Economic concerns that were percolating beneath the surface of the major indices for much of the period, boiled out into the open late in the quarter as COVID-19 cases jumped, employment numbers came in weaker than expected and inflation pressures persisted. The headwinds combined with intraparty wrangling in Washington, D.C. over the fate of nearly $5 trillion in proposed Federal spending, led to a spike in volatility and exposed the fragility of a market that had been running on momentum and positive headlines for the past several months.
The emerging concerns left the major indices flat or modestly down for the period, but valuations remained elevated as measured by the so-called Buffett Indicator. The ratio, shown below, compares the market cap of virtually all publicly traded U.S. companies to the GDP of the U.S. As illustrated, investors are paying nearly $2.40 for every dollar of GDP produced—or about a 91% more than the historical trend line and the highest level in the past 70 years.
Source: FactSet Research Systems Inc., Quarterly data 3/29/1985 to 6/30/2021. Total Market Cap is represented by the Wilshire 5000 Total Market Index. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
The inflating bubble in large growth companies early in the quarter continued to drain oxygen from value stocks, and the portfolio was off modestly and lagged its benchmark, the Russell 2000® Value Index. Stock selection in Utilities was strong on a relative basis as were holdings in the Financials sector. The portfolio’s holdings in Health Care were down but outperformed the benchmark average for the group.
Power Play. As investors chased growth stocks for much of the period, less economically sensitive areas of the market and steady performers lagged. Utilities were a prime example of the dynamic. Due to rate regulations under which most utilities operate, the group can be a challenging area to find compelling opportunities for margin expansion. However, we continue to hold some attractive opportunities, such as Portland General Electric (POR), by focusing on balance sheet strength of power companies that operate in growth markets.
Portland General, which provides electric and gas service to Oregon, stumbled last year after it racked up losses on some power trading contracts it engaged in during the height of a West Coast heat wave that sent wholesale energy prices skyrocketing. The company has taken corrective hedging actions to mitigate future issues and has regained investor interest by producing solid earnings.
We believe Oregon is a burgeoning region for the manufacturing and data industries, which should lead to net growth in power demand versus projections of flat or negative demand nationally. Despite its financial strength and positive growth outlook, Portland Electric trades at 8x enterprise value/earnings before interest, taxes, depreciation and amortization. Going forward, we expect multiples will continue to expand.
Sign of the times. Financials in the broad market continued to climb; however, strength was limited to businesses closely tied to consumer finance. The portfolio’s holdings in the sector outperformed on a relative basis, and the group included FirstCash Inc., (FCFS), a name we highlighted in the second quarter.
Shares of FirstCash, which operates pawn stores in the U.S. and Latin America, continued to move higher as the impact of COVID-19 stimulus checks began to fade and enhanced unemployment benefits expired. Absent government payments, consumers have returned to pawn stores for short-term loans. We remain constructive on the business due to its high margins and view it as uniquely positioned to thrive if the financial resiliency of consumers continues to soften.
Health Check. The portfolio’s Health Care names were down on an absolute basis but outpaced the benchmark average for the group. We continue to find attractive opportunities in the space such as Haemonetics Corporation (HAE), a medical device company that focuses on plasma collection equipment and consumables.
We took a stake in Haemonetics earlier this year after shares slumped on news that it was losing one of its largest customers, beginning in its 2023 fiscal year. Sales of its plasma-related products also slowed during the height of the pandemic and further weighed on the stock. We viewed the sell-off as overdone and saw it as an opportunity to buy a high-quality company at a significant discount.
Haemonetics has seen a recovery in plasma-related sales as COVID-19 concerns have moderated and federal direct payments to consumers have faded. Given its margin profile and prospects for continued sales growth, we view the business as undervalued at its current 12x enterprise value/earnings before interest, depreciation, taxes and amortization.
As bottom-up stock pickers, we continue to focus on individual companies and their ability to succeed in a variety of economic scenarios. However, we’d be remiss if we failed to acknowledge that the increasingly challenging macro environment currently unfolding will impact some businesses more dramatically. For example, persistent inflationary pressures or higher interest rates could be particularly damaging to highly levered companies.
In response, our work continues to center on balance sheet strength and prudent use of capital, and we seek to avoid companies that undertake large-scale transformative acquisitions. Instead, we prefer businesses that are involved in focusing efforts on maximizing profit margins and bolstering bottom-line results by playing to their core competencies.
Outlook and Positioning
Unprecedented fiscal stimulus and direct consumer payments initially served as an elixir in the fight against the economic damage caused by the global pandemic. However, it also had a numbing effect on investors as they glossed over the many risks lurking near the surface in the equity markets.
As the reality of a post-stimulus economy begins to sink in, we believe investors would be wise to recalibrate their expectations. The ability of marginal businesses to ride along on the coattails of a resurging economy, we believe, are winding down. The prudent path forward, in our view, is to focus on mitigating potential downside risk and seeking out business with idiosyncratic opportunities to bolster cash flow generation. We believe this approach will produce a portfolio of companies that should have enduring strength for the long haul.
Thank you for your continued confidence.