The major indices charged higher as investors responded to the rollout of two COVID-19 vaccines and assurances by the Federal Reserve that it would continue to pump money into the economy for the foreseeable future. The developments were widely viewed as an all clear to bid up large growth companies and many debt-laden businesses based on the belief that they could grow their way out of problems posed by shaky balance sheets.
The prevailing sense that the Federal Reserve would backstop even the weakest businesses continues a trend that has been in place for most of the second half of the year and has led investors to riskier names in the market. Traditional safety nets, such as strong balance sheets or attractive valuations, were an afterthought and reasonably priced businesses lagged.
While Wall Street showed a willingness to look past debt levels, signs emerged that the torrent of currency flooding the economy as a results of government and Federal Reserve policy was beginning to cause a ripple in the price of raw materials used in manufacturing, as the chart below shows. If inflation takes root, many of the richly valued businesses with rosy growth forecasts could see their profit margins shrink as they struggle to pass along rising input costs.
Budding Inflation Pressures?
Source: Bloomberg L.P., 12/31/2015 to 12/31/2020 Raw industrials are represented by the Commodities Research Bureau BLS US Spot Index Raw Industrials Subdivision. Past performance does not guarantee future results.
The portfolio finished the year meaningfully ahead of its benchmark, the Russell 2000® Value Index. For the quarter, the strategy was up more than 25%, however, holdings in Industrials and Consumer Staples failed to keep pace, and the portfolio lagged the benchmark during the period.
The flood of liquidity injected into the market along with historically low interest rates, in our view, has lulled investors into a false sense of security when it comes to betting on elevated growth projections and has papered over the potential risk of owning debt-laden companies.
The portfolio’s Health Care names were up on a relative and absolute basis and the group contained a contributor, Phibro Animal Health Corp. (PAHC), an animal health and mineral nutrition company that produces vaccines, microbial products, and medicated feed additives.
Shares of Phibro were up after reporting better than expected earnings in November. We anticipate the company should continue to see healthy gains in free cash flow generation in 2021, as it begins to reap the benefits of investments made in 2020.
Additionally, Phibro has seen growing demand for its products as animal production has rebounded following a slowdown in the meat packing industry due to COVID-19. Despite the favorable outlook for the company, shares trade at 9x estimates of 2021 enterprise value/earnings before interest, depreciation and amortization (EV/EBITDA).
Good advice? Stock selection in Financials was strong, and the portfolio’s holdings in the space outperformed the average for those in the benchmark. With rates expected to be historically low for the foreseeable future, we have found the Banking Industry to be largely undifferentiated. In response, the team continues to focus on identifying standout institutions that can benefit from management initiatives or grow in a specialized niche. For example, we added to our stake in B. Riley Financial Inc. (RILY), a financial services company offering investment banking, corporate finance, securities lending, and wealth management services, amongst other businesses.
The diversified company has grown its EBITDA to well over $200 million as demand for its investment banking, capital raising, and investment advisory services has been strong throughout COVID-19. In the quarters ahead, we expect this little-followed company will catch the attention of more investors as it continues to grow recurring earnings.
Despite its success, the company is trading at only 4x EV/Core Operating EBITDA. As attention grows for B. Riley, we believe this multiple will grow.
As bottom-up stock pickers, we continue to focus on individual companies and their ability to succeed in a variety of scenarios. However, we also recognize that any unforeseen economic headwinds could be particularly damaging to highly levered companies.
As such, our work remains centered on balance sheet strength and prudent use of capital, and we seek to avoid companies that undertake large-scale transformative acquisitions. Instead, we prefer businesses that are involved in selling off noncore, underperforming business lines or those that have the financial wherewithal to opportunistically make small-scale, bolt-on purchases that further enhance core competencies.
Outlook and Positioning
The consensus economic outlook is more optimistic than it has been in the recent past and has resulted in investors excusing shaky fundamentals of individual companies in hopes that a rising tide will lift all boats.
The willingness to overlook idiosyncratic challenges is misguided, in our view. While the outlook has improved given the development of COVID-19 vaccines, the speed and degree to which they will translate into sustainable economic growth is still unknown. Instead of a quick end to the global pandemic, we believe the impact of the virus is likely to linger for several quarters, if not years. Additional Government stimulus may offer a temporary reprieve to the immediate effects of cratering production and demand, but we expect the long-term expansion to be tepid.
Many investors have interpreted government intervention as a potential safety net providing an opportunity to load up on shares of companies with shaky balance sheets, operating in declining industries or those with questionable capital allocation strategies. We view it as a dangerous precedent that may lead to a sharp reversal in fortunes for overvalued businesses when the government spigot is finally turned off.
As such, we are taking a long-term view by investing in businesses that may be well positioned to drive free cash flow growth and those with the financial strength and pricing power necessary to potentially weather the long-term uncertainty caused by the pandemic. We believe this approach can produce a portfolio of companies that should have enduring strength for the long haul.
Thank you for the opportunity to manage your capital.