Commentary – 4th Quarter 2019

Performance

For the quarter ended December 31, 2019, the Mid Cap Dividend Value Strategy rose 7.37% gross (7.21% net of fees) compared with a 6.36% gain for the Russell Mid Cap Value Index. For the full-year 2019, the Strategy was up 26.06% gross (25.24% net of fees) compared with a 27.06% gain for the benchmark.

Macroeconomic Review

After limping into the end of 2018, the market bounced back in the first quarter and never looked back. As measured by the S&P 500 Index (or any other Index for that matter), the market rose in all four quarters, historically the market has had this outcome in almost 30% of past calendar years. The S&P 500’s full-year total return of more than 31% is its 11th best year since 1940. By these metrics, the end of the second decade of this millennium was exceptional for the stock market.

The fourth quarter helped drive these strong gains with a 9.1% total return for the S&P 500 Index. A combination of better economic readings and progress in reaching a trade deal with China drove performance, as it did for much of the year, Growth outperformed Value and for the first time since the second quarter of 2018, small-caps outperformed large-caps, although it was only by 10bps. Mid-caps lagged, interest-sensitive sectors like REITs and Utilities underperformed. Non-dividend paying stocks significantly outperformed dividend-paying stocks.

A year ago, the debate in the market revolved around the potential impact from the government shutdown, an escalating trade war with China, and whether the Fed had gone too far (or would go too far) in raising rates. While the government shutdown ended up being the longest on record, it did not seem to have much short-term impact on the economy and certainly did not throw the US into a recession. The trade dispute with China probably did slow economic growth, but the general perception of progress in resolving this dispute dampened the impact. Furthermore, the progress made in the fourth quarter which culminated in the announcement of a “Phase One” deal likely contributed heavily to fourth quarter gains. The question about the Fed raising interest rates was answered early in 2019 when it signaled that it would be on hold. This concern was put to rest in the middle of the year when it cut rates for the first of what would be three rate cuts.

The future course of the US economy is likely to have a big impact on the markets. After negative growth readings from September 2008 through June 2009, the US posted positive growth in the third quarter of 2009 to start the recovery/expansion. While there have been some negative quarters since, they have not been consecutive and so the economy has not fallen into the definition of a recession. This is now the longest period of expansion since the government started keeping reliable records. With unemployment near historic lows, investors have wondered how much longer the expansion can continue. We think the economy is stable and should continue to grow. While this expansion has been long in duration, the slope of it has lagged most other recoveries, there should be room for continued growth. We are not seeing some of the cost pressures that typically arise when the economy is at an advanced stage in the expansion. The most worrisome is labor costs, but growth in the labor force participation rate seems to be offsetting much of the wage pressure that generally comes from a low unemployment rate. Commodity costs are up some from a year ago, but not much changed over the last five years. Finally, economies outside the US seem to be seeing better prospects. All in all, the economy looks okay, although not robust.

Portfolio Results

For the second quarter in a row, the Mid Cap Dividend Value Strategy outperformed its benchmark. This came after lagging the Russell Midcap Value Index in the first half, but it was not quite enough to get the Strategy ahead for the year. Nonetheless, a mid-twenties total return should help shareholders to achieve their long-term financial goals.

When we disaggregate relative performance into the components of Sector Allocation and Stock Selection, we find that Allocation was a slight detractor and Selection added to relative performance. The under-contribution from Sector Allocation was mostly due to a slight underweight in the strong-performing Technology sector and a little due to the Strategy’s small (2%) cash position.

Within Stock Selection, the Strategy outperformed in six sectors, lagged in four, and one was about even. The sectors that contributed most to relative performance were Real Estate, Industrials, Utilities, and Consumer Discretionary. The sectors that detracted most were Technology, Communication Services, and Energy. It is interesting that these were the three strongest sectors within the Index with each posting a gain of more than 10% for the quarter.

The Real Estate sector was the worst-performing sector in the Index with a slight negative return during the fourth quarter. The Strategy’s holdings, however, generated positive total returns driven by double-digit gains in Hudson Pacific Properties, VICI Properties, and Lamar Advertising. All reported solid third quarter financial results.

Mid-cap industrials stocks performed very well during the quarter, but the Strategy’s holdings performed even better. The Strategy held two stocks that appreciated more than 20% during the fourth quarter and another three that were up more than 10%. The best of these, OshKosh Corporation, will be discussed later in this report. The other thing that helped performance was that only one of the Strategy’s nine Industrials holdings declined (GrafTech) and only two lagged the Russell Midcap Value Index.

The Utilities sector was the other sector that declined during the quarter, but the Strategy’s holdings eked out a gain. This was mostly due to a 15% gain in the shares of PPL Corporation. With about 30% of its profits coming from the UK, the emerging clarity on Brexit helped the shares. In addition, PPL was the subject of potential takeover speculation during the quarter.

The Technology sector was the biggest detractor from relative performance for the Strategy. The Strategy was underweight largely because several of its holdings were acquired during the year and we had not found suitable replacements. In addition, while all of the Strategy’s holdings appreciated during the quarter, they did not measure up to the 11.5% return generated by the Technology sector within the benchmark.

The Communications Services sector is a small one and the Strategy holds only two stock in the sector. One of these, Nexstar Media, performed very well while the other, Cinemark Holdings, was the Strategy’s largest detractor during the quarter. We discuss it further in the next section.

