Commentary – 4th Quarter 2018

Performance

For the quarter ended December 31, 2018, The Mid Cap Dividend Value Strategy fell 15.30% gross (-15.46% net of fees) compared with a -14.95% decline for the Russell Mid Cap Value Index. For the full-year 2018, the Strategy was down 11.20% gross (-11.83% net of fees) compared with a -12.29% loss for the benchmark.

Macroeconomic Review

2018 was a year of extremes. January was the best start to the year since 1997 for the S&P 500. After a correction in early February, the market churned its way higher to record ten new all-time highs, the last coming in September. It was downhill from there. Starting in late September, the market declined for most of the fourth quarter with the low for the quarter and year coming on Christmas Eve. The worst quarter in more than seven years closed out the worst year in the last ten. Midcap stocks and value stocks performed worse than large-cap and growth stocks for the year, although value outperformed growth for the fourth quarter.

Both the early-year strength and the late-year weakness arose from developments in Washington DC, which changed investor perception of the economic outlook, without any really change to economic conditions and results. The strength of the market early in 2018 was driven by enthusiasm for the Tax Cuts and Jobs Act, which President Trump signed on December 22, 2017. As part of a larger tax reform initiative, corporate income taxes were lowered for the first time since 1993. For most US companies, this created an immediate boost to earnings and cash flow. Furthermore, the additional earnings could be reinvested to fuel economic growth, which could lead to even more earnings. With the economic cycle having surpassed a “normal” duration, it was hoped that the tax reform act could extend growth for another several years.

Just as in the January/February timeframe, the correction in the fourth quarter came after President Trump ratcheted up the probability that the United States would engage in a trade war with one or more foreign countries. In the earlier version, almost all of the US’s important trading partners were targeted as the President proposed tariffs on a wide variety of goods coming from Europe, North America, and China. Some compromises with Europe and the USMCA (United States-Mexico-Canada Agreement, the New NAFTA) seems to have resolved issues with many of these parties, but the US/China trade war continued to simmer.

It became more serious in September when US tariffs of 10% on $200 billion of Chinese goods and Chinese tariffs on $60 billion of US exports went into effect. These measures combined with higher interest rates and slowing growth outside of the US have taken a toll on confidence. Consumer confidence in the US has fallen from its October highs and CEO confidence, as measured by the Conference Board, fell to its lowest level since 2012. The ISM Purchasing Managers indices also retreated during the fourth quarter.

So far, actual economic results have not mirrored the sentiment data. The latest jobs report showed a stunning 310,000 new jobs created during December. Furthermore, although the International Monetary Fund (IMF) recently lowered its forecast for global growth from 3.7% to 3.5% and several major banks have downgraded their 2019 forecasts in recent months, none predict a global recession is on the horizon. We would generally concur with this view. Overall, we think that the economy will continue to muddle along. A couple of factors make this view a little more uncertain than usual. First, we assume that calmer heads will prevail in the trade standoff and that this issue will not escalate. If we are wrong about that, the economy will likely perform worse. Second, we assume that the government shutdown will be resolved before it damages the economic outlook. The longer it drags out, the riskier this underlying assumption becomes.

The Strategy performed slightly worse than its benchmark this quarter. This was disappointing to us, as the Strategy has typically performed better than the benchmark during down quarters. Furthermore, dividend-paying stocks outperformed non-dividend-paying stocks.

From an overall portfolio standpoint, the Strategy’s tilt toward companies that benefit from higher rates hurt performance in a couple interest rate-sensitive sectors. In the Financials sector (the largest exposure in the Strategy), we own banks that earn more money in a higher rate environment. The Strategy has also been overweight life insurance companies, which also benefit from higher rates. With concerns growing about a slower economy, long-term interest rates declined during the quarter and these stocks lagged. The decline in rates also contributed to underperformance in Real Estate. We have been working to reign in this exposure as it appears that the Fed is most of the way through its tightening campaign.

When we disaggregate performance between sector allocation and stock selection, we see that allocation helped, while selection hurt. The lion’s share of the allocation benefit came from cash holdings. These are not large, but the decline in the market was relatively large so they had an impact. A slight overweight in Utilities and a slight underweight in Energy (which was down 35% as a sector) also helped. The Strategy’s holdings in Energy, Health Care, and Utilities outperformed those within the benchmark, while the Strategy’s holdings in Industrials, Financials, Technology, Consumer Staples, and Consumer Discretionary lagged.

Within the positive sectors, Energy was the largest positive contributor. The Strategy’s holdings in exploration and production (E&P) companies with more gas exposure appreciated whereas the sector itself was the worst-performing sector in the index.

The Strategy also added value in the Health Care sector as four out of five of the Strategy’s holdings performed better than the overall sector. The lack of any Biotechnology or Pharmaceutical exposure helped and the Strategy’s stocks outperformed other stocks within the sector.

Although Utilities, was the best-performing sector in the index, it still declined in absolute terms. Five of the Strategy’s nine holdings appreciated during the quarter contributing to outperformance led by an 8.5% gain in OG&E Energy (discussed below).

