The migration into large-cap companies that started midyear continued during the quarter but shares of smaller businesses still posted solid returns for the period. Stock selection for the portfolio was mixed, and the strategy was up on an absolute basis but modestly lagged its benchmark, the Russell 2000® Value Index. Holdings in Information Technology (IT) and Materials were up on both an absolute and relative but couldn’t overcome weakness in Financials. Holdings in Health Care were down but outperformed the benchmark average for the group.
Re-engineered. While investors fixated on inflation and supply chain disruptions throughout the economy, our team remained focused on those companies that were executing at a high level or were positioning themselves to grow margins through internally focused efforts. TriMas Corp. (TRS) is an example of this approach.
TriMas, a manufacturer and distributor of engineered packaging, aerospace, and industrial products, has been focused on improving margins by adjusting its business mix through a combination of strategic acquisitions and divestitures. The efforts have resulted in growth in its packaging and aerospace units and deemphasis on its lower-margin lines.
TriMas has enjoyed strong sales growth during the COVID-19 pandemic, but profit margins have been stunted due to supply chain disruptions and rising input costs. With prices for resin, a key ingredient in the company’s products, beginning to ease, we expect margins and earnings to rise going forward.
Financial fallout. The once red-hot Financials sector finished the year on a quiet note as the outlook for future economic growth is clouded and the expiration of stimulus payments to consumers could result in an uptick in loan defaults. For much of the past year, we’ve found value in the sector outside of the traditional banking industry. The approach has boosted performance for much of 2021; however, a stock-specific issue in one of the portfolio’s holdings in the Consumer Finance industry caused the Strategy to lag for the period.
This company operates pawn stores in the U.S. and Latin America. We’ve highlighted the business in previous quarters citing its high margins and our view that it was uniquely positioned to thrive should the financial resiliency of consumers soften. Shares of the company were down sharply after management announced it was acquiring a lease-to-own and retail finance company.
The move caught Wall Street by surprise, and shares sold off. Company leadership has previously been silent on plans to expand into other business lines. We viewed the move as a misstep that could bring greater operational risk and regulatory scrutiny to what has been a successful pawn store franchise. As a result, we liquidated the portfolio’s position in the company.
Good to hear. The Fund’s Information Technology (IT) holdings posted a strong quarter and outperformed the benchmark average. Knowles Corp. (KN) is an example of the type of compelling opportunity we hold in the space. The company is a leading maker of microphones and speakers for cell phones and other electronics as well as hearing aids. Earnings have recently come in higher than expected, and management upped their guidance led by growth in the company’s high-margin precision device segment. Additionally, the company announced it was redeeming convertible debt using cash it had on its balance sheet—clearing up an issue that had hung over the stock.
We view the recent strong quarter as a sign of positive things to come for Knowles. Despite the strong performance, shares of the business trade at just 8x estimated 2022 earnings before interest, taxes, depreciation and amortization.
Valuations in many areas of the market strike us as extreme. Most jarring are the price multiples commanded by weak businesses with weak balance sheets operating in stagnant industries. Many of these businesses exist wholly thanks to a favorable capital raising environment driven by easy credit and low interest rates. We seek to avoid these types of companies in the belief that their bloated valuations fail to compensate investors for the outsized risk of permanent impairment of capital.
As fundamental investors, we continue to focus on individual companies and their ability to improve margins and earnings in a variety of economic scenarios. Our focus on quality businesses and robust balance sheets has resulted in a portfolio that is more defensive than it has been in favor for portions of 2021. However, we view this approach as prudent given that the increasingly challenging macro environment should impact some businesses more dramatically than others. For example, persistent inflationary pressures or higher interest rates could be particularly damaging to highly levered companies.
Outlook and Positioning
Growing economic headwinds ranging from another wave of COVID infections to surging inflation and tightening monetary policy by the Federal Reserve are becoming too hard for investors to ignore.
As the reality of a post-stimulus economy begins to sink in, investors should begin to reconsider previous expectations. We believe marginal businesses’ ability to ride along on the back of a resurging economy is coming to an end. The prudent path forward, in our view, is to focus on mitigating potential downside risk and seeking out businesses with idiosyncratic opportunities to bolster cash flow generation. We believe this approach will produce a portfolio of companies that should endure and thrive over the long term.
Thank you for the opportunity to manage your capital.