“In the middle of difficulty lies opportunity."
First Quarter Market Discussion
Investors still stinging from the small-cap sell-off last September were hit again in the first six weeks of 2016 as fears tied to macro events, including slow growth in China and continued uncertainty in oil, led to heavy selling pressure. Stocks bounced back by the end of the quarter and finished in positive territory.
The modest recovery understates what we believe is a four-pronged case for the asset class:
The U.S. economy is a source of strength. While Europe and Asia are planting seeds for future economic growth, efforts have already taken root domestically. GDP is steady, employment is strong and wages are climbing—all should provide a tailwind for domestically-focused businesses. We believe small companies are a pure play on U.S. business activity.
We’ve already seen a bear market in small caps. During the past six months small companies have endured two major downturns. As a result, the average company in the Russell 2000® Value Index is now down almost 25% from its 52-week high. We believe this fear-driven movement has created a significant opportunity.
Russell 2000® Value Index
Average Percent Change of Current Stock Prices From 52 Week High
Source: Source: FactSet Research Systems Inc. and Russell®, 1/2/2015 to 3/25/2016
Past performance does not guarantee future results.
Compelling valuations. The bear market in small-caps has produced significant discounts for companies with strong balance sheets that in many cases are growing faster than Corporate America as a whole.
Prime targets for Mergers & Acquisitions. The past three years has seen a boom in large companies buying up competitors. As we enter the later stages of an economic expansion, we would expect to see smaller names snapped up at premiums as businesses try to boost sales through tuck-in acquisitions.
Allocation decisions were mixed with six of ten groups contributing on a relative basis. Holdings in Materials did well, but couldn’t overcome weakness in Energy, Health Care, and Industrials names.
Willbros Group, Inc. (WG), a specialty energy pipeline contractor, was a detractor after posting strong performance to close out the year. As we noted last quarter, the company’s new CEO divested two business units and significantly reduced debt. During the quarter, the company reported significant progress toward paying down its debt; however, revenues came in lower than analyst expectations. Adding to the softness was weak performance by Energy names as a whole, and many smaller businesses in particular.
We continue to believe new management is taking the necessary steps to restore operating profitability and shareholder value. Trading at just 3.8x estimated 2016 earnings before interest, taxes, depreciation and amortization, we believe there is significant upside for the stock.
Taking the pulse in Health Care
More than half of the Portfolio’s underperformance in Health Care came from a single name, Invacare Corp. (IVC). This leading manufacturer of health care products for home use with sales of over $1 billion reported continued progress on its operational turnaround, which drove the stock higher. However, the company subsequently issued a dilutive convertible debt offering in order to support new growth initiatives. The move was unanticipated by investors and resulted in selling pressure.
We continue to find the stock attractive, trading at 7.3x estimated 2017 earnings compared to a peer average of 12.6. Strong secular demand for home health care products should make the company a compelling story of top-line growth for years ahead. We expect Invacare’s free cash flow will continue and its low debt level should help it withstand any unforeseen challenges.
An innovator rewarded
Information Technology (IT) contained a top performer, but the group lagged the benchmark. CUI Global Inc., (CUI), a manufacturer of electronic equipment and measuring devices used by utilities and natural gas pipelines, was up after it landed an initial order from Snam Rete Gas S.p.A, one of the largest natural gas pipeline operators in Europe.
CUI’s technology represents a significant shift in the ability of suppliers to measure the quality of gas flowing to customers. While quality of the commodity is a key aspect of pricing for utilities, the industry has been relying on outdated technology from the 1950s to measure the richness of the products in its pipelines.
The outdated meters are expensive and fragile, adding to the challenges for power companies. CUI’s advanced devices are more accurate, robust and less, expensive which should lead to more accurate pricing and significant cost savings for power producers over the long-term. Its superior technology could lead to annual sales growth of 20% or more for the next several years.
Build it and they will come
We are finding attractive value in the Consumer Discretionary space, particularly among select homebuilders. WCI Communities Inc. (WCIC) is an example of a small company that we’ve been tactically adding to on weakness, as shown. We believe its established presence in Florida, which is growing twice as fast as the national average, should help it achieve 20% profit growth this year.
Capitalizing on a Pullback
Source: Bloomberg L.P., 12/31/2015 to 3/31/2016
Past performance does not guarantee future results.
The company develops lifestyle communities and luxury homes on both coasts of Florida. The builder is focused on empty-nesters, clients looking to move up, or those purchasing a second home. The upshot of the approach is a concentration of all-cash purchasers, which should translate to a lower level of order cancellations. With less than 20% net debt to capital and a significant inventory of buildable land, we believe the company will be well positioned to capitalize on the strong migration of retirees and transferees to the state. WCI’s strong order pipeline provides us additional confidence that the company will have another robust year of sales this year and approach $1 billion in 2017.
Positioned for the Future
We continue to evaluate new opportunities looking for idiosyncratic drivers that provide what we believe is the greatest opportunity for success in a variety of macro environments.
A budding opportunity
Landec Corp. (LNDC) is another example of a name that has sold off but that we believe has significant potential for capital appreciation. The company has doubled in size over the past five years and enjoys a leadership position in each of the industries in which it competes. It operates in three divisions: highly profitable Lifecore Biomedical, a provider of medical grade hyaluronan (HA) that is used in ophthalmology and orthopedic procedures; Apio, which sells packaged vegetable and salads under its EatSmart brand; and as a 27% owner of North America’s leading hydroponic, green house that distributes to natural food stores nationally.
Top line revenue has been slowed by a large customer of Lifecore Biomedical destocking this year, as well as a drought, which has limited the availability of vegetables. We believe the market is failing to look beyond these temporary setbacks to see the larger picture. Our analysis indicates earnings could potentially double for the year ending in May 2017 due to the following reasons:
Lifecore should resume double digit growth with improved margins as the effects of client destocking wane.
The Apio division has excess capacity that will accommodate tuck-in products to distribute to its national customer base, including Costco, Walmart, Trader Joe’s, and others. Use of the excess capacity should boost margins and even out the seasonality of the vegetable business.
Windset Farms, its hydroponic investment, has an economic advantage of lower water usage that should result in it taking market share from traditional growers.
Landec, with sales of over $500 million, is trading at 11.6x estimated 2017 earnings, and, based on our analysis, at less than half the sum of its parts. The company’s focus on health and wellness positions it to capitalize on the growing health conscious movement, and we believe it will be hard for it to be overlooked by valuation-conscious investors searching for earnings growth potential.
How we plan to capitalize in Small-Cap Value
We have been finding compelling opportunities among small-caps of all sizes but much of our recent activity has taken place in names over $1 billion in size. Many dividend-paying companies have also hit our screens, and we continue to monitor these names for inclusion in the Portfolio.
Recent swings in performance for smaller companies are, in our view, a sign of a tumultuous bottoming process. Many names in the Russell 2000® Index have hit valuations not seen since the financial meltdown. Yet, the economy continues its slow, steady growth, employment remains strong, and consumer confidence endures. We’ve seen other periods when pessimism temporarily trumped fundamentals, but those stretches generally ended the same, with prices reverting to reflect the actual strength of companies and patient investors rewarded.
Thank you for the opportunity to manage your capital.