Second Quarter Market Discussion
The quarter marked another step in a rotation away from the market being dominated by dollar strength and deflation concerns. The move was helped by a dollar that was volatile yet generally weaker than at the start of the quarter as well as higher oil and commodity prices. As the prevailing themes continued to fade, investors grew comfortable owning businesses with international exposure. Market breadth reflected a willingness to cast a wider net as demonstrated by eight of 10 sectors posting positive returns in the Russell Midcap® Value Index.
Late stage cyclical areas were among the biggest beneficiaries of a growing comfort to risk assets. Economically sensitive names were rewarded to varying degrees based on whether they were helped by currency weakness. As you can see, the dollar softened for most of the quarter before snapping back in response to the United Kingdom’s vote to leave the European Union. The softening boosted dollar-priced commodities and businesses that derive a portion of revenues abroad. Cyclical groups such as Consumer Discretionary, where strong domestic currency and low inflation serves as a tailwind, lagged.
Dollar Declining Vs. World Currencies
Source: FactSet Research Systems Inc., 12/31/2015 to 6/30/2016
Past performance does not guarantee future results.
The rotation to previously shunned economically sensitive areas was welcome news for valuation conscious investors. During the past 12 months, we have consistently found compelling valuations among these groups and our commitment was rewarded as the Strategy outperformed its Russell Midcap® Value benchmark, returning 6.32%† versus 4.77%.
Security selection in Industrials and Materials helped returns. A company specific issue detracted from performance in Consumer Discretionary.
A material benefit. Among names in Materials, Olin Corp. (OLN), the world’s largest chlor-alkali producer, was a standout. Shares were up sharply on the back of an announcement the company was reducing production in North America. This news, along with further signs of upcoming output cuts from competing European and North American facilities, should result in tighter supply and improved pricing.
Investors initially cheered the acquisition of a competitor last year; however, as credit markets softened, souring on the use of debt to finance the deal set in. We continued to meet with management who believes there exists a multi-year window of a favorable supply/demand balance. Those discussions along with additional analysis, including stress testing free cash flow projections under various scenarios, led us to add to our position.
Despite the recent run up, the company is trading at 7.5x enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA). It is possible the valuation could go down even further as benefits from the acquisition are realized.
A Utility player. While Utilities has been a beneficiary of the scramble for yield in light of the Fed’s low rate policies, we believe many regulated power companies are generally expensive with weak prospects for increased revenue. Our research has led us to compelling opportunities among partially regulated players. MDU Resources Group, Inc. (MDU), a utility with construction, pipeline and energy services business lines, fits the mold. The company reported solid earnings this quarter helped by recently approved rate increases. Backlogs for its construction services and materials units also grew considerably during the period, and it is anticipated the aggregate business could see improved margins. Trading at a 20% discount to our sum-of-the-parts analysis, we believe MDU’s diversified business model provides multiple avenues for continued growth.
Not in the shopping mood. The Portfolio’s weakness in Consumer Discretionary was primarily tied to one holding. National department store Kohl’s Corp. (KSS) was down after reporting declining year-over-year sales, which management attributed to poor weather. The company also acknowledged that efforts to enhance online sales ate too deeply into its conventional marketing budget. While we were disappointed in the results, we are encouraged by the arrival of a new Chief Operating Officer, a renewed sense of urgency, and its maintained guidance for the full year.
Kohl’s faces pressure—like many retailers—from the dominance of Amazon.com, Inc. (AMZN). However, the company is trading at its lowest level in a decade as measured by price-to-book, EV/EBITDA, and price-to-earnings. At these significantly depressed levels, even modest improvements in sales should result in a sizeable move for the stock.
Financially sound. Our holdings in Financials were additive on an absolute basis. Nearly all of our holdings in the space performed positively with insurers among the top performers on a relative basis.
Obstructed view. An overweight to Information Technology dampened results and the group contained a key detractor. A banking technology company was down after it reported weak earnings, depressed cash flows, and a rise in inventories. The company also said the sales outlook for the U.S. and India was clouded and prospects in China and Brazil were weak.
Unlike Olin, where we bought on weakness due to a clear, constructive outlook, we exited our position in the technology company because its debt levels made us uncomfortable. We still believe the company is led by a management team that has success in improving operations and product offerings, but believe its risk reward profile is no longer compelling.
We continue to take volatility as an opportunity to upgrade the quality of our holdings. Facing a tighter lending environment, we remain cognizant of debt levels on an absolute basis and relative to free cash flow. Given companies with stronger credit ratings will likely have greater flexibility when pursing growth, we are also focused on credit market dynamics and how they affect the rates companies needing to raise capital will pay.
Economically sensitive names that tend to fare well in the later stages of expansion have caught our attention. As a result of our belief that inflation could hamper consumer-oriented businesses that lack pricing power, we’ve adjusted our exposure away from mall-based retail businesses. Similarly, low interest rates and depressed gas prices have provided a tailwind for Main Street. It is unlikely these benefits will persist in a way that warrants the elevated valuations in some pockets of consumer-oriented industries.
Outlook and Positioning
The economy appears to be reaching a crossroads. We think there are an array of possible outcomes in the coming months ranging from stagflation to a resurgence of value-oriented sectors brought on by a weakening dollar, rising commodity prices, and continued slow growth. While we believe the most likely outcome is modest inflation and economic growth, we remain focused on idiosyncratic factors that provide our businesses with the greatest opportunity to succeed. Balance sheets will matter in the months ahead. Companies with favorable liquidity and strong, consistent free cash flow should be in a healthy position to succeed regardless of the macro environment. Additionally, valuations will continue to be important, and we believe paying up for traditionally defensive sectors heightens downside risk.
Against this backdrop, we are being conservative when analyzing projected earnings and are focused on financial strength that can be drawn upon to either expand in an environment of economic growth or to use as a cushion should the economy falter.
Thank you for the opportunity to manage your capital.