Investors returned to equities during the period and the major indices sprinted ahead, recouping nearly all their losses from the previous quarter.
Both cyclical and defensive areas advanced as investors responded to the Federal Reserve’s freeze on rate hikes and favorable signs from the credit market, where bond yields suggested stronger economic sentiment.
However, later in the quarter, caution about economic strength emerged, as data pointed to slower growth in the quarters ahead and trade tensions continued to simmer globally. The rally lost steam and the equity markets were range bound for much of March.
Security selection in Energy and Information Technology boosted relative results, but the Strategy lagged its benchmark, the Russell 3000® Value Index, for the quarter. Holdings in Communication Services were particularly strong during the period. An overweight to and stock selection in Health Care detracted from relative results. The portfolio’s holdings in Financials were up on an absolute basis but failed to keep pace with those in the benchmark.
Oil prices broke free of their prolonged slump and Energy stocks surged. The portfolio’s holdings in the sector were up sharply and contained a key contributor, Berry Petroleum Corporation (BRY).
Berry, an oil producer focused on reserves in California, was up in response to stable demand and firmer prices. The company’s production footprint is a differentiator in our view. Because it operates outside of the red-hot Permian basin, Berry faces less competition in attracting skilled labor and therefore benefits from lower production costs. Additionally, with fewer domestic producers of Brent crude, prices have been firmer than other grades of crude.
With the stock trading at just 7.4x 2019 earnings per share compared to a 20-year median of 14.5x for the industry, we view Berry as significantly undervalued. Given its plans to grow oil production by 13% this year and ability to continue to pay a meaningful dividend, the company should have a clear path to generate multiple expansion on earnings.
Prescription for improvement?
The portfolio’s Health Care holdings were up for the period and we continue to see opportunity in the group in names such as pharmaceutical holding, Sanofi (SNY).
Shares of the France-based Sanofi have been under pressure due to rising competition for its diabetes franchise of drugs. So far, runoff in the segment has been slower than projected and we believe the bulk of the declines have already occurred. Additionally, diabetes and cardiovascular medicines account for just 13% of sales for the company making it the smallest of its five areas of focus.
Recently there have been signs that Sanofi’s other products may be making up for erosion in its diabetes business as sales estimates have begun to improve. Trading at a mid-teens priced/earnings discount relative to its peers, and offering a 4% dividend yield, the company is a compelling opportunity in the Health Care space, in our view.
The strategy’s Financials holdings were up in several industries. Shares of Berkshire Hathaway Inc. (BRK.B), a multi-business holding company run by legendary investor Warren Buffett, however, were off modestly during the period despite the company announcing better than expected earnings for its most recent quarter.
We believe the lackluster near-term performance of shares has been driven by investors chasing greater growth elsewhere. We view many of those opportunities as offering inadequate upside potential relative to the downside risk should they fail to achieve optimistic growth targets in an aging economic expansion.
Despite strong returns in 2018, Berkshire continues to trade at a nearly 30% discount to its peers, and nearly 40% lower than the broader market based on our analysis. We view these valuations as compelling and anticipate further upside for the shares.
A sharp runup for stocks to start the year provided opportunities to harvest gains and redeploy assets into names where valuations have receded resulting in an attractive risk/reward profile. Through our research, we have sought companies that are poised to succeed against a variety of backdrops or those that are priced at significant discounts to mid-cycle earnings levels.
For example, we initiated a position in ManpowerGroup Inc. (MAN), a global staffing firm. With offices in 80 countries and a mix of industrial and IT staffing services, the company is the third-largest agency of its type in the world.
Shares of Manpower had been under pressure recently due to a slowing European economy, where the company generates two-thirds of its revenue. While we expect revenue to decline in the short term, we see the shares as offering an attractive risk/reward profile, particularly relative to industrial stocks with a greater mix of domestic exposure.
Longer term, we expect margins to expand as a result of management’s strategy of reducing costs and leveraging its scale to gain share in the high-margin recruitment outsourcing industry. Manpower’s balance sheet is strong, and the board has approved opportunistic share repurchases in the past resulting in 4% fewer shares outstanding in 2018 relative to 2017. Higher margins with a lower share count should drive higher cycle-to-cycle earnings power.
With Manpower trading at less than 6.5x 2019 earnings before interest, taxes, depreciation, and amortization (EBITDA), versus a peer group average of over 8x, we believe valuations are overstating the bear case for the stock. Additionally, relative to U.S. industrials, Manpower’s stock is trading at the low end of its 20-year historical average across several valuation metrics.
The sell-off to close out 2018 and the subsequent snap back to start this year highlight the uncertainty about where the economy goes from here. While we could make equally compelling arguments for a continued expansion or a global slowdown, we believe our energy is better spent identifying companies where future downside appears to already be priced into the stocks.
For example, we’ve taken advantage of weakness in the Consumer Discretionary space over the last several months and purchased names that have stumbled, as shown below, due to a tepid outlook for the economy.
Opportunities in Consumer Discretionary
Source: Bloomberg L.P. and Heartland Advisors, Inc., 12/31/2014 to 3/29/2019
Portfolio holdings are subject to change. Current and future holdings are subject to risk.
Past performance does not guarantee future prices.
While broad indices could continue their bumpy ride for the next several quarters, we believe there will be ample opportunities for individual companies to distinguish themselves in the eyes of investors. This dynamic should benefit active investors who focus on fundamentals and identifying catalysts for positive change.
Thank you for the opportunity to manage your capital.