Energy was also one of the best-performing sectors in the market, but the Strategy’s holdings did not keep up. While a 13% gain in the price of crude drove a strong gain in Parsley Energy, the 6% decline in natural gas led to sluggish performance in Cabot Oil & Gas and EQT. In addition, refiner Delek fell on concerns about narrowing crude spreads.

Leading Contributors

OshKosh Corporation (OSK) is a leading manufacturer of specialty trucks for commercial and government uses. Its shares rose sharply on the heels of solid calendar third quarter earnings. More important than the third quarter results was the outlook the company provided for its fiscal year 2020. This was generally in line with expectations and much better than investors had feared. The Street had become concerned about an expected soft patch for the company’s Access Equipment (scissor lifts, telehandlers) segment. It seems at this point that this softness will be manageable within the overall results of the company.

Cigna Corporation (CI) is one of the largest healthcare insurance and management companies.  Cigna shares rebounded nicely during the fourth quarter.  In the third quarter, shares of Cigna and other health insurers came under pressure owing to the rise in the polls of one Democratic presidential candidate who had expressed a desire to eliminate much, if not all, of the health insurance industry by championing so-called “Medicare for All” legislation.  That candidate’s polling sagged during the fourth quarter, spurring an industrywide rally.  In addition to favorable industrywide trends, Cigna reported strong third-quarter earnings at the end of October, raised its full-year guidance and demonstrated growth in its recently acquired pharmacy benefit manager (PBM) business.  Also, Cigna made clear that the firm remains on track to hit its long-stated earnings targets for 2021 that the company laid out back when it announced the acquisition of Express Scripts in early 2018.

Air Lease Corporation (AL) is one of the fastest-growing commercial aircraft leasing companies.  Air Lease was a strong contributor in the quarter as its strong business model was unphased by the prolonged 737MAX grounding and continued low-cost carrier bankruptcies.  High demand for aircraft, exacerbated by the 737MAX situation and Airbus production delays, has led to higher lease rates, higher used plane values and easy placement of planes taken back from bankruptcies.  The company remains attractive as it is still trading below book value.

Leading Detractors

Cinemark Holdings (CNK) is one of the largest operators of movie theaters in the United States and has significant operations in South America. Its share price fell in the fourth quarter due to a subpar earnings release for the third quarter that was driven by an excessively concentrated slate of summer blockbuster films.  Cinemark’s profitability is driven in part by film rental expense – the cost to rent movies from studios that Cinemark then exhibits in its theaters.  In the third quarter, the company had an historically unprecedented level of concentration of popular films.  That resulted in unusually high film rental expense, which pressured profitability.  While shares rebounded some in late November and early December, they also were pressured by some investor concerns over the low number of obvious blockbusters in the box-office lineup for 2020. 

GrafTech International (EAF) is one of the leading producers of graphite electrodes used in electric arc furnaces to make steel. GrafTech has so far not lived up to our expectations as the company continues to work through a set of issues from higher channel inventories driving spot electrode prices lower, higher prices for key raw ingredient petroleum needle coke, and general economic worries.  GrafTech is better insulated from the increased needle coke costs due to its captive supply covering roughly 2/3 of production, but the lower spot prices for electrodes raises concerns about the stability of GrafTech’s long-term fixed priced sales agreements.  Currently, spot prices are above contract prices, but the concerns remain if that relationship inverts. Shares received a boost late in the quarter as it was speculated that GrafTech might be an acquisition target given its cheap valuation (under 5x 2020 P/E and 5x 2020 EV/EBITDA) but instead its controlling shareholder Brookfield announced a secondary offering, further pressuring shares.  Partially offsetting this was the company announcing a $250 million stock buyback in conjunction with Brookfield’s secondary. We anticipate additional repurchases by GrafTech given its strong cash flow characteristics and managements stated targets of returning 50% to 60% of free cash flow to shareholders. The concerns surrounding electrode spot prices should subside as the industry works through channel inventories throughout 2020.

EPR Properties (EPR) is a real estate investment trust (REIT) that owns entertainment-oriented properties such as movie theaters, driving ranges, and waterparks, in addition to charter schools. Triple-net REITs have a defensive component to them, and starting in late October, investors broadly rotated toward more cyclical stocks and away from more defensive ones.  That rotation was fueled by several factors, including reports at the time of a preliminary trade deal with China and a Federal Reserve Board that had signaled no changes to interest rates.  Also, in late November, EPR announced the sale of its charter schools segment and the eventual redeployment of those proceeds into other assets.  That sale and redeployment prompted reductions in analyst earnings estimates for EPR for 2020, as the dilution from the asset sale is more predictable than the eventual accretion from new asset purchases.

Outlook

Whatever the outcome of the upcoming Presidential election, 2020 promises to be an interesting year. It is also likely to be a year in which the parts of the stock market in which we traffic (small- and mid-cap value) do relatively better. We have talked in past letters about the relative attractiveness of small-caps vs. large-caps and value stocks vs. growth stocks. This did not help again in 2019, but we believe it will eventually work.

An interesting observation we have that many people do not talk about is the outperformance of value stocks in Presidential election years. In fact, since 1980, the Russell 2000 Value Index has outperformed the Russell 2000 Growth Index in all Presidential election years, value beat growth in eight of the ten Presidential election years. In addition, small-caps beat large caps in seven of the ten election years. While streaks are broken all the time (UNC basketball recently lost to Clemson at home after 59 consecutive wins!), the combination of relative valuation and history makes us optimistic about the year ahead, at least from a relative perspective.

In conclusion, thank you for your investment in the Mid Cap Dividend Value Strategy. We will continue to work hard to justify your confidence and trust.