Commentary – 1st Quarter 2019
For the quarter ended March 31, 2019, the Mid Cap Dividend Value Strategy rose 13.07% Gross (12.90% net of fees) compared with a 14.37% gain for the Russell Mid Cap Value Index.
The market, as measured by the S&P 500 got off to its best start in the last twenty years and posted its best overall quarter since Q3-2009. The quarter’s 13.6% gain nearly recouped the fourth quarter’s steep drop. The first quarter was the sixth time since 1970 that a quarter with a double-digit loss was followed by a quarter with a double-digit gain.1 In four of the five previous instances of this pattern, the subsequent quarter also saw a double-digit gain. While that is too small a sample size to factor it into one’s outlook, it is an interesting data point.
We think that the bounceback was mostly driven by an easing of the worries that led to the fourth quarter drop. As the fourth quarter progressed, investors became increasingly concerned about the potential that an overshoot on rate increases by the Fed, combined with the impact of trade actions would push the economy into recession. A slight thawing in the rhetoric around trade and clear signals from the Fed that it would at least put its rate tightening campaign on hold were enough to stop the decline and drive a sharp reversal.
And reversal is a pretty accurate description. In the fourth quarter, the market fell, small caps fell more than large caps (as measured by the Russell 2000 and Russell Top 200 indices), and growth fell more than value (as measured by the Russell indices). In the first quarter, the market rose, small caps led large caps, and value lagged growth.
Interestingly, mid-caps outperformed both small-cap and large-cap stocks. We also saw a sharp snapback in the price of oil; up 32% in Q1-2019 after falling 38% in Q4-2018. The two benchmark assets that sustained their fourth quarter trends were gold, which rose in both periods, and the yield on the ten-year Treasury, which fell in both periods. The sum of the last six months is that we have had a lot of movement in the markets, but we are pretty close to where we started.
The economic outlook, on the other hand, has probably deteriorated slightly. While the labor market in the US remains tight, growth expectations around the world are lower than they were six months ago. You see the signs in a variety of reports of both sentiment and activity. We believe that most of this slippage arises from the various trade sanctions coming out of Washington. When we talk to company management teams about any softness they are seeing, they cite higher materials costs as one source of pressure, but also the uncertainty created by the possibility of an expansion of the tariffs.
The good thing about this is that it appears that the US and China will come to a trade agreement that will remove this overhang. Last quarter, we suggested that a conclusion to these trade disputes (along with the ending of the government shutdown) might drive strong market performance. While we think a resolution of the trade disputes would be a positive, at this point the market has discounted much of that potential.
The strong move in the market, combined with a slight reduction in forward EPS estimates, has made the market somewhat more expensive. At year-end, the S&P 500 traded at 14.4x forward EPS compared with 16.5x at the end of the first quarter. This is a little above average, but not worrisome. Small caps, as measured by the S&P Small Cap index, traded at 14.1x then vs. 16.7x now. The Russell indices tell a similar story. In almost all cases, valuation has moved from below average to slightly above average. What has not changed is that small caps continue to look attractive relative to large caps and value looks compelling compared to growth.
The Keeley Mid Cap Dividend Value Strategy lagged slightly in the quarter. Several factors created headwinds to performance. These included the underperformance of dividend-paying stocks within the Russell MidCap Value index relative to non-dividend payers and the overall index. In addition, the small cash holdings within the Strategy had a more meaningful impact than usual due to the large gain in the market. Finally, many of the Strategy’s Financial holdings have benefitted from the rise in interest rates over the last two years. The sharp drop in bond yields in the second half of the quarter caused investors to reassess the attractiveness of these stocks and caused some weakness in them during March.
When we look at the two components of return, Sector Allocation and Stock Selection, we find that Allocation was a slight detractor while Selection was a slight positive. Most of the Allocation impact came from the previously mentioned cash balances (~4% on average for the quarter). The Selection impact came from positive contributions in six sectors, partly offset by more significant give-backs in the Energy and Healthcare sectors.
All eleven Industrial stocks owned by the Strategy rose in the first quarter and five generated total returns in excess of 20%. BWX Technologies led the way after posting solid fourth quarter earnings as it appears to be back on track after some unevenness last year.
All nine real estate investment trusts owned by the Strategy were up double-digits. Brixmor was the strongest of these as investor sentiment about retail real estate appears to be improving (or not deteriorating further). We have more on this stock later in the commentary.
The Health Care sector was the third strongest sector in the index, but the biggest detractor for the Strategy. We provide more detail below, but our holdings in Cigna and AmeriSourceBergen suffered from the talk about drug price controls and “Medicare for All”.
Energy was the other sector where the Strategy lagged its benchmark. It was the strongest sector in the benchmark, but the Strategy’s heavier weighting of natural gas stocks and its minimal holdings in energy service companies held back the gains in the Strategy.
