Commentary – 3rd Quarter 2019

Performance

For the quarter ended September 30, 2019, the Small Cap Dividend Value Strategy fell 1.64% gross (-1.87% net of fees) versus a 0.57% decrease for the Russell 2000 Value Index. Year-to-date, the Strategy is up 17.64% gross (16.82% net of fees) compared with a 12.82% gain for the benchmark.

Macroeconomic Review

Summer is usually a fairly quiet time of year, but the third quarter was anything but quiet. While the market was relatively calm, the cross-currents in the economy and on the political landscape continue to make the outlook cloudy. The trends from last quarter continued as we saw another Fed rate cut, the trade conflict between the U.S. and China churned on, and growth in economies around the world slowed. On the positive side, consumer confidence, as measured by the University of Michigan’s Consumer Sentiment Index, remained steady in July before dropping in August and then strengthening in September. Gains in jobs and incomes helped to offset some of the uncertainty over trade issues. Other positive signs for the U.S. economy included strong growth in housing starts and the labor force participation rate ticked up to 63.2% in August– a level that matches recent highs posted in early 2019. Meanwhile, some less-encouraging data included lackluster job gains in August, with nonfarm payroll growth well below expectations. In addition, ISM U.S. manufacturing Purchasing Managers’ Index declined for a second straight month in September and the 47.8% reading was the lowest since June 2009.

Two issues that had been simmering on the back burner moved forward during the quarter, one domestic and one international. The domestic issue is the effort in the House of Representatives to impeach President Trump. There is no question that impeachment would introduce to the market yet another element of uncertainty. The international issue involves the recent attack on a major Saudi oil production facility.

The equity market, as measured by the S&P 500 Index, was up 1.2% in the third quarter and is now up 18.7% through the year’s first nine months. Larger cap stocks continue to outperform small caps, with the Russell 1000 Index gaining 1.4%, in the quarter, while the Russell 2000 Index lost 2.4% and the Russell Midcap Index landed in between with a 0.5% gain. For the first time this year, value outperformed growth, although it did so only in small cap and mid cap stocks. Large cap growth stocks continue to beat large cap value stocks and were the best performing style category.

Meanwhile, bond market yields continue to fall with the 3-month US Treasury bill yield falling 24bps to 1.88% and the 10-year bond falling 32bps to 1.68%. The yield curve inverted in the second quarter for the first time since 2007 and remained inverted in the third quarter. In the commodities markets, gold was up 2.8%. Oil fell 3.0% in the quarter.

Portfolio Results

While the backdrop of the market challenged the Strategy, we also had some setbacks in particular stocks which hurt performance. As we have pointed out in the past, Stock Selection drives most of the Strategy’s relative performance. This quarter was no exception as Sector Allocation was a slight positive, but Stock Selection had a negative impact on performance. The Strategy benefitted a little from a slight underweight in Energy (the worst performing sector) and a slight overweight in Real Estate (the best performing sector). The Strategy outperformed in three sectors and it lagged in three, while four were a push. The Strategy added the most value in the Energy, Real Estate and Health Care sectors, while the three principal laggards were Industrials, Financials, and Information Technology.

The Energy sector was down almost 21%, but the Strategy’s Energy holdings largely avoided the worst of that industry’s carnage, with only one of the Strategy’s five Energy holdings, Patterson-UTI Energy, underperforming the sector

Three of the Strategy’s real estate stocks posted double-digit gains, well in excess of the sector’s nearly 6% positive return. These were longtime Strategy holdings Sabra Health Care REIT, City Office REIT and National Storage Affiliates. A fourth real estate stock in the Strategy, OUTFRONT Media, gained 9%.

Although Health Care was one of the benchmark’s worst-performing sectors in the third quarter, the Strategy’s holdings only declined slightly. The Strategy only holds two healthcare stocks and one of them, Chemed, rose sharply after it reported strong second quarter earnings.

