“It is impossible to produce superior performance unless you do something different from the majority."
—Sir John Templeton
Fourth Quarter Market Discussion
A surprise outcome in the presidential election unleashed a wave of optimism that pushed markets to new highs. Many investors cheered the incoming administration believing it would usher in tax reform, fewer regulations, and relief from the Affordable Care Act. The reaction was swift and powerful.
Less government influence in the economy was viewed as a catalyst for growth and, as shown below, cyclical areas benefited most. The December rate hike, and expectations of more to follow, boosted Banks as investors bet on a rise in interest income.
Reversal of Fortunes
Source: FactSet Research Systems, Inc., Heartland Advisors, Inc., and Russell®
Holdings data as of 10/3/2016 to 11/7/2016 and 11/9/2016 to 12/30/2016
Past performance does not guarantee future results.
The new administration should breathe life into an underperforming economy. However, valuations appear stretched. Against this backdrop, we believe finding compelling opportunities will require fundamental research—and not a passive approach.
The Portfolio’s holdings were up on an absolute basis but mixed relative to the benchmark, the Russell 2000® Value Index. Stock selection in Financials, Energy, and Utilities boosted performance. Health Care names detracted due primarily to a company specific issue with one of our companies.
Trinity Biotech PLC (TRIB), a developer and manufacturer of diagnostic products, fits our strategy of holding businesses with competitive advantages that should allow them to grow faster than peers. The stock was down sharply after it announced it was pulling its bid for Federal Drug Administration (FDA) approval of a test used for rapid detection of heart attacks in emergency room settings. The test showed promising results, but the company rescinded its application based on an FDA recommendation.
The decision was a disappointment, but the market’s reaction, in our view, is overblown. Trinity remains a premier player in diabetes testing. It also dominates the HIV diagnostic market in Africa and controls a third of the segment in the U.S. The company’s infectious disease line generates $43 million in annual sales—half our estimate of the Dublin-based business’ intrinsic value.
Trinity’s position as a global leader in diagnostics should help it quickly establish itself in new markets such as Brazil. Looking solely at the company’s earnings power from its diabetes line, we believe the stock is trading at a 50% discount of its worth using peer-average multiples.
Cashing in on the cloud
Information Technology holding RadiSys Corp (RSYS) lagged despite seeing an inflection in earnings this year. The developer of high-performance software and integrated systems for the telecommunications space has undergone a transformation over the past five years.
As the wireless industry began to transition away from integrated hardware to widespread use of software, the company adapted to keep pace. During the period sales and earnings declined while RadiSys built up its software line. However, 2016 marked an inflection point. Aided by a multi-year contract for upgrading a Verizon data center, the company finished the year on pace for a 16% jump in revenue.
In the coming years, traffic on mobile, fixed-line, and cable networks is expected to explode. The increased volume should help the company consistently grow sales in the mid-teens compounded annually. Additionally, the business’ software sales are gaining traction. The company has already landed two critical clients in the space and several more are expected to come aboard in 2017. Based on our price to sales analysis, the stock is trading at a discount of approximately 35%.
Looking past the banks
Stock selection in Financials was strong but the group detracted due to a material underweight to the area. The sector makes up almost one-third of the benchmark. We believe an allocation that size would create undue risk for investors and we remain underweight to the sector.
The rapid rise in bank stocks has led to fewer compelling values in the space; however, we continue to find opportunities in other industries in the Financials sector. Radian Group Inc. (RDN), a private mortgage insurance (PMI) company, is a good example.
We have been impressed with its growing book of insurance in force and believe prospects for an uptick in new insurance written are strong. Additionally, a rise in interest rates should help PMI companies as homeowners will be less likely to refinance mortgages. A slowdown in refinancings should lead to insurance policies on existing loans remaining in force for longer.
Radian announced earnings that were better than Wall Street analysts had projected, and the stock was rewarded. We view its current valuation of 9x estimated 2017 earnings as a bargain for a name that has produced a 14% rise in book value per share over the past 12 months. Management has been buying back shares, and the combination of a growing pool of insurance in force and fewer shares in the market could result in strong earning per share growth in the coming quarters.
An improved outlook?
The economic picture has brightened and investors of all stripes have benefited. However, valuations point to the easy money having already been made. Going forward, we believe fundamental analysis is required to uncover businesses serving unique niches, producing top-line growth, with exceptional balance sheets, and that are capable of generating strong free cash flow. In an Index-oriented investment world, we believe this is the best approach to producing superior performance over the long run.
Thank you for the opportunity to manage your capital.