Security selection was strong in several areas, and the portfolio outperformed its benchmark, the Russell 2000® Value Index, for the period and remains ahead through the first three quarters of the year. Information Technology (IT) holdings were key drivers of performance during the period, while Financials names lagged on a relative basis. The portfolio’s Consumer Staples names were mostly flat, and we continue to find compelling value in the space.
Top−line growth prospects for many companies in the Consumer Staples are weak due to undifferentiated product offerings. We continue to believe it is better in the current environment 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, fits with this approach.
We added to the portfolio’s position in Hain when shares came under pressure after a Street analyst issued a negative outlook for the business based on concerns that Brexit could take a toll on the company’s sales and margins. We believed the report was inadequate and didn’t accurately reflect the strides management was taking to reduce debt and focus on higher margin offerings in the product lineup.
Our thesis was validated when Hain announced the divestiture of an underperforming rice brand sold in the UK market. Proceeds from the transaction are slated to pay down debt, and we expect Hain’s leverage will be cut in half once the deal is completed.
With a reasonable debt load and improving margins, we view Hain as a compelling opportunity with meaningful upside remaining.
Strong stock selection in IT more than offset negative performance effects from an underweight to the group. We continue to evaluate businesses in the space and have been willing to add names when we believe idiosyncratic drivers of performance are underappreciated by the market. For example, we recently took a position in MicroStrategy Incorporated (MSTR), an independent developer of business intelligence software that can be used on multiple cloud platforms.
MicroStrategy recently released a new product suite that fits with management’s goal of transforming the business into a subscription−based company that generates higher revenues, operating income, and more stable earnings than in the past.
The rollout of the suite follows a year in which MicroStrategy made heavy investments in marketing and sales. With those costs now behind the company, we expect margins should inflect higher.
As one of the only remaining independent business intelligence software providers, the company in our view has a unique advantage in that it offers flexibility not provided by integrated competitors whose products are tied to a single cloud platform. Additionally, MicroStrategy has a portfolio of attractive domain names that it plans to sell in the quarters ahead.
Despite its unique niche in the market, shares of MicroStrategy trade at a 50% discount to our price target.
We continue to focus on individual companies and their ability to succeed in a variety of economic scenarios. However, we also recognize that any slowdown could have disproportionate effects on highly levered companies, as well as financial institutions that have significant exposure to commercial and industrial loans. As such, it has been challenging to find compelling risk-reward profiles in the Financials sector and we continue to scour balance sheets of our holdings and watchlist names.
In keeping with our focus on balance sheets and prudent use of capital, we continue to avoid companies that undertake large−scale transformative acquisitions. Instead, we prefer businesses that are involved in selling off noncore, underperforming business lines or those that have the balance sheet strength to opportunistically make small−scale, bolt−on purchases that further strengthen core competencies.
Outlook and Positioning
Recession fears have been weighing on investor sentiment for much of this year. While the economy has cooled, employment remains strong, the Federal Reserve is on an easing path and we view the gloomy consensus as premature.
Given this backdrop, we believe inflation may be a more serious threat for businesses with high production costs and limited pricing power.
An Overlooked Risk?
Citigroup Inflation Surprise Index − Global
Source: Bloomberg L.P., 9/30/2000 to 9/30/2019
Citigroup Inflation Surprise Indices measure price surprises relative to market expectations. A positive reading means inflation has been higher than expected and a negative reading means inflation has been lower than expected.
All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future results.
Although the team’s economic outlook is more optimistic than the consensus narrative, we acknowledge that we are in the late stages of an expansion and that businesses will no longer be able to rely on a rising tide to lift all boats. Uncertainty related to many macro challenges is likely to elevate volatility in the near term.
While volatility can be challenging to navigate, it can also provide opportunity to find attractive bargains on businesses that are positioned to improve margins through internal efforts. This dynamic should benefit active investors who focus on fundamentals and identifying catalysts for positive change.
Thank you for the opportunity to manage your capital.