Equities began the year on a sour note as budding economic concerns from late 2021 began to take root. While the somber tone was consistent throughout much of the period, the causes for the caution evolved as did relative winners and losers.
Valuation-conscious investors could take comfort in the fact that the market showed a renewed focus on price paid for opportunities. Likewise, richly valued businesses that were previously riding high on the prospect of future growth lost much of the luster they’ve enjoyed for the past few quarters.
Companies that were positioned to benefit from rising interest rates got off to a fast start in January as investors anticipated the Federal Reserve would be aggressive in raising borrowing costs to rein in inflationary pressure. The dynamic changed as the surge in COVID-19 cases tied to the Omicron variant subsided in late January, and geopolitical tensions ruptured into the headlines when Russia invaded Ukraine in late February. The move caused a spike in the price of commodities, most notably oil, and could lead to a prolonged uptick in production costs for businesses.
The possibility that inflation could prove more stubborn than anticipated comes at a time when consumer savings rates, as shown below, point to the corrosive effects of rising costs on household finances. The challenges Main Street is facing in setting aside cash for a rainy day could be a harbinger of a slowing economy in the quarters ahead.
Deflated Cushion
Source: U.S. Bureau of Economic Analysis and U.S. Census Bureau, retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/. The data in this chart displays personal saving as a percentage of disposable personal income (DPI), frequently referred to as "the personal saving rate," is calculated as the ratio of personal saving to DPI on a monthly basis from 1/1/2005 to 1/1/2022. Past performance does not guarantee future results.
Attribution Analysis
Security selection was strong on a relative basis with holdings in Communication Services and Health Care boosting returns and the portfolio outpaced its Russell Mid Cap® Value Index benchmark for the period. Names in Materials detracted on an absolute and relative basis.
A television star. Holdings in Communication Services were up on an absolute basis and trounced the sector average for the benchmark. The group also contained a top performer, Nexstar Media Group, Inc. (NXST).
Nexstar is the largest local television broadcaster in the United States covering just under 70% of all TV households. The company was assembled through decades of careful mergers and acquisitions by its founder and CEO, Perry Sook.
We took a stake in Nexstar in early autumn of 2020 after it had already come under pressure as part of the COVID-19 selloff that started the year. The company had closed on the acquisition of a competitor’s broadcasting and media assets shortly before the pandemic hit. The purchase was 100% financed with loans, and investors became wary of Nexstar’s debt load when the COVID recession hit.
In addition to the above headwinds, broadcasting businesses have faced challenges in recent years as viewers transition away from cable subscriptions—a portion of revenue of broadcasters is derived from the number of consumers who buy cable. As consumers have shifted their TV consumption toward streaming, investors have assigned lower valuations to broadcasters over time despite the business remaining highly profitable for companies like Nexstar.
While we acknowledge recent challenges for the company, the team believes investors are undervaluing the durability of Nexstar’s significant profit stream from the existing cable subscription market as well the negotiating leverage the company enjoys from its large viewer base. Shares of Nexstar are currently trading at a roughly 25% discount relative to its peers based on enterprise value/earnings before interest, taxes, depreciation, and amortization.
Health check. Staffing and supply chain issues continued to hamper companies in the Health Care space during the period, and the sector was a laggard for the broad indices. The portfolio’s holdings in the sector were down but outperformed the benchmark average for the group and contained a top contributor, AmerisourceBergen Corp (ABC).
AmerisourceBergen Corp. (ABC) is a leading national pharmaceutical distributor with deep relationships with hospitals and retail pharmacies. The company has been quietly bolstering its business model during the past few years to include animal health products for the European market and an expanded line of higher-margin, value-added services that reach beyond drug distribution. During these efforts, valuations for the company were under pressure due to liability issues stemming from opioid litigation as well as concerns about increased scrutiny of drug prices by politicians.
Our team has been following these developments and have been impressed by the strides management has made on the business side. The opioid litigation has largely been resolved, and the company continues to bolster its global reach and portfolio of services offered. While investors have begun to take notice of the strides AmerisourceBergen has made, shares remain attractive, in our view, trading at 13X estimated 2023 earnings per share.
Collateral damage. Last period we wrote about the resiliency the Materials sector had shown in the face of rising inflation thanks to many in the industry being well positioned to pass cost increases on to customers. While the advantage continued for some businesses in the group, the hostilities in Ukraine created new challenges for others in the sector including portfolio holding PPG Industries Inc. (PPG).
PPG is the second-largest coatings supplier in the world and boasts the top market share in the industrial space, including auto refinishing and original equipment manufacturing (OEM), aerospace, and general industrial. The company is second only to Sherwin-Williams in the architectural coatings market.
PPG was able to weather inflation pressures late last year by aggressively raising per-unit pricing including a 6% price increase in the fourth quarter. Shares of the business responded favorably at the time as signs pointed to cost pressures peaking. That momentum was lost, however, as inflation has persisted due to a spike in commodity prices spurred by Russia’s invasion of Ukraine. The conflict in Europe has also exacerbated bottlenecks for auto component manufacturers, putting pressure on PPG’s near-term sales.
The challenges PPG is facing may persist in the near-term, however, we view shares as compelling given current valuation and management’s recent decision to buy back stock at what we believe is a discount to intrinsic value. In the long run, PPG should thrive as a provider of key components for its customers and benefit from its unique position to participate in the shift toward electric vehicles (EVs).