Fourth Quarter Market Discussion
Far too often, investing is thought of in “either/or” terms, when nothing is certain. Large doses of both hope and fear were on display in the fourth quarter. Investors couldn’t decide whether to be optimistic that moderating inflation could provide air cover needed for the Federal Reserve to begin easing monetary policy or to be pessimistic about the state of the economy as the full effect of monetary tightening is realized.
The fallacy of discussing the market in these “risk on/risk off” terms is the implication that money can only be made when the mood of investors is optimistic. As contrarians know, gains can often be found against any backdrop. In fact, “you make most of your money in a bear market,” the famed investor Shelby Davis once noted. “You just don’t realize it at the time.”
We agree with this notion. The erratic shifts in sentiment throughout the quarter and year proved unsettling, and the inverted yield curve (see chart below) suggests more volatility to come as investors come to grips with the economic headwinds ahead. While this speaks poorly for economic growth, this should be a constructive backdrop for active, selective, and opportunistic investors.
Source: Bloomberg L.P., Standard & Poor’s, quarterly data from 3/31/1977 to 12/30/2022. This chart represents the U.S. Treasury bond yield curve. A yield curve reflects the difference between interest rates of bonds having equal credit quality but differing maturity dates. The slope of the yield curve reflects the bond market’s view of future inflation and economic growth prospects. Past performance does not guarantee future results.
In the fourth quarter, we added to both our ‘value’ bucket holdings of high-quality companies and our ‘deep value’ bucket consisting of companies that may be lower in quality but where promising self-help catalysts exist, providing meaningful tailwinds for business fundamentals.
Which brings us to another false choice. Within the value universe, there are those who adhere to a philosophy of only owning high-quality companies trading at decent bargains. Meanwhile, others focus on deeply discounted companies that have generated poor economic returns over time. Just as growth and value generally take turns outperforming, these two styles of value investing also tend to alternate market leadership. Within the mid-cap space, we don’t think it’s prudent to choose one while ignoring the other because, in doing so, a top-down bet is introduced into the portfolio. We want to be in a position to have stock selection drive our results, which we believe can only be achieved if the uncontrollable is somewhat mitigated.
This two-bucket approach combined with the 10 Principles of Value Investing™ stock-selection process emphasizing balance sheet strength and a range of possible outcomes helps in quarters like the past two, which began with across-the-board gains but transitioned to a more circumspect mindset. As markets rise, both quality buckets contribute to returns while downside is mitigated by less financial leverage and by purchasing shares at a meaningful discount to their intrinsic value.
Attribution Analysis
The outperformance during the fourth quarter was driven largely by stock selection, particularly in the Real Estate, Healthcare, and Energy sectors. At a time when positive Wall Street estimate revisions are becoming scarce, our fundamental forecasting and ability to identify catalysts aided performance. In some cases, our winners began to overcome headwinds that they faced in prior quarters. In other cases, company-specific catalysts are beginning to play out. This combination helped us outperform the Russell Midcap® Value Index by approximately 9 percentage points this year.
Value Bucket
Healthcare. One of our best performing stocks in the fourth quarter was Encompass Health (EHC), a leader in inpatient rehabilitation for strokes, neurological issues, and post-op surgical services. Earlier in the year, EHC spun off Enhabit, its home health and hospice business. The move allowed investors to begin properly valuing EHC’s rehabilitation business, which enjoys sizeable scale and operational advantages within the industry.
Other tailwinds include progress in getting past labor supply and cost issues that created a profit squeeze in the post-COVID-19 environment. Revenues are also recovering, as COVID-19-related dynamics, such as fewer elective surgeries and lower general health system utilization, are beginning to clear. Yet the stock, which has historically traded at a premium to the broader midcap universe, remains at a discount, though the gap is closing.
