Security selection was strong in several areas, and the portfolio outperformed its benchmark, the Russell 2000® Value Index, for the quarter and first half of the year. Industrials and Consumer Discretionary holdings were key drivers of relative performance during the period, while Energy names lagged.
The right environment.
Strength among the portfolio’s Industrials was widespread and the group contained a top contributor, Harsco Corporation (HSC). The company has historically provided industrial services and engineered products for multiple industries including energy, steel and railways.
Shares of Harsco jumped after it reported better than expected earnings and the company announced it was selling off its low-margin, cyclical, industrial services segment and acquiring a high-margin, more consistent environmental solutions company.
We expect momentum in Harsco’s end markets will continue in the near-term and should translate to continued top-line improvements. We are pleased with management’s move to refocus the business on environmental solutions and believe the company should be able to generate more than $500 million in earnings before interest, taxes, depreciation and amortization (EBITDA) by 2021. Based on our sum-of-the-parts analysis, we believe shares are trading at more than 35% discount to our price target.
Toll of tariffs.
Looming tariffs took a toll on names in the Consumer Discretionary sector. The portfolio’s holdings outperformed those in the benchmark, but the group still contained a key detractor, Wolverine Worldwide (WWW).
Wolverine, a maker of premium casual footwear, delivered better than expected earnings during the quarter but shares sold off as a result of disappointing sales guidance for the first half of the year. Additionally, the company strategically increased inventories in anticipation of higher costs due to potential tariff increases. Investors focused on the inventory build as a negative instead of seeing the move as a strategic approach to controlling costs. We view both challenges as temporary.
The company has seen growth for its top three brands—Sperry, Merrell, and Saucony—that should bode well for the second half of the year. As sales inflect higher, inventories should return to normal levels.
We continue to believe Wolverine’s strong brands, high margins, and cost-cutting initiatives continue to make the company compelling. We’ve been impressed with company leadership’s prudent capital management as it funds organic growth, pays down debt and buys back shares. Trading at 10x estimated 2019 EBITDA versus the 11x to 12x range for its low-growth peers, we view the company with its 7% free cash flow yield as a prudent investment in an improving retail environment.
Material issue. Throughout much of the current economic expansion we’ve been struck by the disconnect between growth and the cost of raw materials. While commodities have shown life during the past few years, their performance, as shown below, has significantly lagged that of equities.
CRB RIND Index Relative to S&P 500 Index
Source: Bloomberg L.P. and Standard & Poor's, 1/4/1985 to 6/28/2019
Commodity Research Bureau BLS Spot Raw Industrials (CRB RIND Index): is a measure of price movements of 22 basic commodities, whose markets are usually among the first to be influenced by changes in economic conditions. The 22 commodities are combined into an "All Commodities" grouping, with two major subdivisions: Raw Industrials, and Foodstuffs. Raw Industrials include burlap, copper scrap, cotton, hides, lead scrap, print cloth, rosin, rubber, steel scrap, tallow, tin, wool tops, and zinc. Foodstuffs include butter, cocoa beans, corn, cottonseed oil, hogs, lard, steers, sugar, and wheat.
Past performance does not guarantee future returns.
Despite this dynamic, we have been able to find compelling opportunities in the Materials space by identifying players with self-help opportunities that are able to generate consistent sales regardless of the economic backdrop.
For example, we initiated a position in P.H. Glatfelter Company (GLT), a manufacturer of fiber and pulp-based engineered materials such as coffee filters and hygiene products.
Glatfelter has dramatically changed its business in the last year away from highly cyclical specialty paper market and toward household staples where it can generate higher margins and more consistent sales while serving growing end markets.
We expect free cash flows to accelerate for Glatfelter as business investments made over the past 12 months begin to bear fruit. Additionally, the company removed a long-term cloud overhanging the stock by resolving environmental liability litigation. Based on our sum-of-the-parts analysis, shares are trading at a 20% discount to our 2020 estimates of fair value.