With the Federal Reserve signaling it was willing to backstop the economy and prop up even the weakest businesses, investors flocked back to the equity markets. The stampede was heightened by hopes of a V shaped economic recovery, which was based on economic data and earnings reports that were less bad than expected.
The risk-on sentiment was in stark contrast to much of the first quarter when widespread COVID-19 fears roiled the markets. The speed and strength of the rebound paused late in the period as investors grew wary of a second wave of new virus infections across several states.
While the move higher for the quarter was a welcome relief for battered portfolios, a closer look at winners and losers painted a less optimistic picture. Breadth was weak with shares of many companies failing to recoup previous losses. Additionally, as shown below, shares of businesses with low returns on equity, as a whole, materially outperformed their higher quality counterparts. Lower quality names often lead in rallies following selloffs, but the magnitude of the bounce back was noteworthy.
Dash to Trash?
Source: FactSet; FTSE Russell; Jefferies. This chart shows companies held in the Russell 2000 Index. The 2020 bear market is representing data gathered during 1/16/2020 to 3/18/2020. The average bear market data is calculated based on bear markets taking place during 12/31/1985 to 6/18/2020. Bottom was on 3/18/2020. The average 3-month after bear market data is calculated based on 3 months following each bear market taking place during 12/31/1985 to 6/18/2020. Return on equity (ROE) measures the net income after taxes a firm is able to earn as a percentage of shareholders’ equity. A bear market occurs when the price of a group of securities is falling or is expected to fall.
The portfolio remains meaningfully ahead of its benchmark, the Russell 2000® Value Index, for the first half of the year. However, strong stock selection in several sectors couldn’t overcome weakness in Health Care and Materials and the portfolio lagged during the quarter.
Given the low-quality nature of the recent rally, results, while disappointing, are not surprising. We believe, however, that the portfolio is prudently positioned, and investors should reap the benefits of our focus on balance sheet strength and internally driven catalysts over the long-term.
Disruptors wanted. As part of our quest to find businesses with opportunities to improve sales and earnings, we have sought companies that are taking a differentiated path from competitors. We believe these disruptors will be well suited to compete in the aftermath of the global pandemic. Sonic Automotive Inc. (SAH), a top performer for the period, is an example of our thinking.
Sonic is one of the country’s largest automotive retailers, with 95 franchises in 12 states. The business operates in two segments—traditional new and used car sales locations and its EchoPark unit that operates standalone used cars outlets. Shares of the company were up sharply during the quarter as auto sales surged after a dismal first quarter due to COVID-19.
We welcomed the improvement but view Sonic as attractive for the long haul. Specifically, in our view, the company has one of the strongest balances sheets in the industry, a great new car dealer franchise and EchoPark offers a differentiated approach providing it exceptional growth potential in the fragmented and inefficient used-car market.
On the mend?
Health Care, driven by Biotech shares, posted solid gains in the benchmark. Our names failed to keep pace and contained a key detractor, Cross Country Health Care Inc. (CCRN), a health care staffing company specializing in traveling nurses.
Shares of Cross Country were under pressure as demand for health care workers was down due to “elective” procedures being halted during COVID-19. As restrictions have eased and procedures have ramped up, the company has begun to see a rebound in revenue. We expect top-line trends to continue to improve and have been encouraged by meaningful share purchases made by company executives this year.
Traditionally, rich valuations and lackluster growth prospects have created unique challenges for finding compelling opportunities in the REIT sector. However, we have been able to find attractive candidates in the space by looking in areas beyond retail or commercial real estate. This approach benefitted the portfolio as our holdings in the sector, led by Potlatchdeltec Corp (PCH), outperformed on a relative basis.
Potlatchdeltec owns significant timberland acreage and operates wood mills across the U.S. Shares of the company were up after reporting solid results and minimal impact on its operations due to social distancing. Additionally, Potlatchdeltec was one of the few REITs to maintain its dividend during the period.
We believe shares of Potlatchdeltec should benefit going forward given strong housing demand and stable lumber prices. The company also has strong capital allocation policies in place and has a history of buying back shares when they trade at a discount to net asset value (NAV).
Despite the strong outlook for company, shares are trading at a 25% discount to NAV.
The far-reaching economic impact caused by COVID-19 is likely to play out for several years. The pandemic will likely change the way consumers shop, where they eat and how they work. Against this still evolving backdrop, we have sought to identify companies trading at attractive valuations that have avenues to succeed under multiple scenarios. Commoditized areas of the market, such as in Energy, could continue to face headwinds due to excess supply and diminished demand. As such, we have struggled to find compelling opportunities in the space, and it remains an underweight for the portfolio.
Outlook and Positioning
The flood of stimulus unleashed by the U.S. government and its willingness to prop up even the weakest businesses has caused investors to lose their inhibitions. As a result, shares of companies with shaky balance sheets, operating in declining industries and those with questionable capital allocation strategies, have been snapped up. While those types of companies soared during the most recent period, we believe it is a short-sighted approach doomed to failure.
Instead, we are investing in businesses that are well positioned to drive free cash flow growthand those that are financially strong, in our view. We believe this tactic is the most prudent approach given the current environment.
Thank you for the opportunity to manage your capital.