Fourth Quarter Market Discussion
Equities spent much of the quarter building on the strength they enjoyed throughout 2021. However, as the major indices reached new heights, investors grew wary of the long-term impact of the new wave of COVID-19 cases, stubborn inflation, and a growing consensus that the Federal Reserve would likely begin tightening monetary policy sooner than had been anticipated just a few months ago.
With the case for continued economic growth less certain, investors were quick to punish businesses and sectors that struggled to meet sales projections or were meaningfully impacted by supply chain disruptions. The expectation that inflation and interest rates were likely to be higher for longer, hurt growth-oriented businesses that had been riding high on optimism that they could deliver earnings expansion at some point in the future.
The outlook from Main Street also began to fray as consumers faced sticker shock from the gas station to the grocery store. The faltering confidence, as highlighted in the chart below, could create a ripple effect on Wall Street in the coming months in economically sensitive areas of the market that have been elevated thanks to consumers flush with cash from government stimulus payments.
Source: FactSet Research Systems Inc., Monthly data 1/30/1976 to 11/30/2021. The data in the chart represents consumer optimism (not seasonally adjusted) versus the actual CPI for Urban Consumers (seasonally adjusted). 'Consumer Sentiment, NSA, Percent – United States' was pulled from University of Michigan survey of Consumers. The indexes have 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 directly in an index. Past performance does not guarantee future results.
As a result, we’ve been drawn to what we view as attractively valued companies that have prospects for operational improvement that are within their own control where investor euphoria has been more muted.
Security selection was mixed with holdings in Materials and Consumer Discretionary bolstering returns; however, the portfolio couldn’t overcome weakness in Financials and Information Technology, and the Strategy lagged the Russell Mid Cap® Value Index for the quarter.
The portfolio finished the year up more than 20% and kept pace with its benchmark.
A material advantage. While higher input costs and supply chain bottlenecks were a common theme across many industries, some areas were better suited than others to pass along price increases and navigate logistical challenges. The Materials sector is one example. 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 refinishing and original equipment manufacturing (OEM), aerospace, and general industrial. The company is second only to Sherwin-Williams in the architectural coatings market.
Shares of PPG lagged sector peers in early autumn after management warned that earnings would come in lower than expected for the third quarter and withdrew sales guidance for the period. Shortages of key coating ingredients have tightened inventories and caused costs to rise. Externally, customers, including those in the automotive industry, have slowed production as they grapple with their own supply chain issues. The moves have had a chain reaction resulting in a decline in orders for PPG products.
The company has responded to the above headwinds by aggressively raising per-unit pricing including a 6% increase in the fourth quarter and another hike planned for the first quarter of 2022. PPG’s stock responded favorably as real-time indicators suggest cost pressures may be at or near a peak.
Despite PPG being a provider of key components for its customers and uniquely positioned to benefit from the shift toward electric vehicles (EVs), the company trades at a discount to historical levels against both the S&P 500 and its peers.
COVID complications. Shares of many Health Care companies lagged as the continuing threat of COVID-19 dampened demand for elective medical procedures and health care providers struggled to maintain adequate staffing in the face of burnout and resistance to vaccine mandates. The Strategy’s holdings in the sector trailed the benchmark average, and the group contained a key detractor, Encompass Health Corporation (EHC).
Encompass provides inpatient rehabilitation services as well as home-based health and hospice care. Both businesses enjoy a competitive advantage over many of their peers and, we believe, are well positioned to grow organically, and acquire smaller competitors that could further economies of scale.
A labor shortage has taken a toll on sales and profit margins at Encompass as the company struggles to fill positions in a challenging environment for nursing wages and availability. Revenues have also been hurt by a slowdown in elective surgeries performed, which results in a smaller pool of patients in need of rehabilitation services.
When we took a stake in Encompass late in the summer of 2020, we recognized that COVID-related headwinds could endure longer than anticipated. However, the team believes the current challenges will eventually fade as enhanced nurse recruiting outreach helps mitigate staffing pressures while COVID-19 containment and treatment efforts gain traction. With shares producing an 8% free cash flow yield and trading at just 9x 2022 enterprise value/earnings before interest, taxes, depreciation, and amortization, we believe our patience will be rewarded.
