A fresh flood of Federal stimulus spending and optimism that the rapid deployment of COVID-19 vaccinations would bring a return to normalcy in the economy boosted investor confidence and resulted in a surge for equities. The growing consensus that the worst of the pandemic was in the rearview mirror prompted investors to broaden their search for opportunities to include previously overlooked areas such as smaller companies and attractively valued businesses.
As shown below, during the first quarter, the equal-weighted S&P 500 index outperformed the S&P 500, a market-cap weighted index with more than 20% of the index in just five companies. The outperformance highlights a broadening of market strength, which is a welcome development for bottom-up investors.
Total Return of S&P 500 Equal Weight Index vs. Market Cap Weighted S&P 500 Index
Source: FactSet Research Systems Inc., Monthly data 3/29/1991 to 3/31/2021
The data in the chart represents the S&P 500 Equal Weighted Index less the total return relative to the S&P 500 Index. All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future results.
As economic growth and inflation expectations moved higher, yields on the 10-year U.S. Treasury bond benchmark reached levels not seen since before the pre-pandemic days of early 2020. The sudden uptick was a headwind for shares of technology companies and other growth stocks as it caused investors to favor near-term cash flows over businesses with low or no earnings that were offering rosy forecasts for sales growth further out into the future.
Stock selection was strong in several sectors, and the portfolio beat its Russell Midcap® Value benchmark for the quarter. Holdings in Industrials and Consumer Discretionary performed well on a relative basis while names in Energy were up double-digits but failed to keep pace with the average for those in the benchmark.
On the move. Following a muted start to the year, Industrials gained traction during the second half of the period and posted solid gains. The portfolio’s holdings in the space outperformed the benchmark average and contained a top contributor, Amerco (UHAL), a leading provider of moving equipment and storage facilities under the U-Haul brand.
Amerco continues to reap the benefits of accelerating equipment rentals and rising occupancy rates at its self-storage facilities. We believe equipment rental demand surged because COVID-19 caused urban dwellers to migrate out of densely populated business districts as work environments became more flexible. Additionally, Amerco has made progress in leasing newly developed storage units and has moderated spending on the buildout of additional facilities. The efforts resulted in a 6.5% jump in occupancy rates for the most recent quarter.
We expect Amerco will continue to benefit from migration trends that began in 2020. The company’s network is particularly well positioned, in our view, for one-way moves because of its comprehensive national footprint. Whether the current trend of migrating away from cities persists or people begin moving back to centralized locations, Amerco should benefit.
Financially fit. A steepening yield curve during the period was welcome news for bank stocks and helped drive double-digit gains for the Financials sector. Our holdings in the space outpaced the benchmark average; however, we have sought opportunities beyond the banking industry. Longtime holding Reinsurance Group of America, Inc. (RGA) is an example of the type of differentiated business we find attractive in the sector.
Reinsurance Group is the largest pureplay life reinsurance company in the world. Shares of the company were up for the period as concerns over the underwriting exposure posed by mortality rates tied to COVID-19 have subsided and the company has remained profitable throughout the pandemic. Additionally, liabilities tied to a block of policies underwritten during a five-year period beginning in the late 1990s have been more manageable than anticipated.
As the shadow of COVID continues to lift, Reinsurance Group should be well positioned to make greater inroads into the market in Asia where it is already the number-two player. Additionally, the growing need for governments and businesses to offset pension liability risks could be a boon for reinsurers like RGA.
Despite its improving liability profile and strong balance sheet, Reinsurance trades at less than book value. We believe at current levels the company offers an attractive risk/reward profile.
Filling a niche. The Real Estate sector continued to add to the strong run it has enjoyed since the COVID-19 lows of early 2020. At that time, we took a stake in PS Business Parks, Inc. (PSB) based on our view that the market was being overly pessimistic about the long-term prospects for the real estate investment trust (REIT). Our actions were validated as the business has been a solid performer in the portfolio.
PS Business Parks operates in the industrial, warehouse, and “flex” (combination of industrial & office) real estate segment. Unlike competitors who often lease tens of thousands of square feet to single tenants, many of PS Business’ clients rent less than 5,000 square feet at a given location. The business also offers shorter leases—usually one to three years—than many of its peers.
The company’s differentiated approach results in fewer competitors and less pricing pressure when seeking to attract tenants. Many investors initially saw the duration of PSB’s leases as a headwind for the business as the economy shut down and prospects for the commercial real estate market were dismal. However, rent collections and commercial activity have proven more resilient than feared, and PSB’s fundamentals appear to be heading in the right direction.
Longer term, we continue to be impressed with PSB’s management team, which has demonstrated a knack for efficient use of capital all while maintaining a strong balance sheet. Management’s focus on highly efficient capital deployment is evidenced by the company’s trailing 10-year free cash flow to invested capital yield of ~9% vs. an industrial real estate investment trust (REIT) peer median of 2%. The yield is impressive in our view, given the company has grown its inventory of square footage by a 10% compounded annualized growth rate over the past two decades.
Surging economic optimism and a sense that the worst of COVID-19 has passed has been a welcome boost for equities. However, the speed and strength of the rise resulted in stretched valuations that leave little room for error, with signs that investors are increasingly rewarding or punishing businesses based on underlying fundamentals. The rotation has boosted attractively valued businesses and those positioned to benefit the most in the early stages of an economic return to normalcy.
In response to recent strength, we’ve harvested gains and redeployed capital into areas that offer a more attractive risk/reward profile. Balance sheet strength and catalysts that can result in a change in perception by investors remain a priority and are, in our view, an effective way to mitigate the impact of unforeseen macro risks. We believe this disciplined application of our process will be key to navigating the quarters ahead in a market that may become less forgiving as a result of heightened valuations and expectations.
Thank you for the opportunity to manage your capital.