap space this year.
One size doesn’t fit all
Policy changes and regulatory reforms from the Trump administration should breathe life into an underperforming economy. Consumers are also anticipating brighter days as reflected by consumer confidence hitting a 16-year high.
However, valuations of widely held equity indexes appear stretched and not all companies, or industries, will benefit from moves out of Washington. On the other hand, smaller companies in particular should be the primary beneficiaries of lower tax rates and revamped health care rules. At the same time, niche businesses should be better positioned to grow revenues even if the economy hits a lull. While this small-cap optimism may not be the consensus view, it is shared, as shown, by the group that may have the best insight of all—small business owners. The bullish outlook should result in increased hiring, which could lead to greater sales growth.
Small Business Optimism Index
Source: Bloomberg L.P., 1/31/1987 to 2/28/2017
NFIB Small Business Optimism Index: is a small business optimism index compiled from a survey that is conducted each month by the National Federation of Independent Business (NFIB) of its members. The index is a composite of ten seasonally adjusted components based on questions on the following: plans to increase employment, plans to make capital outlays, plans to increase inventories, expect economy to improve, expect real sales higher, current inventory, current job opening, expected credit conditions, now a good time to expand, and earnings trend.
Running small but walking tall
Against this backdrop, we believe it is time to be a discerning investor—looking at what others have seen and thinking in a way others haven’t. This approach begins with studying balance sheets, valuations, and getting to know managements. Fundamental analysis is required to uncover businesses addressing unique needs, producing top-line growth, with exceptional balance sheets, and that are capable of generating strong free cash flow. In today’s era of pervasive passivity, we believe this is the best approach to producing superior performance over the long run.
Thank you for the opportunity to manage your capital.