Buck up. The resiliency of the consumer has been a driving force over the past 18 months as the economy rebounded from early COVID-19 lows. While inflation may be a challenge to spending habits in the new year, the portfolio benefited from holdings that we believe are less economically sensitive and should continue to perform as government stimulus payments fade. Dollar Tree Inc. (DLTR) provides an example of our approach.
Dollar Tree owns two brands, Dollar Tree and Family Dollar, each operating roughly 8,000 locations in the United States and Canada. The Dollar Tree brand has historically operated a true dollar store with its locations offering products at the fixed $1 price point.
The Family Dollar unit was acquired in 2015 and sells mostly daily essentials to lower-income customers. The retailer was an underperforming asset when Dollar Tree acquired the business. Over the past six years, management has invested significantly in remodeling Family Dollar stores and improving merchandise to raise profit margins closer to those of industry peers.
Shares of Dollar Tree were up to close out 2021 as investors applauded management’s move to raise the price point of goods sold at Dollar Tree to $1.25, which is expected to offset inflation pressures for the company and help it maintain margins on the goods it sells. Additionally, as headwinds have begun to emerge for consumers, the company’s mix of products, in our view, should produce more resilient sales among its cost-conscious customers.
As shares have appreciated, we’ve trimmed the portfolio’s stake in the business to manage exposure. However, we continue to maintain a position on the belief that shares are still priced at a discount to their historical average based on our 2022 earnings estimates.
The run-up in equity prices over the past year and a half has narrowed the pool of attractively valued businesses. Economically sensitive areas of the market, in particular, have seen valuations stretched—but the impact of investor exuberance is evident in share prices of companies throughout the broader market. In our view, the elevated valuations commanded by many stocks have heightened risks and dampened upside potential.
In response to this backdrop, we continue to focus on finding and owning companies that are poised to succeed against a variety of backdrops or those that are priced at significant discounts to peers regardless of the sector or industry. Recent addition Expedia Group, Inc. (EXPE) is an example of the type of business we’ve found attractive.
Roam with the gnome. Expedia is an online travel agency that operates under multiple brands including Expedia.com, Hotels.com, Orbitz, Hotwire, and VRBO. The company has grown over the years through a combination of acquisitions and capitalizing on the trend of consumer preferences toward booking vacation plans via the internet as opposed to through traditional travel agents.
Following years of acquisitions that left Expedia’s cost structure inflated, in 2019, a new management team was brought in in 2019 to streamline operations and shutter unprofitable businesses. As the company was executing their turnaround plan, COVID-19 disrupted the global travel industry and sent Expedia’s business in a tailspin.
As the travel industry emerged from the depths of COVID-19, management has executed on its cost streamlining initiatives while finding new ways to optimize the cost structure in light of a more challenging travel industry backdrop. As vacation activity continues to recover, we believe the positive impact of initiatives to cut variable costs will become clearer.
Although it remains unclear how long it will take for the leisure travel to fully recover, we expect the industry to benefit from several years of pent-up travel demand as the pandemic subsides. Despite the promising outlook for Expedia, shares trade at just 9X normalized earnings before interest, taxes, depreciation, and amortization.
Outlook and Positioning
As companies adjust to growing economic headwinds, volatility could remain elevated during the coming quarters. In fact, the emergence of the Omicron COVID-19 variant provides a vivid example of how fluid the economic narrative has become and how quickly today’s market darlings can become tomorrow’s dogs.
While we cannot predict when economic growth will falter, our recognition that it is a distinct possibility serves as a reminder to stick with our time-tested process. As such, the team is steadfast in its focus on finding businesses with attractive valuations, balance sheet strength, and catalysts that can result in a change in perception by investors. This approach should result in a favorable risk-reward profile in the quarters and years ahead.
Thank you for the opportunity to manage your capital.