First Quarter Market Discussion
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.
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.
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).
The broad pullback in equities to start the year has created short-term pain for some investors but has helped rein in historically high valuations in some pockets and has created opportunities where pessimism may be overdone when viewed against historical normalized earnings.
Economically sensitive areas of the market such as Industrials, Materials, and Consumer Discretionary are among the sectors where we have been finding attractive businesses at valuations that have caught our attention. BWX Technologies, Inc. (BWXT), is one such example.
The company is a manufacturer of nuclear power and fuel components for the Department of Defense and Department of Energy. BWXT also services existing nuclear power facilities in North America, and produces radioisotopes used in medical imaging and diagnostics.
Shares of BWXT Technologies sold off in the second half of 2021 as growth in the company’s defense business showed signs of slowing. The softening of growth, in our view, is tied to customer ordering patterns that will likely impact growth over the next few years. Over the longer term, there are clear growth drivers that should benefit BWXT’s defense end markets. The company’s margins are also facing pressure as it has ramped up investments in the development of a key component used in radioisotope production. Currently, there is no domestic supply of the component, and the global supply is limited.
Earlier this year when shares were trading at just 14X earnings projections for the next 12 months, we took a stake in the business. The team believes revenue growth from BWXT’s defense business will return to high single digits in the next few years. Additionally, we anticipate the company will gain clarity into the success of its investments in its medical business line that will result in either a boost in high-margin sales or a winding down of associated spending.
Following our initial purchase, the stock moved higher in late February as money poured into defense stocks on optimism that military spending would grow after Russia invaded Ukraine. While the team does not view the conflict as boosting near-term results for BWXT, we believe the war could support growth in defense budgets in coming years after recently plateauing.
Outlook and Positioning
The hostilities taking place in Ukraine add to the string of unpredictable developments that have buffeted the economy and markets over the past two-plus years and serve as a reminder that sound investing, in our view, requires the discipline to maintain a long-term focus and a disciplined approach to evaluating opportunities. Our work against this backdrop has led us to opportunities to upgrade the quality of the portfolio’s holdings in industries where we believe investors have become too pessimistic.
Recent elevated volatility is likely to persist during the coming months, in our view, and the team believes the best path forward starts with our commitment to finding business with attractive valuations, balance sheet strength, and catalysts that can result in a change in perception by investors. This approach should result in a favorable risk-reward profile in the quarters and years ahead.
Thank you for your continued trust and confidence.