Third Quarter Market Discussion
Major indexes built on last quarter’s move higher. Strength in the Russell 3000® Value Index was broad with nine of 11 sectors positive, as shown. Areas such as Information Technology and Financials were strongest, and yield plays such as Utilities lagged. The mix highlighted moderate optimism.
Source: FactSet Research Systems, Inc., 7/1/2016 to 9/30/2016
Past performance does not guarantee future results.
Sentiment toward U.S. and global economies inched up and helped lead cyclicals higher. With recession fears fading, defensive areas lagged. While no glaring pitfalls appeared on the economic horizon, investors focused on valuations as they sought to hedge unforeseen risks. We believe the search for attractive multiples boosted smaller companies, which have trailed for much of the past 18 months.
Security selection was mixed. Financial holdings were a key source of strength along with names in Materials. The portfolio’s Consumer Staples and Health Care names lagged. The majority of our holdings in Industrials were up and the group contained one of our top contributors. Performance among the portfolio’s smaller names hurt results.
Standout on defense. Oshkosh Corporation (OSK) was up after it announced earnings that beat Street estimates and raised full year guidance. The majority of its business lines posted double-digit revenue growth and strong margin expansion. The company trades at 16x estimated 2017 earnings versus a median of 19x for peers. Price appreciation has nudged valuations higher, but we expect earnings will continue to improve. A ramp up in deliveries of mine resistant defense vehicles should provide revenue growth for the coming year, followed in 2018 by increased sales of light joint tactical vehicles. The company’s lift equipment unit has been under pressure but we believe sales have troughed and inventory management will offset some of the softness.
A tank half full. Not all Industrial names were strong, however. Kirby Corporation (KEX) was down after it reduced guidance for the quarter and full year. The largest inland barge operator in the country cited depressed utilization rates for its tankers and a slower than expected recovery in the Energy sector. We remain committed to the company and anticipate inland barge pricing will firm in the second half as the petrochemical industry scales up due to low natural gas prices.
Good information. The portfolio’s Information Technology (IT) holdings were up on an absolute basis, led by a standout in network computing.
Top 10 holding Cisco Systems (CSCO) was a key contributor. The company unveiled details of a restructuring plan that calls for cutting costs from lower-margin lines and redeploying the savings into more profitable businesses, including security, next generation data centers, and cloud computing. Shares drifted lower after the announcement but were up for the quarter as its margins continue to hold up better than the market anticipated. We expect the improved perception of the company will continue.
With a free cash flow to enterprise value yield greater than 10% and low-debt balance sheet, we believe the company has the strength needed to gain market share in an industry battling commoditization. Despite its advantages and a 3% dividend yield, the company trades at 13x earnings.
Starting over? Weakness in Consumer Staples was driven by one of our retail holdings. The company announced a leadership change and will pursue a new business strategy. The new effort may also require additional spending. We were disappointed by the announcement and are reevaluating our commitment to the name.
Given the economy remains unsettled, volatile stocks present greater downside risk in our opinion. We have sought to mitigate that factor by holding higher market cap stocks with superior franchises. The team has also looked for smaller companies that have a dominant industry position or those with realistic opportunities to improve results through self-help measures.
Recent addition Kennametal Inc. (KMT) is an example of a smaller name with an industry leading franchise that could significantly improve results through increased efficiencies. The company is the third largest maker of tools used in the metal working industry. Despite its dominant position in a consolidated space, it has suffered from a downturn in orders. Additionally, its decision to pursue a direct sales model that bypassed large dealers resulted in lower sales and reduced market share.
A new CEO with a plan to reduce costs and reorganize its sales efforts was appointed early in 2016. We are confident the approach should improve results. The stock is trading at 11x estimated 2017 earnings versus a historic average of 14x, which makes for a compelling risk/reward profile.
Outlook and Positioning
While the lingering economic uncertainty that has hung over the markets remains, the distortions it caused have tempered. As a result, we’ve been able to find compelling opportunities and have found a concentration of attractive investments among late stage cyclical names as well as larger companies.
While a move into late cyclical businesses is prudent in our opinion, we continue to monitor allocation risk and have structured the portfolio to benefit from stable companies with idiosyncratic factors. We continue to balance exposure to economically sensitive names with those that produce more consistent results regardless of the economy.
The byproduct of our bottom-up research is a portfolio with stronger balance sheets, which is more levered to global growth and is less sensitive to changes in dollar strength or a rise in inflation.
Thank you for the opportunity to manage your capital.