Second Quarter Market Discussion
Investors continued to bid up equities as COVID-19 infections plummeted, shutdown mandates were lifted, and consumers received another infusion of direct stimulus payments from the government. The speed and strength of the response to the winding down of the global pandemic was reflected in corporate financial results during the period, with the vast majority of businesses in the S&P 500 reporting sales and earnings that beat Wall Street estimates.
The optimism that led the major indices to flirt with new highs during the quarter continued a trend that has been in place for most of the past 12 months. While the buying mood remained during the period, the red-hot pace of the market moderated as investors harvested earlier gains and looked for opportunities beyond those businesses that would benefit quickest from a post-COVID recovery.
There was plenty for investors to cheer during the period, but the persistence of the consumer-driven recovery may be challenged in the quarters ahead. As the chart below shows, the growth in retail sales over the past year has coincided with the amount of stimulus being doled out to consumers, as opposed to base wages. While consumer spending will likely remain robust in the short term as individuals splurge with roughly $1.5 trillion in excess income, we believe spending will begin to moderate and converge with long-term trends as government payments wind down.
Source: U.S. Bureau of Economic Analysis and U.S. Census Bureau, retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/. The data in this chart displays US dollars scaled to a value of 100 on a monthly basis from 6/30/2011 to 5/31/2021. Past performance does not guarantee future results.
Stock selection was strong in several sectors, and the portfolio finished the first half of the year ahead of its Russell Midcap® Value benchmark. Holdings in Materials and Information Technology (IT) performed well on an absolute and relative basis while names in Consumer Discretionary were up single-digits and failed to keep pace with the average for those in the benchmark.
Putting on a fresh coat. The reawakened economy was a boon for businesses in the chemicals and metals industries, as mothballed manufacturers came to life. The portfolio’s holdings in the space outperformed the benchmark average and contained a top contributor, PPG Industries Inc. (PPG).
PPG is the second-largest coatings supplier in the world and boasts the top market share in the industrial space, including auto, aerospace, and general industrial. The company is second only to Sherwin-Williams in the architectural coatings market.
Shares of PPG sold off in early 2020 as global economies fell into recession. Given the company’s economically sensitive client base, earnings were hit by a broad-based decline in sales of coatings. While PPG’s stock rallied throughout the middle part of 2020 as fears about the economy subsided, it lagged sector peers throughout the winter because investors began to fear margin pressure fueled by rapidly rising input costs. This weakness presented us with an opportunity to sell a more capital-intensive portfolio holding that lacked pricing power and upgrade the portfolio with PPG, which we view as a higher-quality business.
At the time of our initial investment, we were confident that any margin pressure caused by rising input costs would be offset over time by PPG’s pricing power. Our view was validated when PPG reported growing profit margins in its first-quarter earnings release for 2021.
The company is also uniquely positioned to benefit from the shift toward electric vehicles (EVs). PPG has a robust portfolio of protective coatings for EVs. Given PPG’s supply chain scale, we anticipate the company will see a material increase in content penetration due to the ongoing market adoption of electric vehicles, which should drive organic sales growth going forward.
Cash is king. Financials in the broad market continued to benefit from anticipation of rising rates and better than expected loan performance. The portfolio’s holdings in the sector outperformed on a relative basis and the group included FirstCash Inc, (FCFS), a top contributor for the period.
Shares of FirstCash, which operates pawn stores in the U.S. and Latin America, jumped as the impact of COVID-19 stimulus checks began to fade and the demand outlook for pawn loans were expected to improve. We remain constructive on the business due to its high margins and view it as uniquely positioned to thrive should the financial resiliency of consumers soften.
Checking lab results. Health care names in the portfolio posted tepid gains during the quarter, continuing a pattern from the beginning of the year. The group has been overlooked as investors flock to economically sensitive areas of the market, however we believe that attractive opportunities still exist in the space. Long-time holding Quest Diagnostics, Inc. (DGX), is one such example.
Quest, one of the largest diagnostic testing and services company in the U.S., has been mostly passed over as investors have reacted to a falloff in COVID-19 testing volumes, which had provided a boost to earnings. While we welcomed the spike in sales last year, we remained focused on our long-term investment thesis for the company.
With shares trading at 11.8x estimated 2021 earnings, we believe investors are failing to recognize a positive inflection in Quest’s core sales. Additionally, the company is gaining market share from smaller players that should further enhance its scale.
Quest should also benefit from industry trends including further consolidation, telemedicine, and a shift by managed care companies toward designating preferred lab networks.
For more than a year, the markets have been operating in unchartered territory. From the havoc caused by mandated shutdowns and surges in COVID infections to the long-term effects—both planned and unanticipated—brought about by historic levels of fiscal stimulus, much of what has shaped the investment landscape over the past 18 months is without precedent. Instead of trying to predict how long the current boom will last, we have instead used recent volatility as an opportunity to uncover businesses where we believe valuations reflect a misunderstanding of risk and those businesses that are poised to succeed against a variety of backdrops. Recent portfolio addition Grand Canyon Education Inc. (LOPE) is an example of this approach.
Grand Canyon offers post-secondary education through traditional campus settings and a growing online presence. Its Orbis unit also provides healthcare curricula to leading universities across the country.
Grand Canyon reported weaker than anticipated enrollment data for its first quarter of 2021, causing the stock to sell off, which provided an attractive buying opportunity for the portfolio. We believe the shortfall is a temporary setback and shouldn’t tarnish the appeal of the business. We remain constructive on the company because it is a differentiated consumer holding that is less affected by the strength of the economy compared with other businesses in the sector. The company boasts high returns on capital and yet trades at less than 14x estimated 2022 earnings and offers a 7% free cash flow/enterprise value yield.
Given Grand Canyon’s strong graduation and job placement performance, the company offers an attractive value proposition for prospective students. Consequently, we don’t believe soft enrollment trends will endure. Additionally, management continues to invest in its Orbis unit. While the investment is a headwind to earnings in the near-term, we believe it will result in additional profits as the unit gains scale.
Outlook and Positioning
The ongoing march higher for equities has provided many investors with what we view as a false sense of security. After starting the year with an eye on fundamentals and valuations, buyers have cast aside concerns about price metrics and balance sheet strength as well as the potential for inflation to erode consumer demand going forward.
Many areas of the market are trading at levels that leave little room for error. We believe a superior path to navigating the quarters ahead in a market that has become increasingly fragile requires a fundamental investment approach that incorporates valuations and financial strength, as well as seeks to identify catalysts that can result in a change in perception by investors.
Thank you for your continued trust and confidence.