Cooler heads prevailed during the period, and the major indices regained much of the ground they lost in the closing months of 2018.
The mostly optimistic tone reflected a realization that macro concerns such as trade wars and political tensions—which had stoked panic just a few months prior—were temporary distractions and unlikely to have a lasting economic impact over the long term.
While largely anticipated, the Federal Reserve’s decision to pause on its path of higher rates reassured investors concerned that elevated borrowing costs would derail the still growing economy.
On balance, a measured view of near-term challenges plus long-term potential for continued economic growth drained much of the volatility from the market, as shown, and led to strong performance among economically sensitive sectors as well as growth stocks.
A Return of Calm
Source: Bloomberg L.P., 9/28/2018 to 3/29/2019
Chicago Board Options Exchange Market Volatility Index (CBOE VIX): is a popular measure of the implied volatility of the S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30 day period.
Past performance does not guarantee future results.
Security selection was strong in several areas, and the portfolio outperformed its benchmark, the Russell 2000® Value Index. Financials and Energy holdings were key drivers of relative performance, while Health Care names lagged. Allocation decisions also boosted results.
Stars Aligning. Finding compelling opportunities in the Consumer Staples area has been a challenge. Top-line growth prospects for many companies in the space are weak due to undifferentiated product offerings. We believe given the current environment it is better to focus on businesses able to increase margins—as opposed to those seeking to grow sales regardless of cost. Portfolio holding Hain Celestial Group, Inc. (HAIN), a packaged food company focused on organic and natural products, is one such example.
Shares of Hain Celestial were up sharply as management, led by new CEO Mark Schiller, continued to make progress on its strategy of selling non-core business lines and eliminating low-margin product offerings. The company recently began selling off its volatile protein business. In addition to boosting overall margins for the company, the proceeds should help fortify its balance sheet.
Delayed takeoff? The portfolio’s Industrials holdings were up on an absolute basis, but the group included a key detractor. AAR Corp. (AIR), a parts, maintenance and logistics company serving the airline industry, was down after providing fiscal-year earnings guidance below consensus estimates.
AAR is a top three independent service provider and offers a completely integrated parts and maintenance model. The company has robust pipeline of sales that we expect should experience up to 10% in organic growth with some share gains through the aftermarket parts distribution business. In addition, management is taking costs out of the business, expanding a key contract, and divesting non-core assets.
Recent weakness in shares of AAR was overdone, in our view. With the company trading at a discount to recent private market equity valuations, we added to our position during the period.
Energized. Oil prices rebounded during the period, and Energy stocks benefited. An overweight to and stock selection in the group boosted portfolio returns. Holdings in the Equipment and Services space were particularly strong including Dril-Quip, Inc. (DRQ), which specializes in serving the offshore/subsea markets.
Dril-Quip posted strong results for the quarter and provided solid guidance for the full year based on a positive inflection in bookings for future projects. Sales forecasts, coupled with cost reductions for the company, should result in meaningful growth in earnings before interest, taxes, interest, depreciation and amortization, in our view.
The growing backlog of bookings and improving market share in a consolidating industry could point to continued strength for Dril-Quip. Additionally, new products could drive up to 15% of revenue in 2020, while the company’s strong balance sheet provides comfort should the Energy space stall in the quarters ahead.
Despite the favorable outlook for the company, shares trade at just 1.5x tangible book value vs. a long-term average of 2.5x.
Despite isolated weakness in some near-term economic data, bellwether commodities such as copper and nickel point to healthy growth going forward. We believe the underlying strength isn’t being fully appreciated by investors, and we could see an uptick in inflation. As such, companies with pricing power should be in a better position to thrive in an environment of rising costs or will be well-situated to withstand margin pressures should the economy soften.
We continue to believe businesses that demonstrate financial discipline and are taking opportunities to reduce costs and improve margins through internally focused efforts should be well-positioned to capitalize on operating leverage in an expanding economy. At minimum, they should be able to modestly grow earnings should sales plateau. The importance of balance sheet strength also makes us wary of holding businesses that are aggressive acquirers of competitors.
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