Security selection was strong in Real Estate and Materials but could not overcome weakness in Information Technology (IT) and Consumer Discretionary, and the portfolio lagged its benchmark, the Russell 3000® Value Index. Allocation decisions also detracted from performance.
A chicken in every pot.
The portfolio’s Consumer Staples holdings were up on an absolute basis, and the group contained a key contributor, Sanderson Farms, Inc. (SAFM), the third−largest producer of fresh chicken in the U.S.
A few years ago, Sanderson was riding high. Chicken prices in mid−2017 were nearly double the five−year average. As profits gapped higher, many producers added capacity to keep up with demand. However, the resulting surge in supply put pressure on pricing, and shares of Sanderson and its peers weakened.
In response to soft pricing, Sanderson has focused on growing its business and improving its already impressive efficiency level. The company’s rock−solid balance sheet and expertise as a low−cost producer gives it a competitive advantage, in our view.
As chicken prices have rebounded, profits have jumped, and the company could now earn as much as $5 per share for fiscal 2019. That outlook is a drastic contrast to Street estimates at the beginning of the year, which forecasted just $1 for the same period. We have been pleased with the appreciation in share price and believe the company remains an appealing investment given its financial position and the potential for further sales growth in China.
A haircut in discretionary.
Despite the threat of higher tariffs and an unsettled economic outlook, Consumer Discretionary stocks finished the period up modestly. Our holdings in the space lagged the benchmark average and included a key detractor, Mohawk Industries Inc. (MHK), one of the world’s largest manufacturers of commercial and residential flooring.
Since late 2017, Mohawk has faced headwinds including increased costs, a slowing housing market, and margin pressures relating to ramped−up investments in expanding its luxury vinyl tile (LVT) production capacity. Over the next year, we expect the company to benefit from both improved LVT production efficiency and rising volume as Mohawk responds to improving retail and wholesale demand for flooring. Together, we expect these drivers to improve sales and margins.
Shares of Mohawk are trading at less than 12x estimated earnings compared with a long−term average of over 14x. As its LVT production continues to ramp up, we expect investors will reward the company for improved margins and sales and valuations will be more in line with its building−product peers, which are currently trading at about 16.5x earnings.
Health Care names in the benchmark and portfolio struggled this quarter, but the sector contained a key contributor for the strategy. Long−time holding CVS Health Corp. (CVS), a national pharmacy and health services company, was up as investors began to embrace its model of offering value−based care at its retail locations. The move began in earnest with CVS’ 2017 acquisition of Aetna, a healthcare benefits company.
The purchase of Aetna gave CVS access to a significant pool of potential customers that it could serve at retail locations. Initial reactions to the merger were lukewarm due to the complexity of the transaction and the meaningful financial and operational risk tied to the deal. Recently, lingering concerns were eased as the company reported better than expected results and a judge removed the final hurdle standing in the way of the merger going through.
While investors have begun to give CVS credit for its ongoing transformation into an integrated health−care services provider, the stock remains meaningfully undervalued based on our conservative estimates. We expect that gap to close further in the coming quarters.
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 Weyerhaeuser Company (WY), a real estate investment trust (REIT) that is one of the world’s largest owners of timberland with over 12.2 million acres in the U.S., as well as a manufacturer of wood products. Shares of the trust have been under pressure since the boom in lumber prices ended last year.
With timber having bounced off recent lows, we believe the worst may be behind Weyerheuser. We expect earnings before interest, taxes, depreciation and amortization to begin to inflect higher in the coming quarters. Based on a sum−of−the−parts analysis, shares of the REIT are trading at a discount based on our team’s conservative outlook for an improving end market for lumber. We also believe Weyerheuser’s 5.1% dividend yield make it an attractive holding in an environment of low−yielding bonds.
Mixed economic data and uncertainty about when or how ongoing trade disagreements will be resolved highlight the need for a balanced, disciplined investment approach. We believe elevated volatility could endure in the coming months. That can bring opportunities—for example, the names we noted above as “oversold” in our view—but we believe it’s vital to avoid jumping into a position just because selling pressure has created somewhat more attractive valuations. 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.
Thank you for your continued confidence.