The Value Fund continued to beat the Russell 2000® Value Index for the quarter, adding to its lead for the year.
If we had to pick one word to describe 2020 it would be, Unprecedented. From COVID-19, to the scope of the wildfires on the West Coast and nearly everything in between, it has been a year unlike any other.
Yet, while circumstances may be unique, reactions have a way of following familiar patterns. Take investing for instance. Whether it’s the Nifty Fifty bubble of the 1970s, the Dotcom craze of the 1990s or the lead up to the Great Financial crisis a little more than a decade ago, investor emotion and groupthink resulted in a similar pattern—a blind rush into a narrow slice of the market, with little regard for valuations or risks.
Judging by the chart below, which shows the enormous gap in performance between the tech-driven Russell 1000® Growth and the Russell 1000® Value indices, it looks to us that we are once again seeing the same old response to the latest “different” backdrop for equities.
Growth Pains
Source: The Leuthold Group and FactSet Research Systems Inc. 10/1/1990 to 9/30/2020 monthly. This chart shows relative strength between the Russell 1000 Growth and Russell 1000 Value Indices.
All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future results.
Keeping our Eye on the Ball
While investors have been clamoring to bid up large growth companies, we’ve stuck to our time-tested formula that emphasizes finding growing companies, with solid balance sheets that are trading at discounts to what we view as their intrinsic worth. One of the portfolio’s bank holdings offers a vivid example of this approach.
A Value Vault?
In contrast to the recent new highs by the popular market indices, shares of many small cap banks are off 50% or more. With interest rates at historic lows, investors have avoided this industry due to compression of net interest margin and potential credit risk.
In our view, widespread abandonment of the group has created opportunities in well-run, unique franchises. A long-time favorite of ours, TriState Capital Holdings Inc. (TSC), is an example of the bargains available.
Headquartered in Pittsburgh, TriState is a branchless bank with a terrific record of growth—driven by double-digit percentage gains in deposits and loans. In less than five years, assets have tripled to over $9 billion. The bank’s efficiency is outstanding with revenue per employee of $650k, twice the median for peers.
TriState has a differentiated product line led by a unique private banking model with $4 billion in assets serving a network of high net worth clients throughout America. The offering has been growing double digits and since inception has had zero losses. Fortune has ranked Tristate in their 100 fastest growing companies list three years in a row.
Overall loan quality is outstanding, with non-performing debt to total loans of just .09%. We believe the company has strong management and are impressed by their 9% stake in the company. During the recent selloff, leadership has continued to buy shares.
With shares priced below book value at a single-digit multiple to earnings, we believe TriState represents an exceptional opportunity.
In the Right Light?
Industrials is another sector that has struggled to maintain traction and, despite a solid quarter, remains down double digits year to date. We’ve sought to capitalize on weakness in the space with holdings that are nimble and taking share from competitors. We’ve found one such example in our backyard, Manitowoc Wisconsin-based Orion Energy Systems Inc. (OESX).
Orion is an electrical supply company specializing in converting industrial and commercial properties to high-efficiency LED lighting solutions. Shares of the company have had an impressive run despite the COVID-19 selloff that hit many Industrial names. We view the company as a potential beneficiary of newly cost-conscious businesses.
The LED lights Orion installs are more efficient than the systems they replace, resulting in significant potential energy savings for customers. Additionally, the company enjoys a cost advantage through their use of an army of local contract electricians for installations. Their small size also allows management to be nimble in addressing new opportunities and adapting to the market.
A new CEO has beefed up Orion’s sales force that is focused on winning larger contracts. Management has cut costs and initiated new products like mold and mildew killing UV lights. Early results have been impressive with the company notching major wins including Prologis—the real estate investment trust that operates Amazon’s warehouses REIT.
Orion, in our view, should be able to build on recent momentum and gain additional market share in the LED lighting industry. We would not be surprised if the company landed numerous large contracts in the quarters ahead and saw its top and bottom line growth continue to move higher.
Mask up
Information Technology (IT) was a source of strength for the portfolio during the period, and we added to one of our holdings as shares pulled back.
We featured Photronics Inc. (PLAB), an industry leading, global manufacturer of photomasks used to transfer circuit patterns onto semiconductor wafers and flat panel displays, in our June Commentary. Since then, the company reported better than expected earnings, but shares faltered as the company forecasted a temporary softening in demand due to COVID-19.
Despite the pause in forecasted growth, we remain steadfast in our belief that Photronics is set to reap the benefits of several years of growth investments. Along with an expected jump in sales, margins should expand as capital improvements wind down leaving the company well situated to generate robust cash flow going forward. We also view the business’ strong financial position, with almost $3 a share in net cash, as a competitive advantage that provides management the flexibility to buy back shares as they see fit.
Patience—The Forgotten Virtue
For those who judge investments based on headlines and the performance of a few broad indices, the case for small-cap stocks trading at attractive valuations may seem like a stretch. As a group, the asset class has lagged the large, growthy darlings of the market for longer than we’d thought possible. Yet, a closer look at fundamentals, balance sheets and growth potential, suggests that investors willing to put in the work can find meaningful opportunities.
In the past several quarters, our process and attention to detail has led us to winners in industries ranging from for-profit educators to gold miners to housing related stocks. While the catalysts for the portfolio’s top performers have varied, they shared the common trait of valuations that we found far more compelling than the multiples paid by momentum investors for a handful of tech stocks.
We believe this fundamental approach can at times require patience but also is the best way to help our clients achieve their goal of capital appreciation. The valuations of your portfolio, shown below, are compelling, in our view, with solid sales and earnings growth which could exceed that of many ridiculously priced market darlings.
We remain unwavering in pursuit of investments that fit with our principles but also unrelenting in our commitment to improving. So to us, this time is no different. Our approach is particularly useful as we navigate a world with unprecedented challenges but where investor’s reactions and herding impulses are hardly unique from past bubbles.
Thank you for your continued trust.