Fourth Quarter Market Discussion
A surprise outcome in the presidential election and growing confidence that the Federal Reserve was on the path of raising rates from artificially low levels unleashed a wave of optimism that pushed markets to new highs.
Investors concluded the incoming administration is business friendly, a proponent of tax reform and deregulation, and likely to lead to a less influential Federal Reserve. These factors were viewed as catalysts for growth, and economically sensitive sectors benefited most. Meanwhile, rising interest rates made so-called bond proxies less appealing, causing Utilities and Real Estate Investment Trusts to lag.
Optimism about potential economic growth spread beyond Wall Street and into executive suites. As shown, confidence among chief executives spiked following the election and reached its highest level in almost two years. We believe CEOs’ positive outlook supports the case for growth and healthy inflation and should result in near-term business investment.
CEO Confidence on the Rise
Source: Bloomberg L.P., 11/30/2002 to 11/30/2016
CEO Confidence Index: Chief Executive Magazine conducts a monthly survey of CEOs' expectations for overall business conditions over the coming year using a rating scale of 1 to 10 (9-10 being excellent and 1-2 being poor).
Security selection in a majority of sectors was positive and helped the Fund beat its benchmark, the Russell 2000® Value Index. An overweight to and strong selection in Industrials boosted results. Our holdings in Materials were also key contributors. Allocation decisions were additive, with an overweight to Energy and underweights to Utilities and Real Estate boosting performance. An underweight to Financials detracted.
Staffing up. Industrials holding Heidrick & Struggles International, Inc. (HSII) exemplifies what resonated this quarter. The staffing services company was a top contributor after it posted better than expected earnings on solid growth. Management also noted that executive search activity has been up the past two months, reversing some softness experienced this summer.
We are encouraged by the company’s growth prospects and believe an improving economy should boost revenues. Additionally, the company’s balance sheet strength is an underappreciated asset, in our view. With cash reserves and no debt, the staffing firm can make strategic acquisitions or hire additional consultants—a low cost way to increase operating leverage and drive margins higher. Additionally, Heidrick & Struggles’ clean balance sheet should help it withstand unanticipated challenges if the economy treads water in the near term.
A green outlook? Our Materials names were up sharply and outpaced the Index. American Vanguard Corporation (AVD), a manufacturer of chemicals and insecticides used in agriculture, was a strong contributor. The company’s sales have been down as corn prices have been under pressure from bumper crops. Soft sales and efforts by intermediaries to reduce product inventories put downward pressure on margins as manufacturing slowed and the company’s factories operated at less than capacity. However, management recently reported an uptick in sales for herbicides used on non-corn crops such as cotton. We believe this could be the beginning of a broader recovery in agriculture that will lead to top-line growth.
With channel inventories under control, an uptick in sales would also lead to higher margins, which would provide additional flexibility for the company to pursue attractive product acquisitions from competitors as they become available.
With the stock trading at 1.9x stated book value (BV) versus long-term average of 2.83x, we believe the market isn’t fully valuing AVD’s operating leverage and is overlooking its capital allocation strength, which can be used to fund organic growth, pay down debt, and buy back shares.
Well heeled. Our Consumer Discretionary holdings were up on an absolute basis but lagged the benchmark. Wolverine World Wide, Inc. (WWW), a maker of premium casual footwear is an example of the kind of company we favor in the space. The manufacturer and marketer of Sperry, Merrell and Saucony shoes is in the early stages of reducing its store count and is seeking to divest its non-core brands and focus on higher-margin business.
Wolverine’s strong brands, high margins, cost cutting initiatives, and prudent capital allocation make the company compelling, in our view. With just 2.5x total debt to earnings before taxes, interest, depreciation, and amortization (EBITDA), the company’s balance sheet provides it flexibility as it reconfigures its business, in our view. Trading at 10x estimated 2017 EBITDA versus the 11x to 12x range for its low-growth peers, the shoe maker also offers the potential for downside protection should its initiatives take longer than expected to produce results.
While the economic backdrop appears to be brightening, we continue to focus on businesses that:
can generate margin expansion through self-help,
are prudent allocators of capital, and
have low debt.
We are avoiding businesses we expect will undertake significant capital expenditures in the near term and are finding businesses that can thrive in a growing economy.
Companies 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 our smaller positions. The result is a compact portfolio of about 50 names with approximately 30% of assets held in the 10 largest positions.
Outlook and Positioning
The transition from a market driven by macro events to one focused on individual company fundamentals should continue. We believe a renewed interest on valuations and earnings prospects reflects improved clarity for the economy.
The recent strong run for equities has led some investors to question whether valuations have gotten ahead of themselves. While pockets of the market appear expensive, as bottom-up investors we are focused on the valuations and business prospects of individual names we hold as opposed to the price-to-earnings of a broad index.
Additionally, we want to own 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.
Thank you for the opportunity to manage your capital.