After riding high for the past several months on unbridled economic optimism, investors had to grapple with the emergence of new headwinds. Employment numbers came in weaker than expected despite businesses struggling to fill open positions, and inflation pressures persisted as supply disruptions stemming from the pandemic-related shutdowns over the past 18 months remained unresolved. The bottlenecks in the global supply chain resulted in a cost spike for everything from raw materials to, as shown below, a quadrupling of international shipping rates from pre-pandemic levels. The headwinds, combined with a resurgence in Covid-19 infections, also weighed on consumer confidence
Source: Bloomberg L.P., Standard & Poor’s, weekly data from 1/7/2011 to 9/24/2021. This chart represents the Shanghai Containerized Freight Index. This index reflects the ocean freight and the associated seaborn surcharges of individual shipping routes on the spot market. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Investors initially responded to the challenges with a shrug, but as the period wore on they began gravitating to larger names. As a result, shares of many businesses appear priced for perfection, and we believe could disappoint investors should inflation weigh on margins or the economy fail to generate robust top-line growth.
Consequently, we’ve been finding what we view as attractively valued opportunities in less economically sensitive companies with prospects for operational improvement that are within their own control where investor euphoria has been more muted.
Security selection was mixed with holdings in Real Estate and Financials leading on the upside, but the Strategy lagged its Russell Mid Cap® Value Index benchmark for the period. Holdings in Materials detracted from relative performance. The portfolio continued to outpace its benchmark year to date through September 30.
Through the first three quarters of the year, the Strategy was up double-digits and outperformed its benchmark.
Attractive options? Financials in the broad market continued their strong run, with leadership during the period broadening beyond banks, which had led the group for much of the year. The portfolio’s holdings in the sector outperformed on a relative basis, and the group included Cboe Global Markets, Inc. (CBOE), a contributor from the capital markets industry.
CBOE, also known as the Chicago Board of Options Exchange, is one of four publicly traded U.S. financial exchanges. The company’s niche is in two areas: 1.) Cash equity and options trading where CBOE holds a roughly 30% market share of all exchange-based trading and 2.) Proprietary products including VIX and SPX futures, which are hedging tools tied to expected market volatility and S&P 500 Index performance, respectively.
Shares of CBOE languished during the second half of last year as volatility—and consequently trading of VIX futures—dropped following a tumultuous first half of 2020. Additionally, the company continues to invest in building a European financial derivatives platform. The costs have put what we view as temporary pressure on margins and earnings.
We took a position in CBOE early this year based on our research suggesting that trading volume in its proprietary products had likely troughed and investments made in the European derivatives platform business today should generate operating leverage in the future as expenditures tied to the buildout begin to subside. Our thesis was validated during the second quarter of this year as trading volume for the company’s VIX and SPX products improved.
While shares have appreciated since we first initiated a stake in CBOE, they still trade at a meaningful discount to its peers. At current levels, we continue to view valuations as compelling given the quality of the company and its unique position in a high-margin industry with few competitors.
Power aid. A renewed interest in less-volatile industries and income-generating businesses helped propel less volatile names in areas such as Utilities. Our holdings in the sector were up modestly during the period and outperformed the benchmark on a relative basis, led by Exelon Corp (EXC).
The company is a large multi-state utility with regulated as well as unregulated operations. Following a strategic review, Exelon announced a plan this year to separate the two businesses. Since the time of the announcement, investors have gotten a clearer view into prospects of both operations and have seen improvements in results, and shares have appreciated. The decision and recent improvements, in our view, set the stage for a further re-rating of the company.
Based on our analysis, investors appear to be undervaluing Exelon’s two business lines under the current operating structure. We believe the regulated line has desirable transmission/distribution assets and strong opportunities for rate base growth. Meanwhile, the unregulated merchant power segment trades at less than 5x enterprise value/earnings before interest, taxes, depreciation, and amortization, which represents a steep discount to the average multiple for publicly traded power companies.
We also believe Exelon’s merchant business, with its nuclear fleet and an inventory of alternative energy assets, is poised to benefit from an increased emphasis on clean energy from the Biden administration.
With shares trading at a discount to our sum-of-the parts analysis, Exelon, in our view, remains a compelling opportunity relative to fully regulated utilities.
Narrowing the spectrum. While investors spent much of the period bidding up businesses based on sales growth expectations, we continue to be drawn to companies that have an improved outlook through self-help measures. Spectrum Brands Holdings (SPB), a household products company, is one such example.
Spectrum sells a variety of home goods through its market-leading brands including Black and Decker, Pfister and Remington. During the past 18 months, management has undertaken an initiative to exit non-core business lines such as auto care and batteries, reduce debt and improve efficiencies. The latest of these efforts came in mid -September when the company announced it was selling its home improvement segment for a sum greater than the market capitalization of the entire company.
Management expects to use the proceeds to further bolster Spectrum’s balance sheet, continue to buy back shares and do tuck-in acquisitions to increase scale in its secular growth businesses, such as Pet and Home and Garden lines.
Despite recent improvements in its share price, the company still trades at a meaningful discount to its peers on an enterprise value/earnings before interest, taxes, depreciation and amortization basis.
Our team has been following these developments and believes the strides management has made on the business side are not being fully recognized by the market. As more clarity has emerged related to opioid litigation, we’ve increased the portfolio’s stake in AmerisourceBergen and believe the investment provides the portfolio with additional exposure to a high-quality business that is well positioned to grow despite operating in a mature industry.