Our view is that if credit markets tighten, as one would expect in a recession, companies that can self-finance their growth stand to be far more attractive. That’s why we prefer well-managed companies with strong balance sheets and consistent free cash flow generation. This is also why we tend to prefer dividend payers and growers—though not the highest yielders—because the ability to consistently boost dividends, even in difficult economic times, signals management’s skills at capital allocation.
For similar reasons, we prefer companies with little or no leverage, which is a constant in our Ten Principles of Value Investing™. While the markets haven’t been rewarding companies with low leverage, that could soon change in today’s “risk off” market, especially if the economy takes another leg down. In June, the median net debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio for our portfolio stood at just 0.7 times, versus around 2.3 times for our benchmark. That gap between our net debt-to-EBITDA ratio and that of our benchmark is the widest it has been in nearly four years.
Attribution Analysis
Even with multiple layers of safety nets, strong balance sheets and cash flow generation, investors likely can’t protect against stock market losses in the short term. In the second quarter, for instance, the portfolio was down slightly, though less than the Russell 2000 Value Index, thanks in part to stock selection and a focus on quality.
Industrial Strength. To address inflation in the long-term, we believe the economy will need to expand capacity through reshoring industrial production back to the United States. Several of our holdings are likely to benefit if this theme unfolds. Powell Industries (POWL), for instance, develops, manufactures, and services custom-engineered equipment systems used in oil and gas refining, mining and metals, electric utility, and other heavy industrial markets.
Until the recent quarter, Powell shares seemed to be acting like they were in their own mini recession after running up against a series of headwinds, including the COVID-19 shutdowns, supply chain problems as the economy reopened, and inflation in the post-COVID-19 environment. While the company has been working its way back to profitability, the stock has been trading below book value with an attractive dividend yield. This past quarter, Powell enjoyed very strong bookings, a proxy for future revenues, while benefiting from the tailwind of the infrastructure build out while also being able to raise prices.
Healthy Healthcare. Like Powell, many of Healthcare stocks never benefitted from the post COVID-19 rally in the stock market. As a result, our Healthcare stocks are among our cheapest holdings. Haemonetics (HAE) and Phibro Animal Health (PAHC) are two good examples. Haemonetics, which provides disposables and devices used for blood and plasma collection, appears to be a recession friendly stock as its products are not economically dependent. Moreover, as households feel economic pressures, they are more likely to donate plasma, for which they are compensated.
Phibro’s strength lies in its animal-health related franchise, with medical feed additives and nutritional products for production animals. The company is also working on early-stage opportunities in its companion pet business, which could not only diversify its revenues but potentially provide a catalyst for the stock. Phibro is trading at only around 1x sales, and the stock has enjoyed insider buying.
Outlook and Positioning
We believe we are well positioned for the current environment. Well before this past quarter, we began looking for opportunities among beaten-down high-quality stocks with defensive attributes. If we hit rockier shores, the attractive valuation of such companies should provide some downside protection. And if the credit markets begin to shut down, such holdings shouldn’t need access to debt financing to fund themselves.
This speaks to the nature of our portfolio. In great times, we try to exceed expectations. In not-so-great times, we try to win by avoiding big drawdowns. And in all types of markets, we seek out investments demonstrating financial strength, capable management teams with sound capital allocation policies, and solid business strategies at attractive prices—all of which is more possible now, after the downturn, than a year ago.
Thank you for the opportunity to manage your capital.