In the third quarter, equity markets were highly volatile with a strong summer rally followed by a dramatic decline. In addition to the continuing war in Ukraine and supply chain bottlenecks, another negative was the Federal Reserve’s more hawkish stance.
The Fed set a record by increasing rates +75 basis points for the third time this year and telegraphed its intent to keep hiking aggressively to combat inflation. All this, in the face of a dramatic decline in CEO confidence, an inverted yield curve, and long-term mortgage rates doubling to over 6%. The result: economic activity has slowed, fears over a Fed-induced deep recession have risen, and equity valuations have come down markedly.
As the playwright Arthur Miller noted, eras only come to an end when its myths are extinguished. Well, the speculative mindset, fueled by a decade of “easy money” that led many equity investors to turn a blind eye toward valuations and leverage, seems to be over. As the chart below shows, the percentage of companies expected to see improving earnings over the next year is likely to be extremely low.
Source: Piper Sandler Portfolio Strategy, Monthly data 12/31/1985 to 9/30/2022. The data in this chart represents the S&P 500 Positive Earnings Revisions (% of total) being led by The 2 Year Change in Basis Points Of The 10 yr. Yield. IBES Aggregates S&P 500 Analyst Earnings Revisions (Up – Down / Total), and Bloomberg US Generic 10 Yr Yield (USGG10YR In Bloomberg). Higher interest rates lead to fewer positive earnings revisions from sell side analysts. All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results. There is no guarantee that a particular investment strategy will be successful.
Advantage: Value
In our opinion, this is precisely the time to be an active, selective investor. We also believe this is a backdrop in which value, after being out of favor for many years, can continue to outperform. Year-to-date, the Russell 2000 Value® Index is off 21%, while the Russell 2000 Growth® is down 29%. The valuation disparity between value stocks and growth/momentum favorites has narrowed, and with higher interest rates likely to compress further.
Patient investors should be rewarded for owning high quality assets with balance sheet strength and low price-to-earnings. But remaining disciplined will be key, as a combination of materially lower earnings estimates and stock prices will likely be needed to improve the risk-return profile of many companies on our research “watch list.”
Attribution Analysis
The Long Game in Energy. This is not to say that we weren’t buyers in the quarter. Where opportunities presented themselves, we initiated and added to positions as appropriate.
In the third quarter, recession-related concerns weighed on crude oil as the price sank from $110/barrel to $80 at quarter’s end, causing the energy sector rally to wane. But there seems to be a longer-term trend at play. Traditional oil and gas spending peaked in 2014, and since then, multiple forces—including fears over peak oil demand, the rise of ESG focus, and capital discipline by producers—have delayed an upcycle in traditional oil and gas spending.
Post COVID-19, the demand for oil has been strong, expected to exceed 100 million barrels a day. Our sense is that energy service-related companies have entered the early innings of a positive earnings revision cycle, a rarity in the markets. To take advantage of this, we own NOV, Inc. (NOV), a leading oilfield services company that provides technical expertise, advanced equipment, and operational support for the oil and gas industry. NOV generated $4.6B in EBITDA in 2014, but just $230M last year, which speaks to the under investment in the broader energy patch. NOV’s outlook continues to improve though, as the company is now forecasted to produce over $600M and nearly $900M in 2022 and 2023, respectively. Interestingly, estimates are up ~10% since the start of the year and maintain an upward bias.
Being Patient with Healthcare. We continue to have a meaningful allocation to healthcare, but it proved to be a challenging quarter for the sector. Yet we remain patient in situations where we believe investors have overreacted.
Case in point: Patterson Companies (PDCO), a leading distributor of dental and animal health related products, reported first quarter results that included a sequential decline in dental equipment-related sales and price deflation in consumables. The former is in part a hangover from a strong fourth quarter while price deflation is being driven by inventory build-ups during COVID-19. With a healthy 4% dividend yield and attractive valuation, only 11X estimated earnings, we continue to hold Patterson. Notably too, a competitor in the dental space, Henry Schein, Inc., trades at a 1.5x+ premium to PDCO on estimated EBITDA while Covetrus, Inc., an animal health player, was acquired for 14.0x EBITDA in May.
Financial Opportunities. Banks have been buoyed by rising interest rates that offer larger spreads. The question is, ‘How bad will credit get during the current downturn?’
Texas Capital Bancshares (TCBI) is a Dallas-based middle market commercial lender with a particular focus on the four major Texas markets of Dallas-Fort Worth, Houston, San Antonio, and Austin. TCBI is a classic self-help story: Prior management ran the bank as a “growth at all cost” institution. When the bank was small and rates were at historic lows, it was easy to sustain growth by booking new loans and growing deposits regardless of the quality of either relationship. Credit problems began to percolate after the company downgraded several levered loan credits in 2019. Last year, a new CEO was brought in from J.P.Morgan Chase who quickly exited risky loans and reoriented TCBI as a local Texas commercial lender with a niche focus on deep customer relationships.
A position was initiated due to our belief that under new management’s focused strategy, the bank is on the verge of improving its returns and market perception. The stock trades at only 1.1 times tangible book value, compared to 1.8 times for regional banks in general. Granted its return on assets is below the average for peers. In our opinion, over time TCBI will close the return gap with valuations likely to follow suit.
Outlook
Our purchase of TCBI demonstrates the Team’s focus on the margin of safety in all of your investments. This focus requires understanding the fundamentals, both the qualitative and quantitative, through the application of our Ten Principles of Value Investing™. We believe the output from this process produces a portfolio that exhibits balance sheet strength and below market valuations, two attributes that could offer relative downside protection as the markets move on from an era of speculation and irrationality.
We are encouraged by the renewed interest in value investing and the portfolio’s relative performance. Based on valuations, we remain optimistic on the long-term outlook.
Thank you for your continued trust and confidence.
Small Cap Value Composite Valuations
Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 9/30/2022. Price/Earnings and EV/EBITDA are calculated as weighted harmonic average. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Certain outliers may be excluded. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future returns.