The Strategy’s underperformance in the Industrials sector was driven by declines in Altra Industrial Motion and Granite Construction. Both companies reported disappointing second quarter results and provided cautious outlooks. They were amongst the Strategy’s worst detractors and we provide more detail about them in the Let’s Talk Stocks section below.

In Financials, more than half of the contribution shortfall vs. the benchmark came from Virtu Financial. Its earnings suffered from lower market volatility, a leading driver of profitability for the firm. We also saw disappointing performance from three banks, Wintrust, Cadence, and Bank of Butterfield. The first two reported disappointing second quarter results due to credit issues.

During the quarter, the Strategy added two new positions and liquidated three positions.

Leading Contributors

Sabra Health Care REIT (SBRA) is a Healthcare REIT focused on Skilled Nursing facilities (SNF) and Assisted Living and Independent Living facilities. The market rewarded Sabra’s second quarter of in-line results as the company has been plagued by missteps and industry woes since the acquisition of Care Capital Properties in August 2017. Investors are starting to become comfortable with management’s focus on fixing the credit quality of the company by cleaning up the portfolio and improving the balance sheet to maintain investment grade ratings. Underlying trends remain favorable and with management’s focus shifting back towards growth should continue to help close the significant valuation gap with peers.

Chemed Corporation (CHE) is one of the largest providers of Hospice services through its VITAS segment and provides plumbing, drain cleaning, and water restoration services through its Roto-Rooter segment. The company reported a very strong quarter beating estimates on broad strength in both segments. Following quarter end, the company announced better than expected earnings guidance due to positive developments within each segment. At VITAS, CMS increased reimbursement and moderated headwinds caused by the two-tier payment system. Roto-Rooter announced its largest franchise acquisition in very attractive service territories.

City Office REIT (CIO) is a real estate investment trust that owns office buildings in fast-growing urban areas. The company has done a nice job over the past few years in improving newly acquired office buildings and expanding into new markets. Shares have rallied after the company reported a strong earnings report, including healthy organic growth and robust occupancy, and raised full-year guidance. In addition, City Office REIT has meaningfully improved its balance sheet, which should assist in further accretive acquisitions.

Leading Detractors

Granite Construction (GVA) provides construction and infrastructure solutions for the Transportation, Water, and Materials sectors. The company has struggled with a few large legacy fixed priced road projects and these projects required a write-down of roughly $100 million in the quarter sending shares down. These projects are close to completion, but potential risk remains for another write-down. Management is confident that won’t be necessary, but the market is skeptical. Unfortunately, these developments overshadowed positive underlying trends in the remaining segments.

Altra Industrial Motion (AIMC) is a diversified manufacturer of off-highway vehicle and material handling parts and systems. Due to a transformative acquisition that closed almost a year ago, investors were caught off guard by 2Q19 results that fell well short of expectations and caused the company to lower its guidance for the year. While detractors questioned the wisdom of the acquisition, we would ascribe the weakness to growing pains and see the synergy target as achievable.

Entercom Communications (ETM) is the second-largest owner of radio stations in the U.S. and operates digital and events businesses. Shares declined 39 percent in the quarter after the company reported revenue and earnings miss. The main culprit was deteriorating local advertising sales, which has been a longstanding problem for Entercom and other radio station operators. Entercom also experienced weak ticket sales, largely due to poor weather, at some events that the company operated. While Entercom has done a fine job extracting synergies from its 2017 merger with CBS Radio, it has struggled to boost local ad sales thus far. Entercom’s outlook is for better revenue growth by the end of the third quarter, but for now, the investment community remains skeptical.

Outlook

When the year began, we were optimistic about the outlook for the market. The fourth quarter 2018 market slump had lowered valuations to a very attractive level. Furthermore, we thought the factors that led to the fall (trade wars and the government shutdown), would be resolved. The government shutdown was short-lived, but the trade conflict lingers. The trade disputes had led to some of the softness in the economic numbers in the U.S. and abroad. Over this same time period, the market has been strong with solid double-digit gains across the board. As a result, valuations have moved up, but the only segment where valuation is below its long-term average is small-cap value, while mid-cap value is a little above its long-term average.

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