In the late stages of a bull market, there’s normally no shortage of things to worry about. It certainly feels that way today.
For instance, the yield curve isn’t merely inverted, which is historically a sign of a looming recession. The inversion between 10-Year Treasuries and 3-Month T-Bills is the longest and most severe on record. Late in the third quarter, the Russell 2000® Small-Cap Index also dipped below its 200-day moving average, pointing to a potential downtrend ahead. Meanwhile, consumer spending, the engine that drives the economy, is starting to stall. Credit card and auto loan delinquencies are climbing, as households appear to be strapped for cash. Not only has the personal savings rate plunged, but the percentage of household spending also directed at essential items, such as food, is now rising after an extended decline, another traditional red flag.
Yet, the market seems to be ignoring all of this. Investors have placed their faith in a narrative that says the Federal Reserve is about to do something it has only accomplished once in more than a century: Stick a “soft landing.” It’s a frustrating and familiar disconnect.
Growth led the markets in the first half of the year owing to the euphoria surrounding artificial intelligence-related stocks and the hope that the Federal Reserve might soon start cutting rates. Value managed to outperform in the third quarter, but even within Value, high beta has been working while defensive strategies and low volatility generally have not.
Our portfolio is priced for a recession by focusing on undervalued, high-quality names. The vast majority of our holdings pay a dividend and have compelling self-help strategies, with little debt and strong balance sheets. Until the market gives up the ghost of a soft landing, we’re committed to being patient.
Attribution Analysis & Portfolio Activity
The Value Plus Strategy was down approximately 5% in the third quarter, trailing the Russell 2000® Small-Cap Value Index, which returned -2.96%.
While stock selection has been responsible for the lion’s share of our performance over the past five years, this wasn’t the case in the third quarter, when selection effect detracted in most sectors. Our Industrials holdings were a bright spot this quarter, up 4.7%, versus -3.9% for the benchmark.
We’ve seen a fair amount of insider buying in our holdings, an encouraging sign that gives us confidence to hold tight. One such company is Carter’s Inc. (CRI), which sells apparel for babies and children under the Carter’s and OshKosh B’gosh brands. So far in 2023, CRI has returned $96.6 million to shareholders in the form of share repurchases and cash dividends. That brings the repurchase and dividend totals to roughly $3 billion over the past 15 years.
Like all retailers, Carter’s has been undertaking inventory reduction in the aftermath of the pandemic. CRI, however, was 6 to 12 months ahead of other retailers in managing its inventories, a focal point of Carter’s self-help strategy. Since there is limited fashion risk in baby and infant apparel, the company recently packed a portion of its inventory in storage to be brought back later, thereby avoiding the need for steep discounts to work down backlogs. Management has also done a good job de-risking its supply chain in China and globally. For example, Carter’s was early to recognize that low water levels in the Panama Canal threatened delays through that waterway and moved to reduce the amount of its merchandise going through that route.
Meanwhile, CRI has an enviable balance sheet, very little debt, and very strong free cash flow. Yet, the stock trades at less than 12X earnings and less than 7X enterprise value to EBITDA.
Outlook
The third quarter demonstrated how challenging it can be to invest in a market driven by a narrative that does not add up. But the short-term thinking of other investors is not our concern. Our job is to keep our heads down and make sure we are positioned appropriately for the long term, by focusing on well-managed companies trading at attractive prices to their intrinsic value.
In this challenging environment, we are doing just that. Our disciplined approach allows us to become well acquainted with the stocks we own through deep research and regular engagement with the management teams of these companies. As our holdings are generally underfollowed by sell-side analysts, we are constantly checking to make sure they maintain the same level of discipline we demand of ourselves. Our intent is to avoid being reactive. But while we can’t dictate the nature of the economy or the attitudes of other investors, the one thing we can control is our understanding of—and confidence in—the strategies of the businesses we own.