Oversold conditions at the end of 2018 led to a burst of buying activity to start the year, and the equity markets rebounded sharply.
Many of the areas that were hardest hit during the previous period—cyclicals, growth stocks and inflation-sensitive names—led on the upside.
The snap back reflected a stark change in mood from the pessimism that closed out 2018, yet the fundamental narrative for companies was largely unchanged. Earnings growth projections remained muted, and global trade tensions persisted. Data began to confirm earlier forecasts of a slowing economy, as shown in the Citi Economic Surprise Index. Even the Federal Reserve’s decision during the period to suspend its program of raising rates, which was cheered by investors, had been widely anticipated for months.
Source: Bloomberg L.P., 3/29/2018 to 3/29/2019
The Citigroup Economic Surprise Indices measure data surprises relative to market expectations. A positive reading means that data releases have been stronger than expected; a negative reading means data releases have been worse than expected.
While investors pivoted to an optimistic stance, they showed signs of caution for some highly levered industries. The skepticism played out in Consumer Staples, where shares of companies with significant debt and undifferentiated products lagged the broader market.
Stock selection was strong in a number of areas but the portfolio lagged its Russell Midcap® Value benchmark for the quarter. Consumer Staples stood out on a relative basis, along with the strategy’s Materials holdings. The portfolio’s Financial names lagged.
Something to cluck about.
The recent tone for Consumer Staples has been weak. However, we have found opportunities in companies with strong balance sheets and those that have already weathered a downturn. Sanderson Farms, Inc. (SAFM), the third largest producer of fresh chicken in the U.S., is a prime example of this approach.
A few years ago, Sanderson was riding high as chicken prices in mid-2017 were nearly double the five-year average. As profits gapped higher, many producers added capacity to keep up with demand. However, the resulting surge in supply put pressure on pricing, and shares of Sanderson and its peers weakened.
In response to soft pricing, Sanderson has focused on growing its business as a producer and wholesaler and improving its already impressive efficiency level. The company’s rock-solid balance sheet and expertise as a low-cost producer gives it a competitive advantage, in our view. As chicken prices rebound, we believe investors will take note of the company’s attractive return on equity profile and shares should rise.
Hard at work.
Economically sensitive areas such as Industrials had a strong showing during the period, and the portfolio’s holdings in the space contained a top contributor, ManpowerGroup Inc. (MAN).
The global staffing firm features a mix of industrial and IT staffing services and is the third-largest agency of its type in the world. Shares were under pressure in late 2018 due to a slowing European economy, where the company generates two-thirds of its revenue. As economic sentiment improved to start the year, shares retraced losses from the previous quarter and were up double-digits for the period.
While we anticipate revenue to decline in the short term, we see the shares as offering an attractive risk/reward profile, particularly relative to industrial stocks with a greater mix of domestic exposure.
Longer term, we expect margins to expand as a result of management’s strategy of reducing costs and leveraging its scale to gain share in the high-margin recruitment outsourcing industry. Manpower’s balance sheet is strong, and the board has approved opportunistic share repurchases in the past; these have resulted in 4% fewer shares outstanding in 2018 relative to 2017. Higher margins with a lower share count should drive greater cycle-to-cycle earnings power.
With Manpower trading at less than 6.5x 2019 earnings before interest, taxes, depreciation, and amortization, versus a peer group average of over 8x, we believe valuations are overstating the bear case for the stock. Additionally, relative to U.S. industrials, Manpower’s stock is trading at the low end of its 20-year historical average across several valuation metrics.
A healthy opportunity?
The portfolio’s Health Care names were up on an absolute basis but lagged those in its benchmark. AmerisourceBergen Corporation (ABC), a pharmaceutical distributor, performed inline with the group average despite reporting better-than-expected earnings and sales in its most recent quarter. Investors have grown cautious toward the industry as politicians have ratcheted up scrutiny of drug prices, creating uncertainty about profit margins in the future.
We trimmed our exposure to the AmerisourceBergen in late fall of 2018 as part of an effort to mitigate some risk the company could face related to the political backdrop. However, we continue to believe shares are attractive.
While we remain mindful of legislative headwinds related to drug prices, we believe ABC operates with a unique competitive advantage. The Pennsylvania-based business, along with two competitors, controls 90% of the drug distribution market. Its partnership with Walgreens has helped the company gain economies of scale, which has allowed it to be more aggressive in pursuing additional clients. Despite its attractive balance sheet, shares trade at approximately 11.5x earnings per share and offer an 8% yield of free cash flow/enterprise value.
Market gyrations over the past six months have created opportunities for patient investors. During this period, we’ve trimmed winners when valuations have become stretched and redeployed assets into current holdings or new opportunities where prices, in our view, don’t accurately reflect the risk/reward profile of the business. The lack of consensus on how long the business cycle will continue its robust growth has led to attractive valuations in both economically sensitive and defensive areas.
We continue to scour both economically sensitive and defensive areas for opportunities but are following our fundamental analysis to where it leads. We recently added First Horizon National Corporation (FHN), a Tennessee-based bank that ranks among the top-50 in the country based on assets. The company has significant market share in its home state and a solid foothold in fast-growing North Carolina, South Carolina, and Florida.
Shares have been under pressure recently as First Horizon continues to make progress toward integrating its 2017 acquisition of Capital Bank Financial. As part of those efforts, First Horizon sold riskier loans from Capital Financial’s book of business. The sales had a negative impact on loan growth numbers and played into investors’ fears that lending was slowing industrywide.
We believe investors are missing that First Horizon is a “self-help story” and well-positioned for the future. Cost cuts related to the Capital Financial merger should fall to the bottom line in 2019. Additionally, management has worked to neutralize the company’s exposure to interest rates and should be able to eliminate high-cost deposits it inherited through the acquisition, which could provide a tailwind to interest income. Lastly, recent bank mergers in its footprint should allow First Horizon to take market share from competitors.
With the company trading 9.7x 2019 estimated earnings compared to a historical average of over 14X, we believe the current slump in share price offers a compelling opportunity to own a successful regional player with meaningful upside potential in the years ahead.