Third Quarter Market Discussion
The quarter ended as it started with contradicting economic data and mixed messages from the Federal Reserve on if or when it would nudge rates higher. A contentious election at home and economic and political challenges globally added to the murky outlook.
Many consumers and businesses reacted by sitting on the sidelines waiting for a consensus view of the economy’s strength to emerge. Retail sales growth, as shown, continued to soften and growth in consumer spending was on track to slow to just 3% during the quarter.
Retail Sales Slowing
Source: Cornerstone Macro LP, 12/31/2010 to 9/30/2016
*Estimates as of 9/28/2016 are used for the quarter ended 9/30/2016
Series measures real retail and food services sales in millions of chained 2009 dollars
Despite the subdued mood by companies and households, investors continued to bid up stocks in hopes that the economy would grind on for the remainder of the year before accelerating in 2017. This hopeful outlook was reflected in strong performance among economically sensitive areas of the market with Industrials and Materials among the top performers.
Security selection in several sectors was positive on an absolute basis, but weakness in Consumer Staples and Real Estate caused the Fund to lag its benchmark, the Russell 2000® Value Index. An overweight to and strong selection in Information Technology (IT) boosted results. The Fund’s holdings in Energy were also key contributors. Allocation decisions yielded mixed results: underweights to Utilities and Real Estate boosted performance, while an underweight to Financials detracted.
A good draw. Haemonetics Corporation (HAE), a provider of products used in the processing, handling and analysis of blood, was a strong contributor. The company was up after it beat analysts’ estimates for revenue and reiterated guidance for the full year. The name fits with our goal of finding businesses that can improve bottom line results through internally focused efforts.
Management has been aggressively slashing costs and repositioning sales efforts toward its plasma and diagnostic instrument business lines that generate more than 45% gross profit margins. We think the new approach is prudent and have been impressed with the progress so far. Trading at 9x enterprise value (EV) to estimated 2017 earnings before interest, taxes, depreciation and amortization (EBITDA), and with a solid balance sheet, we believe the risk-reward profile is compelling.
Banking on improved margins. Financials detracted on a relative basis, however, our Bank holdings were strong. Zions Bancorporation (ZION), is an example of the type of name we found attractive. The stock traded higher as Zions’ book of loans with Energy exposure performed better than expected. The regional bank has also made faster-than-expected progress on improving efficiency and is pursuing fee generating opportunities.
The company trades at 1x tangible book value despite its premium core deposit base. The discount, in our view, doesn’t fully reflect greater revenue opportunities and the cost-cutting efforts underway. These initiatives should result in a greater efficiency ratio and an improved return on equity.
A stock specific issue in the Real Estate Investment Trusts industry accounted for the majority of weakness in Real Estate. Our Materials holdings performed well on an absolute and relative basis. Names in the Metals and Mining Industry were the primary drivers, but we are finding opportunities in multiple parts of the sector.
The value of good ingredients. Innophos Holdings Inc. (IPHS), a mineral-based special ingredients company, should be able to continue to improve margins under a plan introduced by new management. The approach calls for aggressive cost cutting, reduction of inventory and debt, and repositioning the company to focus on higher profit margin products.
Revenues were down for the most recent quarter, but earnings beat analysts’ estimates, reflecting the positive impact of some of management’s new initiatives. We believe the cost-cutting efforts along with a more aggressive marketing plan should allow margins to increase and sales to expand. Trading at less than 7x EV to 2017 estimated EBITDA, we believe the market is not fully appreciating Innophos’ upside.
Against an uncertain economic outlook, we continue to focus on businesses that can (1) generate margin expansion through self-help, (2) are prudent allocators of capital, and (3) have low debt. We are avoiding businesses we expect will undertake significant capital expenditures in the near-term and are moving away from those that are reliant on cyclical growth.
Companies with opportunities to reduce costs and improve margins should be able to grow earnings in a flat economy or will be well positioned should the climate improve. Heightened volatility has allowed us to add positions opportunistically as prices warrant.
Outlook and Positioning
The global economic picture remains muddled. Central bank policies appear to have lost their effectiveness, and businesses and consumers are hesitant to spend. Against this backdrop, market uncertainty could persist for the next several months. Inflation is starting to creep up and could force the Fed to abandon its commitment to historically low interest rates.
Instead of making a call on how the macro environment will unfold, we are focusing on owning businesses with multiple levers management can pull to improve results and increase margins. Self-help opportunities that are particularly attractive against the current backdrop include:
Reducing overhead expenses
Divesting or discontinuing less profitable product lines
Capitalizing on pricing power
Focused investment in profitable growth opportunities
Additionally, we want to own businesses that have strong balance sheets and that will 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.