During the quarter, the Strategy added 5 new positions (A.O. Smith, Fortune Brands Home & Security, Franco-Nevada, Ingredion, Quanta Services, and Tapestry) and eliminated two holdings (Patterson-UTI and UGI Corporation).
Versum Materials (VSM) is a leading maker of chemicals used in the production of semiconductors and other electronics. Its stock appreciated sharply during the quarter after it received an acquisition offer from Entegris for cash and stock. It moved even higher after Merck KGaA topped that offer with a $48 cash proposal. At quarter-end, the Strategy had sold most of its stock, although we believe there is a good chance that the final sale price could be above the Merck offer.
Brixmor Property Group (BRX) is a real estate investment trust that owns and operates grocery-anchored shopping centers. This past quarter, Brixmor rebounded from meaningful share-price weakness in the December quarter as it reported largely in-line fourth-quarter earnings. Brixmor also reaffirmed its guidance of significantly stronger same-store profit growth in 2019 relative to 2018, which helped to fuel Brixmor’s rally. Looking ahead, Brixmor should begin seeing better earnings growth, owing to the benefits of redevelopment activity, a reduced level of dilutive asset dispositions, renewals at much higher rents, and less exposure to retailer bankruptcies.
BWX Technologies (BWXT) provides nuclear components and products to the U.S. Navy and Canadian nuclear power markets along with environmental site restoration services. The company reported very good quarterly results which was welcomed as the past couple of quarters were disappointing due to welding issues. It appears that these issues are behind them and the focus will shift back to one of the more attractive parts of the business being the sole supplier of nuclear components to the U.S. Navy. This should start accelerating over the next couple of years as the Navy starts to rebuild its fleet. /p>
Cigna Corporation (CI) is a global health insurer that in 2018 acquired pharmacy benefit manager Express Scripts. Investors initially were not fans of the deal, but later came around. In the first quarter, however, shares were pressured after investors began questioning whether Cigna can execute on the deal’s integration. Investors also started to worry about potential changes to rebate practices for PBMs and proposals from Democratic Presidential candidates and Congressmen for “Medicare for All”. While we acknowledge that changes may come to the way healthcare is paid for in the US, we believe Cigna and the other managed care companies will be part of the solution.
Tapestry Inc. (TPR) is a fashion holding company that is the parent company of handbag brands Coach and Kate Spade, as well as shoe firm Stuart Weitzman. In the first quarter, Tapestry reported below-consensus earnings. Some product from Kate Spade’s previous design team was not well received by customers during the December quarter. Looking ahead, new Kate Spade designs from a new head designer have arrived in stores and should be fully rolled out by June. We expect these to drive a pick-up in sales beginning in the June quarter. In addition, the rolling-off of some higher computer systems investments and the continued capturing of synergies from the Kate Spade acquisition should serve as further tailwinds to earnings growth acceleration.
RPM International (RPM) is a leading manufacturer of high-performance coatings, sealants, and specialty chemicals. Shares fell in the quarter after it released its November quarter results. Earnings were disappointing due to a combination of higher raw materials costs and wet weather. RPM is in the midst of a substantial restructuring program and the recent results have been uneven. At the beginning of April, however, the company reported better February quarter results which were well received. These results showed the beginnings of the benefits from its cost-cutting and price improvement efforts.
As we look ahead, we believe the economy will muddle along. The resolution of trade disputes should resolve some uncertainty, but unemployment is very low and the stimulative impact of the 2017 tax cuts should begin to fade. In addition, a stronger dollar and higher energy prices are slight headwinds as well.
It seems to us that a slow, steady-growth environment, combined with stable low interest rates, and above average valuations suggests only modest market returns. We also believe we are entering a great period for dividend-paying stocks and a good environment for differentiated returns from stock selection. Value should begin to outperform growth.
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.
Quarterly performance return is based on the stock’s total return for the period which reflects any dividends or income earned. Prior to 09/30/16 return was based on price percent change.
Top five contributors: Versum Materials, Inc., 81.09% total return change, 73 basis points of contribution; Brixmor Property Group, Inc., 27.52% total return change, 42 basis points of contribution; BWX Technologies, Inc., 30.14% total return change, 38 basis points of contribution; Oshkosh Corp, 22.97% total return change, 36 basis points of contribution; Vulcan Materials Company, 20.17% total return change, 35 basis points of contribution.
Top five detractors: Cigna Corporation, 2.13% total return change, 1 basis point detracted; Tapestry, Inc., -2.76% total return change, 0 basis points detracted; RPM International Inc., -0.61% total return change, -4 basis points detracted; Ingredion Incorporated, -36.88% total return change, -66 basis points detracted; Franco-Nevada Corporation, -38.73% total return change, -58 basis points detracted.