It was full steam ahead for the rampant economic optimism that has reigned over the markets since the year began. Plummeting COVID-19 cases, high demand for workers, and a steady stream of proposals out of Washington D.C. to pump ever-more trillions of dollars into the economy left investors with a sense of invincibility.
The euphoria continued this year’s surge for equities, and the major indices hit record highs during the closing days of the period. With investors seemingly fixated on only positive headlines, little attention was paid to fundamentals of individual companies. The indifference toward risk led to a surge for so-called meme stocks, such as AMC Entertainment Holdings Inc. (AMC), a money-losing business with a shaky balance sheet whose shares were up 2,500% through the first half of the year.
As fundamental investors, we are always wary of markets driven by momentum and macro events, and the current situation is no different. While the snap back from the pandemic has been impressive, it loses some of its luster when looking at the amount of debt it generated.
The correlation between ballooning balance sheets at the Federal Reserve and the fortunes of the equities market, as shown below, is striking. The willingness of the Fed to open up its balance sheet to save debt-laden businesses is unsustainable in our view and underscores the importance of active managers who make clear-eyed risk assessments of prospects for individual companies.
A Fed-Funded Party
Source: Bloomberg L.P., Standard & Poor’s, Daily data from 7/1/2020 to 6/29/2021. The FARBAST Index outputs the US Federal Reserve’s balance sheet in millions of USD, updated weekly. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
The portfolio added to its double-digit gains from the prior quarter but ended the period lagging its benchmark, the Russell 2000® Value Index. Stock selection in Financials was strong as were holdings in the Health Care sector. The portfolio’s holdings in Industrials were down and lagged the benchmark average for the group.
Energized. Oil prices remained firm during the period, and Energy stocks benefited. Stock selection in the group boosted absolute 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’s sales were slightly weaker than forecasted for the most recent period, but the company reported strong margin growth as efforts undertaken to boost bottom-line results began to pay off. Additionally, bookings for future projects were up, and we expect expenses will continue to improve as management’s plan for reducing inventory levels continues to progress.
Despite the promising outlook, Dril-Quip trades at less than 8x estimated 2022 earnings before interest, taxes, depreciation, and amortization.
No pain no gain. The portfolio’s Health Care names were up on a relative and absolute basis but also contained a key detractor, Avanos Medical Inc. (AVNS).
Avanos, a medical device company that focuses on the pain management and chronic care markets, saw its shares weaken after its gross profit margins shrank due to a combination of short-term supply chain issues and a sales mix for the most recent period that was light on some of its high-margin products.
We remain constructive on Avanos and believe the issues with its supply chain are temporary and that management has a sound plan for driving margins back up to the 60% level the business previously enjoyed. Additionally, the improved outlook for elective procedures should drive a resumption of demand for Avanos products.
While the outlook remains positive for the company, shares trade at 2.5x estimates of 2022 enterprise value/sales—well below the 4x multiple commanded by its medical device peers.
Cash is king. Financials in the broad market were flat despite better than expected loan performance. The portfolio’s holdings in the sector outperformed on a relative basis, and the group included FirstCash Inc. (FCFS), a top contributor for the period.
Shares of FirstCash, which operates pawn stores in the U.S. and Latin America, jumped as the impact of COVID-19 stimulus checks began to fade and pawn loan demand started to improve. We remain constructive on the business due to its high margins and view it as uniquely positioned to thrive should the financial resiliency of consumers soften.
Despite the favorable move for shares of the company, the stock trades at just 1.5x tangible book value vs. a long-term average of 2.5x.
The flood of fiscal stimulus unleashed to restart the economy has created distortions in the supply/demand balance in many industries. As the last of the stimulus checks are spent and enhanced unemployment payments wind down, we believe some of those anomalies will be righted. The sustainability of consumer spending and the outlook for companies in the Consumer Discretionary sector is an area that could be ripe for revised expectations.
An analysis of recent trends shows that the growth in retail sales over the past year has coincided with the amount of stimulus being doled out to consumers, as opposed to base wages. While consumer spending might remain elevated in the short term, we believe spending will begin to fade as government payments wind down. In response, we remain underweight the group as we seek businesses where our clients will in our view be adequately rewarded for the heightened risk that could come as stimulus funds wane.
Outlook and Positioning
There was plenty for investors to cheer during the first half of the year, yet sensible bullishness toward an economy that was regaining its previous form has morphed into excessive optimism and an intense focus on immediate rewards without consideration of longer-term challenges.
The willingness to extrapolate the current goldilocks backdrop of low interest rates, easy sales comparisons and low inflation into the foreseeable future seems misguided—and fraught with risks.
As such, we believe as active managers it is important to maintain a focus on appropriately managing risks in the portfolio. That means seeking out businesses that are well positioned to drive free cash flow growth and those with the financial strength and pricing power necessary to weather the long-term uncertainty of a world awash in debt. We believe this approach will produce a portfolio of companies that should have enduring strength for the long haul.
Thank you for the opportunity to manage your capital.