Communications. Volatility in the fourth quarter allowed us to add what we consider a best-in-class holding in communications: Cable One (CABO). Cable One is a broadband and cable provider with a focus on rural markets in the Midwest, Northwest, and Southeast. Graham Holdings Company (GHC) spun CABO out in 2015, and investors became attracted to management’s strategy to exit pay TV, which has been in secular decline amid the streaming boom, in favor of more-profitable broadband. As a result of this early strategic pivot, CABO operates with one of the highest margins in the cable industry.
The stock, a perceived “work from home” winner during the pandemic, became overvalued in 2021. So far this year, though, the stock has fallen about 60%, and it now trades at just 8.3 times Enterprise Value to EBITDA (EV/EBITDA) over the next 12 months. By comparison, CABO’s median valuation post spin-off is 11.5 times EV/EBITDA.
Deep Value Bucket
Industrials. U-Haul Holding Company (UHAL; UHAL/B) owns DIY moving and storage assets under the “U-Haul” brand name. The company is a collection of company-owned and independent dealership, moving truck, self-storage real estate, and insurance assets. Through decades of expansion and focus, UHAL has built a dominant distribution network that is more than three times larger than its next two largest competitors combined. This scale has created a significant moat around the franchise as independent dealers are unlikely to switch to a competing brand because doing so would immediately have a negative impact on their revenue.
Yet the stock trades at less than 15 times earnings and more than a 40% discount to our sum-of-the-parts estimate. We believe the market glosses over UHAL’s high-quality moving equipment rental business because of management’s focus on ground-up self-storage development, a strategic decision that reduces short-term profit and creates the illusion of a company with poor returns on capital. In fact, UHAL’s management team has created tremendous value through their real estate investments. There are no major Wall Street analysts covering the stock while peers of similar size have 10 to 20 analysts under coverage. This creates an opportunity to own a high-quality company disguised as a deep-value stock.
Financials. RenaissanceRE (RNR) is a reinsurance underwriter focused on global property catastrophe and casualty & specialty (C&S) lines of risk. Reinsurance involves selling coverage to primary insurers for protection against excess losses. It is largely a commodity with industry economics heavily dependent upon the supply of and demand for capital. Prior to 2017, property catastrophe industry losses were abnormally low, resulting in excess returns and capital entering the industry. More recently, though, property cat losses have been unusually high. Combined with weak pricing, this has resulted in significant industry losses.
In response to the irrationally competitive market, RNR’s management team made the decision to pull back capital for underwriting and reallocated it to repurchase shares. This pivot piqued our interest last year. We began purchasing the stock in the third quarter, prior to Hurricane Ian. We added to our position when shares fell on fears that Ian could result in massive losses for property insurers. Our thinking was that RNR had sufficient capital to sustain cat losses from Ian, and if the storm proved to be bad, it would further catalyze a hard market. Hurricane Ian turned out to be the costliest hurricane in U.S. history, resulting in industry losses forecast to be well in excess of $50 billion. After RNR reported its Q3 cat losses, we were quickly rewarded as pricing for the important January renewal period shot up in excess of 25%, and the stock rallied more than 40% from the Ian lows. RNR still trades at a price/earnings ratio of 8.3, based on the next 12 months’ profit forecasts, which is below the company’s long-term median valuation of 9 times earnings.
Outlook
As the markets inched closer to the point where economic risks are starting to get priced into securities, we’ve grown more comfortable adding cyclical exposure to the portfolio. We believe an economic recession over the next year is consensus, profit expectations are falling quickly in certain pockets of the market, and management teams are increasingly capitulating on the demand environment.
While we expect further economic deterioration in the coming quarters, our focus remains on quantifying both the risk and the reward under multiple good and bad scenarios. It doesn’t always feel good buying cyclical businesses when fundamentals are clearly deteriorating. There is a point, however, where less-defensive businesses become highly attractive even though visibility is poor and economic prospects are deteriorating. As always, we will allow our 10 Principles of Value Investing™ to drive our bottoms-up decision making.
Thank you for your trust and Happy New Year!