First Quarter Market Discussion
Optimism that drove the market toward the end of 2016 continued, but enthusiasm tempered as the quarter wore on. Positive economic data and stronger than expected job growth were balanced against political discord in Washington and elevated valuations for the major indexes.
Investors remained constructive on equities but hedged some of their bullishness by favoring larger companies and less volatile names. The Federal Reserve Board’s mid-March interest hike was widely expected and viewed as another step on the road to normalized rates. Following the tightening, investors turned their focus back toward the underlying strength of the economy and prospects for earnings growth going forward.
Despite the rate increase, Fed commentary was interpreted as a willingness by the Board to move slowly and accept elevated inflation as a trade-off for allowing the economy to grow faster.
Security selection was positive with Financials and Real Estate holdings leading the way on a relative basis. Our stocks in Utilities and Health Care lagged and the Fund trailed its benchmark, the Russell 2000® Value Index. An underweight to Financials also boosted results. Our holdings in Materials detracted but an overweight to the group offset some off the weakness.
A boost from rising rates. MGIC Investment Corp. (MTG), one of the largest private mortgage insurers in the U.S., experienced a surge in new mortgages as home buyers rushed to lock in loans before rates rise. 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 is beginning to benefit from excellent performance of its current pool of policies. Delinquencies are down and insurance in force continues to grow.
MGIC has been generating solid cash flow and reducing debt. With the company trading at 10.5x estimated 2017 earnings (P/E) and only 1.3x tangible book value, we view the company as an undervalued leader in an industry vital to the domestic economy.
Done in by the dollar. Our Materials names lagged, with the majority of weakness coming from the Metals and Mining industry. Schnitzer Steel Industries, Inc. (SCHN), was a key detractor for the portfolio. Shares of the industry-leading scrap and finished metal producer were off after the company reported weaker than expected results for the quarter. A strong dollar and lower scrap metal prices weighed on results.
Steel prices have begun to inflect, and we expect them to continue higher going forward. Schnitzer’s technological advantages over competitors—which allow the company to produce more cost-effectively— should result in greater benefits from an incremental gain in pricing. Additionally, the company has already reduced costs and is well positioned to benefit from future pricing strength in a consolidating industry.
With the stock trading at 6.7x enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA), we believe the market isn’t fully valuing the company’s operating leverage and is too pessimistic on steel prices.
Chipping in. The Fund’s Information Technology names were up moderately on an absolute basis but lagged the benchmark. Our bottom-up research continues to uncover attractive opportunities in the space. For example, we initiated a position in chip maker Exar Corp. (EXAR).
The company has been actively reducing supply chain costs and has shifted its product mix to higher margin offerings. We also were attracted to its pipeline of new products that should boost top-line growth in the coming quarters. Weeks after we started accumulating shares, the company announced it had agreed to be acquired by a competitor at a significant premium. We exited our position on the news.
While we anticipate regulatory relief and Washington’s focus on improving the domestic business climate will be a tailwind for the economy, we are avoiding companies that could be adversely impacted by rising inflation. Instead, we are focused on beneficiaries of rising raw material prices. Inflation has been building for the past several months and, as illustrated in the chart, began to outpace market expectations in December. Companies that lack pricing power or which rely on commodities in production of goods could face margin pressure in the quarters ahead.
Cost Increases Outpacing Expectations
Citi Global Inflation Surprise Index
Source: Bloomberg L.P., 1/31/2004 to 3/31/2017
Businesses with opportunities to reduce costs and improve margins through internally focused efforts should be able to capitalize on operating leverage in an expanding economy or modestly grow earnings should sales remain flat.
We’ve trimmed some holdings on recent strength and redeployed assets into more attractively valued businesses in various industries. The result is a compact portfolio of approximately 50 names with more than one-quarter of assets held in the 10 largest positions.
Outlook and Positioning
We believe a renewed interest on valuations and earnings prospects will be closely tied to improved clarity for the economy and the geopolitical backdrop. If the administration in Washington is able to deliver on expected regulatory relief, a second leg up for the business climate should materialize.
The strong run for equities and the length of the bull market has led some investors to question whether valuations have gotten ahead of themselves. The market as a whole appears fully valued; however, as bottom-up investors we are focused on the valuations and business prospects of individual names we hold as opposed to the P/E of a broad index.
Additionally, we want to invest in businesses that have strong balance sheets and that employ solid capital allocation strategies. Companies that can drive operational improvements regardless of the macro backdrop should produce solid results in multiple environments and be recognized by the markets as catalysts occur.
Thank you for the opportunity to manage your capital.