In December, our Value Fund celebrated its 35th anniversary. We’re proud to report that since inception, the portfolio has delivered a compounded annual growth rate of better than 11.25%, outpacing its Russell 2000® Value Index benchmark.
The historic performance is particularly gratifying because it was achieved by following a single, disciplined philosophy—focus on small companies with solid growth prospects but buy them with an eye on the price paid. In a market where large-cap growth stocks dominated, the approach resulted in a 17.96% return this year.
Keeping it Simple
When it comes to investing jargon, sometimes, the simplest definition is the best. Take reversion to the mean. In our view, it’s a complicated way of saying a return to common sense. But as any value investor who’s lived through the last 10 years of mega-cap growth mania knows, simple isn’t always easy—a fact that became only clearer in 2019.
So, what is behind this disconnect between fundamentals and performance? Some of it, in our view, is fear of missing out, and a misguided belief that large companies are somehow safer bets. The thinking creates a stampede of assets into the largest companies by market cap, which in turn drives performance and valuations even higher. Like a sugar rush, the ride up can be exhilarating but when the music stops and companies can’t produce the growth required to justify lofty earnings multiples and $1 trillion-plus valuations, the downfall can be quick and painful.
As the chart below shows, the 10 largest companies in the S&P 500 have a combined market cap of MORE THAN 3X THE ENTIRE RUSSELL 2000® INDEX of small companies. It looks to us like we could be approaching one of those painful inflection points.
Source: Furey Research Partners, LLC, Standard & Poor’s, and Russell®, 12/1/1985 to 12/31/2019. This chart
shows the aggregate market cap for the ten largest companies in the S&P 500 Index divided by the total
market cap of the Russell 2000® Index.
Past performance does not guarantee future results.
While the stubborn lack of interest in small companies priced at attractive valuations has been frustrating, we’ve also welcomed the striking opportunities that have emerged as a result. As headwinds such as an unheard-of three-year ramp up in rates has reversed, and trade wars have started to subside, your portfolio has reaped some of the benefits of a market waking up to the bargains to be had in small-caps. The following are a few examples of the businesses that drove performance.
More than Where You Hang Your Hat
Low mortgage rates, strong employment and a massive, 90 million strong, millennial generation poised to buy into the American dream has been a boon for the housing market. During the past few years, your portfolio has benefited from this megatrend directly through a few select homebuilders, and indirectly from businesses like industry leading mortgage insurers Radian Group Inc. (RDN) and MGIC Investment Corporation (MTG).
Radian and MGIC were up sharply this quarter and for the year as the housing market for entry-level homes has been strong resulting in increased sales for both companies. The duo, with a combined $450 billion in insurance in force, has done an excellent job in strengthening credit underwriting since the financial crisis, in our view, and each should continue to benefit from current low mortgage rates.
Despite the strong performance, both are priced at less than 8X estimated earnings for an attractive earnings yield of 12%. Additionally, Radian trades at just 1.3X book value, while MGIC is at a lowly 1.2X book value. Given their growth prospects and attractive valuations, we continue to see opportunity for further appreciation.
Unheard of Success
As investors in small/micro-cap companies, our research analysts are on the lookout for niche businesses with unique models that provide a competitive advantage. The Bancorp, Inc. (TBBK) fits with this approach. The company, with $4+ billion in assets, may be one of the most widely used banks you’ve never heard of. As a white-label operation, TBBK provides behind-the-scenes banking services including prepaid gift and debit cards to more than 100 non-bank partners ranging from PayPal to Verizon. Through the card unit, the company can gather significant deposits at extremely low rates and then lend those assets out at open market rates. Additionally, TBBK generates high-margin fee income with each transaction completed using one of its cards.
TBBK came under regulatory scrutiny in 2014, relating to some issues in their prepaid card business. We sensed an opportunity and took a stake in the company when valuations created what we viewed as a favorable risk/reward dynamic.
Shares received a boost in early December when regulators lifted all remaining operating restrictions on the business, which frees up management to reinstitute a dividend. Despite the competitive advantage of low-cost assets, TBBK trades at a nearly 17% discount on tangible book value to its peers. We expect a bright future for the company and further appreciation for shares.
Longtime holding SRC Energy Inc., (SRCI), an oil and gas producer, has been hampered by political challenges in Colorado and by a bottleneck in pipeline capacity to transport natural gas out the Denver-Julesburg (DJ) Basin where it operates. To enhance scale and efficiencies SRCI is merging with PDC Energy, (PDCE), to create the 2nd largest oil and gas producer in the DJ Basin. Negative political headlines notwithstanding, the combined entity should generate above peer group average debt adjusted growth with a robust free cash flow (FCF) yield.
This looks to us like a compelling value with a healthy balance sheet—net debt/EBITDA of just 1X—and shares trading at less than 3X pro-forma EBITDA (earnings before interest, taxes depreciation and amortization). The strong FCF should provide a potential return of capital optionality to shareholders via a stock buyback, debt repurchases and/or dividend initiation.