Third Quarter Market Discussion
The third quarter was a tale of two markets, starting with a sharp rebound in “risk on” stocks in July and early August, followed by another downturn for the broad markets in the second half of the quarter. Early on, our Mid Cap Value strategy lagged the Russell Mid Cap Value® Index, as our holdings didn’t enjoy quite the bounce that speculative and heavily indebted areas of the market experienced, owing partly to our defensive tilt. However, by the end of September, the market seemed to refocus on balance sheet strength, valuations, and the risks to company fundamentals. In this backdrop, we were able to largely close the gap versus our benchmark in the quarter while maintaining our year-to-date outperformance.
We try not to think in months and quarters, preferring instead to focus on years. In a nutshell, though, our performance in the third quarter was a microcosm of our value proposition: The Mid Cap Value strategy may trail its benchmark in speculative rallies, but the goal is to be positioned to outperform in difficult times and in the long run.
Don’t be surprised if those challenges persist in the short run. We don’t claim to be economic forecasters, but management teams are highlighting continued inflationary pressures and pockets of weakening demand. Companies are finally resetting earnings expectations. In September, the number of companies cutting their third quarter and full year outlook has risen materially, and this trend is expected to continue.
Meanwhile, inflation remains a headwind to real economic growth. The economy continues to weaken, and further pressure is likely coming as history indicates that interest rates must rise to a level closer to headline inflation before it is tamed (see chart below). Though the effects of those rising rates may lag, they’re real and will likely continue to weigh on the economy. In such an environment, investors should be rewarded for owning high-quality assets with sound financing and attractive valuations.
Source: FactSet Research Systems, Inc., Monthly data 1/1/1970 to 8/31/2022. The data in this chart represents the United States Federal Funds Target Rate – Yield versus Consumer Price Index (year over year change for Federal Funds versus inflation). Consumer Price index has a base of 1982-84=100 (the average of the monthly index values is 100 over the 36 months in 1982 through 1984). All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.
Security selection continued to be the primary driver of Mid Cap Value’s performance in the third quarter. This included underperformance in the Consumer Discretionary, Consumer Staples, and Energy sectors and outperformance in Financials and Utilities.
Utilities. Our best-performing holding in the quarter was Constellation Energy (CEG) in the utilities sector. CEG is a great example of “deep value” holding with a self-help catalyst and is the leading provider of clean energy in the U.S., derived primarily from nuclear power. Earlier this year, the company was spun-off from a prior long-term utility holding. Post spin-off, we increased our position in CEG on the belief that the company was materially undervalued and catalysts were in place to change investors’ perception.
One of those catalysts was the August passage of the Inflation Reduction Act of 2022. Nuclear power has never benefitted from its zero-carbon emitting properties, like wind and solar. This legislation provides nuclear power plants with zero-carbon treatment, establishing a “floor” under power prices that could protect CEG from much of the potential downside swings in commodity power prices.
Technology. Before the risk-on rebound early in the quarter, we were searching for opportunities to shift from our defensive stance, looking for beaten-down, high-quality “early cycle” leaders. Existing holding, Skyworks Solutions (SWKS), represents one such opportunity that was added to on weakness.
Skyworks is one of two leading providers of radio frequency system components to smartphone makers and electronics manufacturers. With every step-up in product complexity, over the past two decades, the competitive landscape has shrunk while gross margins have increased significantly. 5G represents another such step-up, which is likely to increase how much Skyworks can make per smartphone.
Apple is a big customer, accounting for more than half of Skyworks’ sales. That customer concentration has depressed Skyworks’ valuation over time. More recently, fears surrounding a global recession and risk to consumer demand have further pressured valuation. However, the handset business is expected to benefit from 5G content, which may help offset some macroeconomic pressures. Away from the handset business, Skyworks’ growth is expected to accelerate thanks to other secular drivers such as WIFI 6 and growth of the industrial internet (i.e., “Internet of Things”).
At a P/E of less than eight and a 2.3% dividend yield, SWKS rarely gets this cheap, making this high-quality stock compelling for long-term investors.
Consumer Discretionary. We also found an opportunity to add to our existing position in Advance Auto Parts (AAP) as the stock fell and the risk/reward profile improved. Advance underperformed early in the quarter as lower-quality sector peers bounced significantly. In August, shares fell further after the company reported second quarter earnings that disappointed because of weaker-than-expected same-store sales. Furthermore, management reduced its full-year earnings outlook by ~4%, citing softening consumer purchasing patterns within AAP’s “do-it-yourself” business.
The most important driver of Advance Auto’s earnings power seems to be the management team’s ability to improve margin expansion. However, the market remains myopically focused on sales growth. The margin expansion opportunity originates from the consolidation of an overly complex and inefficient distribution network. Management is planning to roll out new distribution center software through 2023 that will reduce costs, improve network productivity, and enhance customer experience through better inventory availability.
In addition, the auto parts retailing industry tends to be less cyclical than the Consumer Discretionary sector because consumers often hold onto their used cars longer and make necessary repairs rather than buy new vehicles when their financial prospects are weakened. AAP is currently trading at less than 12 times forward earnings, well below the company’s long-term median P/E of more than 15—while having significant room to improve profitability owing to its self-help initiatives.
The late-quarter market slide has created another chance to be selectively opportunistic when it comes to high-quality companies. If market volatility and the negative earnings revision cycle continues to broaden out, names on our “watch list” are likely to come into focus.
We do not force deep value exposure into the portfolio, preferring instead to identify self-help opportunities and act when progress is evident and headwinds are clearing. One such example is Texas Capital Bancshares (TCBI), a Dallas-based middle market commercial lender with a particular focus on the four major Texas markets of Dallas-Fort Worth, Houston, San Antonio, and Austin.
We initiated a position in the third quarter because the company could be on the verge of improving its returns and market perception. TCBI is a classic self-help story: Prior management ran the bank as a “growth at all cost” institution. When the bank was small and interest rates were at historic lows, it was easy to sustain growth by booking new loans and growing deposits regardless of the quality of either relationship. Credit problems began to percolate after the company downgraded several levered loan credits in 2019.
As the bank grew and approached a critical asset level that triggered a greater degree of regulatory burden, management engaged in a merger-of-equals between TCBI and another Texas-based bank, Independent Bank Group. While the merger was pending, the pandemic struck and the deal was called off exposing, Texas Capital’s problems to the market.
Last year, a new CEO was brought in from J.P. Morgan Chase. He quickly exited risky loans and reoriented TCBI as a local Texas commercial lender with a niche focus on deep customer relationships. The stock trades at around 1.1 times tangible book value, compared to 1.8 times for regional banks in general. While its return on assets is below the average for its peers, in our opinion, over time TCBI will close the return gap with valuations likely to follow suit.
Looking for early-cycle and self-help opportunities remain high priorities. Until the “risk on” rebound gives way to a more sober perspective, which seems to be occurring in real time, we will remain cautious, defensive, but decisive.
Thank you for your continued trust and confidence.