Industrials topped the losing side of the ledger. Only one of the Strategy’s ten holdings was up in the quarter and four were down more than 30%. We exited one of these four, maintained our holdings in one, and adding to two. We believe the weakness in BWX Technology was overdone and think the fundamentals at Air Lease and GrafTech remain solid, in contrast to the weakness shown in their share prices.

The Financials sector was the second largest detractor. As we stated before, weakness in banks and life insurance company stocks drove weakness in the sector for the Strategy. We think the fundamentals have not changed much and estimates continue to look reasonable. At this point, Financials are one of the cheapest sectors of the market. The average P/E (based on forward four quarters earnings) for the financials stocks in the Strategy was 8.8x at year-end.

In the Technology sector, two of the Strategy’s technology services stocks, DXC Technology and Perspecta dragged down performance. At DXC, revenue softness in the September quarter offset earnings gains in investors’ minds. Perspecta’s shares fell on concerns about how a potential (now actual) government shutdown might impact financial results because it derives almost all its revenues from government contracts.

In the Real Estate sector, in addition to the interest-rate impact mentioned above, the Strategy’s holding in Sabra Health Care REIT hurt performance. Through a recent acquisition, the company acquired some struggling tenants that have proved to be more disruptive than expected. Sabra has made a great deal of progress in resolving these issues.

Leading Contributors

Lamb Weston Holdings (LW) is one of the largest producers of frozen potato food products (French fries and other starchy goodness). Through both solid demand, particularly from North American quick-service restaurants (QSRs), and steady price increases, Lamb Weston has continued to exceed consensus expectations, and the company did so again at the start of the fourth quarter.  Despite the market downturn later in the fourth quarter, Lamb Weston shares held up nicely throughout the entire quarter, driven by investors’ belief that the underlying dynamics facing the company remained favorable.  In addition, some U.S. QSRs, like McDonald’s, reported good earnings and impressive same-store sales numbers during the quarter.

Foot Locker (FL) is the largest footwear specialty retailer. Driven by an ongoing turnaround at Nike and improved store traffic trends, Foot Locker posted better than expected earnings during the fourth quarter that were underpinned by its best same-store sales growth in seven quarters.  Foot Locker also telegraphed better same-store sales from here, guiding to likely higher same-store sales in the next quarter, and announced that two laggards within the company – basketball shoes and its European operations – have seen improved performance.  Investors anticipated a better report from Foot Locker, prompting shares to rally even before the company released its earnings report in the middle of the quarter. 

OGE Energy (OGE) OGE Energy is a utility holding company that produces electricity in Oklahoma and Western Arkansas and is a general partner in publicly traded master limited partnership Enable Midstream Partners (ENBL).  The company produced a very good quarter that exceed consensus earnings estimates and allowed management to increase full year guidance. Earnings contribution from the Utility segment increased due to better weather and customer growth while Enable’s earnings contribution increased due to record processing and gathering volumes. It also appears that the underlying regulatory environment has improved which helped close the valuation gap to peers./p>

Leading Detractors

SM Energy (SM) is a mid-sized oil and gas exploration and production company with most of its core operations in the Permian Basin in Texas. While the company continues to generate solid production growth and third quarter financial results were in line with expectations, SM lowered its forward outlook slightly due to storm-related disruption in its operating schedule. The bigger impact in the quarter was the steep drop in oil prices. Crude fell from about $73 per barrel at the end of September to about $46 at year-end. This increases investor concern about SM’s debt level and its ability to operate on a cash-flow neutral basis in 2019.

DXC Technology (DXC) is one of the world’s largest providers of information technology services. While the company continued to report solid earnings gains that exceeded investor expectations, revenue growth continues to struggle. DXC reported lackluster bookings trends over the last few quarters leading investors to question whether the company will be able to improve the revenue trajectory. This slowdown has come as DXC moved deeper into its integration and cost-cutting program raising concerns about the sustainability of earnings growth.

Air Lease Corporation (AL) Air Lease Corporation (AL) is one of the leading aircraft leasing companies purchasing new commercial aircraft directly from manufacturers and leasing those aircraft to airlines worldwide at attractive returns on equity.  The stock has acted poorly during the quarter due to investor concerns regarding the impact of higher interest rates on the company’s leasing spreads as well as its exposure to emerging markets. The long lead times in ordering commercial aircraft offset these issues, as Air Lease does not lock in the lease rate until it delivers the plane and it is very easy to place planes from order termination or early lease termination given the high demand.  There were a few emerging market airlines that filed for bankruptcy and the aircraft lessors easily re-leased these aircraft given the increasing demand for air travel from the growing middle class.

Outlook

As we look ahead, we are more optimistic about the outlook for the stock market than usual. If both sticking points mentioned above are resolved favorably, the market could do well. Valuations were more attractive at year-end than they have been in a long time. The S&P 500 traded at 14.4x forward EPS, the lowest point since late 2013 and below its 15.7x average since 1999. For mid cap stocks, the valuation story is even more compelling. The Russell MidCap trades at 14.3x forward EPS, the lowest point since early 2013 and below the long-term (since 1999) average of 15.8x. Mid cap value stocks are even more interesting with a forward P/E of 12.3x for the Russell MidCap Value index. This compares with a long-term average of 14.1x. If investors come to believe that deterioration in economic growth will not undermine company earnings, stocks look undervalued.

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.