The year closed with the major indices buckling under the weight of “what if?” During the period, employment remained relatively strong, economic forecasts pointed to continued expansion, and manufacturing activity maintained its solid footing. Yet investors fled as they wrestled with the potential impact of ongoing macro concerns.
Among the sources of concern were trade tensions with China, rising interest rates, and slowing earnings growth. The result was a widespread selloff, with economically sensitive areas under the most pressure.
As the pessimistic tone gained strength, investors late in the quarter showed a tentative interest in balance sheet strength. The new scrutiny of debt levels is prudent, in our view, and due to aggressive corporate borrowing over the past decade, as shown, could have a meaningful impact on share performance for levered companies.
S&P 500 Index
Total Debt/ LTM EBITDA
Source: Cornerstone Macro LP and Standard & Poor’s, 12/31/1996 to 12/31/2018
Last twelve months (LTM); Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
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Holdings in Energy and Health Care held up on a relative basis but couldn’t overcome weakness in Financials and Consumer Staples and the portfolio lagged its benchmark, the Russell 2000® Value Index. Allocation decisions also hampered results.
While selling was widespread with all 11 sectors of the Russell 2000® Value down for the quarter, Utilities fared somewhat better as investors sought safety and less volatile earnings. Due to rate regulations under which most utilities operate, the group can be a challenging area to find compelling opportunities for margin expansion. However, we have still been able to find some attractive opportunities such as Portland General Electric Company (POR) by focusing on balance sheet strength of power companies that operate in growth markets.
Portland General, which provides electric and gas service to Oregon, was up after reporting better than expected earnings for its most recent quarter. Results were aided by a favorable legal settlement the previous quarter that led to an additional influx of cash. Management used the windfall to pay down debt and further bolster an already strong balance sheet.
We believe Oregon is a burgeoning manufacturing and data industries region, which should lead to net growth in power demand versus projections of flat or negative demand nationally. Despite its financial strength and positive growth outlook, Portland Electric trades at 8x enterprise value/earnings before interest, taxes, depreciation and amortization—well below its peer range of 10x-11x.
The portfolio’s Industrials names were down for the quarter but held up better than those in the benchmark, and we remain confident in our names in the space. For example, Powell Industries, Inc. (POWL), a manufacturer of complex power management systems continues to show promise.
The Houston-based company reported results that beat analysts’ expectations, but shares sold off as orders were weaker than anticipated. However, management indicated that bookings for the first quarter were robust and on pace to meet or exceed projections. We expect the positive revenue trend will continue as major petrochemical, oil and gas, liquefied natural gas, and other power-intensive industrial projects commence in 2019 and 2020.
Despite the improving market for its products, Powell remains undervalued in our view. At 1x tangible book value, its shares are trading well below their 10-year average of 1.6x.
Fallout in Financials.
An underweight to and selection in Financials hurt results. We’ve sought to take advantage of weakness in the sector by adding to positions where we believe investors have overreacted to temporary setbacks for otherwise solid companies. Hanover Insurance Group, Inc. (THG) is an example of this approach.
Shares of Hanover, a specialty property and casualty insurer, were down despite the company reporting solid earnings for the quarter excluding the results from its recently divested specialty international business, Chaucer. Going forward, we expect improved profitability, higher premium growth profile, and a higher return on equity. In addition, the transaction should add to tangible book value and allow the business to increase its dividend payout and potentially repurchase shares.
We remain confident that while the pace of earnings growth may slow in 2019, underlying economic fundamentals remain relatively solid. However, we also recognize that until there is a resolution to some of the macro questions that are concerning investors, volatility and selling pressure may persist for many businesses. Our response has been to take advantage of excessive market reactions and put money to work as valuations warrant.
For example, we have added to a handful of our Financials holdings. As the economic outlook has become less clear, sentiment towards the group has cooled. As a result, valuations based on tangible book value (TBV) have dropped by as much as 40%. At 1.5x TBV, banks are trading more in line with a recessionary backdrop. This view, in our opinion, is overly pessimistic and valuations are not reflective of our estimates of the underlying intrinsic value of these businesses.
While we have added to some positions, we have also acted decisively to eliminate holdings when management teams have made what we view as ill-advised acquisitions or expenditures that have negatively impacted balance sheet strength.
Economic data continues to reflect a healthy, albeit slightly decelerating, economy. A focus on hard data as opposed to the latest speculation about the impact of trade wars and rising interest rates reveals a backdrop where corporate earnings are up, unemployment is at lows not seen in more than a decade, and manufacturing activity remains relatively strong. However, we acknowledge the pace of growth is likely to slow in the months ahead, and so we are focused on owning businesses that:
Have strong or improving balance sheets
Are well positioned to expand operating margins through self-help initiatives and idiosyncratic catalysts
Are generating strong free cash flows, and
We continue to believe businesses that demonstrate financial discipline and that have opportunities to reduce costs and improve margins through internally focused efforts should be well-positioned to capitalize on operating leverage in an expanding economy or modestly grow earnings should sales plateau.
Thank you for the opportunity to manage your capital.