An escalation of long-simmering trade tensions added to concerns that the economy was running out of room to expand. Investors responded with increased caution that led to a surge in volatility and left the major indices flat for the quarter, yet still up for the first half of the year.
This more risk averse attitude provided a tailwind to defensive areas as well as companies that are domestically focused. Still, balance sheet strength remains largely overlooked by investors. Signs are emerging, however, that heavily leveraged companies are no longer getting the benefit of the doubt when they disappoint on earnings or guidance.
Treasury yields tumbled on expectations that the Federal Reserve was likely to cut interest rates by year end. Yet investors showed some selectivity when looking for sources of yield. While real estate investment trusts (REITs) remained a go-to space for income hungry investors, as shown, many avoided real estate tied to the beleaguered retail sector.
More Than Just Location
Source: FactSet Research Systems Inc., 12/31/2010 to 6/28/2019
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Security selection was mixed, with holdings in Health Care and Consumer Staples boosting relative results, but the portfolio lagged its benchmark, the Russell 3000® Value Index, for the quarter. Our holdings in Real Estate also contributed to relative performance while weakness in Financials detracted.
The portfolio’s Health Care holdings were up solidly, and the group contained a top contributor, Dentsply Sirona Inc. (XRAY), a manufacturer of health care technology and supplies with an emphasis on dental products.
We initiated a position in Dentsply in mid-2018 after the company saw its sales growth soften and margins erode due to a lack of management focus. A new CEO was brought in at the time, and we believed fresh management could instill a renewed sense of urgency to the business. Since then, the company has undertaken cost-cutting initiatives and plans to divest lower margin units with an expectation the moves will result in up to $225 million in annual savings by 2021.
As the company continues to make progress on reducing costs and streamlining its business units, we expect margins to increase and the stock to trade more in line with medical device peers.
Consumer Staples stocks faced headwinds as the economic outlook became more clouded. Our holdings in the space fared better than the benchmark average and included a top contributor, Walmart Inc. (WMT). The business remains an exception to the shaky retail industry. The company posted its largest jump in same-store sales in nine years and has now posted 19 consecutive quarters of growth in comparables.
Walmart’s ability to grow same-store sales and its ongoing focus on inventory management has been impressive and has allowed the company to rollout a competitive on-line offering. While valuations have increased from the meaningfully discounted levels of late 2015—when we first took a stake in the company—we believe there remains room for further upside.
As the world’s largest retailer, Walmart is well positioned in our view to successfully compete with Amazon.com, Inc. (AMZN) and maintain market share at a time when many smaller competitors can’t make investments necessary to stay relevant.
As debate swirled around the timing of the next rate move by the Federal Reserve, the Financials sector edged upwards. The portfolio’s holdings in the space lagged yet we remain patient with many of our long-time holdings.
Bank of New York Mellon Corporation (BK), one of the big three custody-bank pure plays in the U.S., was off as revenue came under pressure from tighter net interest margins and a slowdown in capital markets business. We view the set back from the perspective of our seven-year investment in the company.
During the time we’ve owned Bank of New York, its margins have increased by almost one-third to 34%. Sales have increased by roughly $1.5 billion during the same period. Management was able to keep costs in check by reducing large-ticket expenses such as maintaining the company’s sizeable real estate footprint. We believe recent investments in technology, which have led to a bump up in costs, will pay for themselves by driving even greater efficiency and margins will rebound in the periods ahead.
With shares trading at a 10% discount to the sector vs. its historical average of a 10% premium, we believe Bank of New York remains an attractive long-term opportunity.
We have sought to maintain a balanced approach in the face of heightened volatility by selling names that are approaching our estimates of intrinsic value and opportunistically buying market leaders we view as being oversold.
For example, we initiated a position in FedEx Corporation (FDX), a global shipping and e-commerce company. Shares have been under pressure as management has lowered guidance three times since December in response to slowing global economic growth. As long-term investors, we are looking past what we view as a temporary slowdown and, instead, focusing on long-term prospects and valuations.
FedEx should be able to take significant market share from its primary competitor due to its more flexible workforce. We also expect that integration of its acquisition of European shipper TNT Express, which got off to a rocky start, will begin to gain traction and lead to greater sales and margins globally.
Despite its strong long-term prospects, shares of FedEx trade at a 40% discount to their historic average based on forward price-to-earnings multiples.
Softening economic data and uncertainty about when or how ongoing trade disagreements will be resolved, highlight the need for a patient, disciplined investment approach. We believe it’s important to avoid jumping into positions that have only recently come under pressure, even if their valuations have improved. Buying a name too early carries a substantial downside risk. In our view, the prudent course is to get past a fear of missing out on upside potential and stay focused on company-specific factors.
While volatility can be challenging to navigate, it can also provide opportunity to upgrade the quality of a portfolio as well as to find attractive bargains on lesser known names that may have stumbled. This dynamic should benefit active investors who focus on fundamentals and identifying catalysts for positive change.
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