“The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.”
― Seth Klarman, Investor
Third Quarter Market Discussion
Attractively valued companies held their own against growth/glamor stocks for a second straight quarter. Market strength was broad and smaller names were among the top performers. Boosted by strong results among our smallest holdings, the Value Fund outperformed its benchmark.
For the period, the smallest 30% by market cap in the Russell 2000® Value were up an average of 11.90% compared to 8.51% for the largest 30%. The willingness by investors to go further down the market–cap range points to continued broadening of the market and a willingness to dig deeper for compelling opportunities.
Strength in Small
Source: FactSet Research Systems, Inc., Heartland Advisors, Inc., and Russell®, 6/30/2016 to 9/30/2016
Deciles are represented by the Russell 2000® Value Index and organized by market capitalization with 1 representing the largest and 10 representing the smallest.
Past performance does not guarantee future results.
As investors continue to hunt for companies that outperform in a flat economy, we believe they will look to niche businesses with strong sales and earnings prospects—the kinds of names that have gone unloved for too long in the small–cap space.
Stock selection was positive with holdings in many sectors outperforming. Industrials, Real Estate, and Consumer Discretionary led the way. The portfolio’s Energy names lagged. Performance was solid regardless of market cap with larger small–caps and micro–caps each contributing.
TiVo Corp. (TIVO) fits our strategy of owning businesses with a competitive advantage that should allow them to grow faster than the economy. With over 5,000 patents and serving 500 pay TV providers in 70 countries, the company is a dominant player in providing interactive programming guides to the cable/satellite industry and offers predictive analytics to advertisers.
We initially purchased Rovi Corp. (TIVO), which acquired TiVo because of its superior technology and position as a provider of a must–have product. The recently completed merger between the organizations furthers the combined company’s intellectual property dominance, expands its customer base, and provides opportunity for $100 million or more in cost cuts (equal to $1 per share). Additionally, the company has had contract wins with larger clients at favorable pricing, which should result in growth in the years ahead.
Intellectual property holding Acacia Research Corporation (ACTG) is reaping rewards from its book of patents while planting seeds for future revenue. The company, which partners with third–party firms to license and enforce patents on technology, was a top contributor. It recently won a lawsuit against Apple Inc. (APPL) revolving around the computer giant’s use of Acacia’s patented cell phone technology. The jury determined Apple must pay the company more than $22 million in damages. CEO Marvin Key has focused on quick, profitable resolutions with patent infringers, reducing legal costs, and restructuring staff compensation.
The results since Mr. Key took the reins in late 2015 have been impressive. Overhead has been slashed more than 50%, and cash settlements have increased leading to an additional $1 per share in cash generation.
The company has also actively invested for the future. Through a funding deal with a cloud–based, artificial intelligence (AI) business, Acacia could gain a foothold into the untapped business of cataloging data to make it more accessible. The market potential in our opinion is exceptional and has yet to be fully appreciated by analysts. With no debt and $3 per share on the balance sheet, we are happy to hold shares alongside insiders who have been piling in!
Getting its magic back
MGIC Investment Corporation (MTG), one of the largest private mortgage insurers in the U.S., has benefited from improved loss ratios and firmer pricing in the industry. The company, along with its competitors, was hit hard with loss payouts stemming from the real estate implosion of 2007–08. With the majority of bad loans from the pre–financial crash behind it, the Milwaukee–based company has begun to benefit from excellent performance by its current pool of policies. Delinquencies are down and insurance in force continued to grow.
It has been generating solid cash flow and buying back some of its convertible debt, which lessens the threat of future dilution of shares. Trading at 8x estimated 2017 earnings and only 1.1x tangible book value, we view the company as an undervalued leader in an industry vital to the domestic economy.
The private mortgage insurance market should continue to recover and we’ve been encouraged by pricing strength. There was heavy insider buying in early 2016 that we viewed as validation of our fundamental research.
A bright future for value?
The clouded earnings picture has heightened the risk of holding turnaround stories. Instead, we are focusing on companies serving unique niches, with exceptional balance sheets that can generate strong free cash flow. As Seth Klarman noted, the market is a story of cycles and after a long wait for the cycle of macro–driven, index mania to unwind, patient value investors, such as yourself, should be well positioned to have their perseverance rewarded.
Thank you for the opportunity to manage your capital.