Put simply, this was a frustrating quarter, as our style of value investing fell out of favor. On paper, we looked as daft in recent months as we seemed smart last year. Investors turned their backs on the types of companies we embrace — well-managed businesses with strong balance sheets and consistent free cash flow to self-finance their growth and raise dividends over time.
As recently as March, investors coveted such businesses when the banking crisis left investors scrambling for financially strong companies earlier in the year. Yet investors’ appetite for risk taking returned in a big way over the past three months, thanks to a new narrative taking hold. According to this new line of thinking, the Federal Reserve may not only be done tightening, they may actually be close to cutting rates shortly. It isn’t surprising, then, that speculative, low-quality stocks outperformed in recent weeks, since those types of equities led in the previous easing cycles.
Underlying this narrative is the hope that the Federal Reserve has threaded the proverbial needle and is about to engineer a quick takeoff for the economy after achieving a ‘soft landing.’ Never mind the fact that if this is true, the yield curve would likely begin to ‘uninvert’, and stocks have struggled historically in those moments.
Source: Bloomberg, daily data from 1/3/2000 to 6/28/2023. This chart represents the Russell 2000® versus the 2 to 10 Year US Treasury Yield Curve and how the market generally falls significantly as the 2 to 10 Year Curve ‘uninverts.’ All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Right now, the markets are embracing this narrative hook, line, and sinker. While we don’t view this as an impossibility, the chances of this occurring seem slim. By contrast, we think there is a high likelihood of some form of stagflation weighing on the economy going forward, and we continue to position our Strategy for that scenario.
We believe it’s risky to bank on a rising tide keeping ships afloat. Balance sheet strength and the ability to self-finance organic growth remain important attributes, especially in the small-cap space as banks are tightening their lending standards in this challenging economy. As we’ve noted before, credit stress typically shows up as the Federal Reserve raises rates, and we’re already seeing that with an uptick in leveraged loan pricing and defaults.
No matter what narrative the market is buying at the moment, economic realities continue to shine a spotlight on financially sound, well-run businesses with sound strategies, which are traits rooted in our 10 Principles of Value Investing™.
Attribution Analysis & Portfolio Activity
The second quarter was a challenging period for value investors in general. With the yield curve as inverted as it is — 2-year Treasuries are yielding 4.87% versus 3.81% for 10-year notes — the bond market is bracing for a recession. Historically, when earnings growth is hard to come by, investors tend to gravitate to the few parts of the market that are growing, even if they have to pay a premium, putting value at a disadvantage.
Our brand of value investing was hit even harder. Our Strategy was down slightly for the quarter, -0.08%, versus 3.18% for the Russell 2000® Value Index, as factors we gravitate toward — such as low volatility, low leverage, and dividends — didn’t work. And while our stock selection has been a leading driver of our performance over the long run, our selection effect was negative in the quarter as the market moved away from high-quality names with strong balance sheets.
We underperformed in several sectors including Health Care, Materials, and Information Technology. But we outperformed the benchmark in Consumer Staples, Real Estate, and Industrials, where our stock selection added positive value.
An example in industrials is Healthcare Services Group (HCSG), the leading provider of housekeeping and culinary services to skilled nursing facilities. As those healthcare providers scale, it makes sense for them to outsource ancillary services, yet currently only around 30% of skilled nursing facilities do so.
The stock has come under pressure in recent years, as occupancy levels at their clients’ facilities plummeted during the global pandemic. Meanwhile, inflation in the aftermath of the pandemic disadvantaged HCSG’s contract pricing, meaning they were taking a hit on both revenues and costs. We believe those headwinds have abated. Not only is occupancy improving, the company’s two-year self-help strategy of renegotiating all contracts with all customers to include more dynamic pricing is finally starting to pay off. The company’s EBITDA margins fell to 4-4.5%, but our projections show that improving to +6% this year and +7% in 2024 on their way to a target of 10%.
Today, the stock trades at 0.6 times enterprise value to sales. Yet when it was at this level of profitability in the past, the stock has traditionally traded at 1.5 times EV/Sales.
With more credit stress to come in this slow-growing economy, now is the time to be patient and not be distracted by all the bright and shiny objects that received the lion’s share of attention in the second quarter. It’s also more important than ever to have conviction on the companies we own. This means doing the work to confirm the financial strength of every company under consideration, while making sure that each company’s self-help strategies remain intact and compelling.
Whether other investors choose to ignore it is not our concern. Our job is to keep our eyes on the long-term prize by identifying well-managed companies trading at attractive prices to their intrinsic value. We hold many such names that are currently flying under the market’s radar. We see them as small kernels ready to pop. That may not happen in the coming weeks or months. But our goal isn’t to win the quarter; it’s ensuring that our portfolio is going to outperform in the long run.