Commentary – 4th Quarter 2018

Performance

For the quarter ended December 31, 2018, the Small-Mid Cap Value Strategy declined -19.31% gross (-17.12% net of fees) versus a loss of -17.12% for the Russell 2500 Value Index. For 2018, the Strategy declined -16.11% gross (-16.52% net of fees) versus a decline of -12.36% for the Russell 2500 Value Index.

Macroeconomic Review

Crisis of Confidence. What began as a year with a strong note of optimism post tax reform passage, less regulation and synchronized global growth, violently reversed to close out with doubt and concern. The sharp market decline in the fourth quarter can be explained by two primary factors: U.S. Federal Reserve monetary tightening and fears over a trade war with China. These two factors have resulted in slowing global growth, collapsing oil prices, and companies re-evaluating capital spending plans. We do not believe such extreme investor pessimism is warranted, yet the fear factor of the Fed or trade wars pushing the economy into recession led to significant fund industry outflows in December. Although the International Monetary Fund (IMF) recently lowered its forecast for global growth to 3.5% for 2019 and several major banks have downgraded their 2019 forecast in recent months, none are predicting a global recession is on the horizon. The dramatic stock market weakness in the fourth quarter has created the perception of a more serious economic downturn than economic indicators are showing. Unless the Federal Reserve makes a serious policy mistake leading to a credit crisis and the Trump Administration cannot settle the trade issue with China, a recession scenario in the near-term is unlikely.

Coincident with the publication of the “List 3” tariff goods, made effective on September 24, domestic companies which reported underwhelming third quarter earnings often linked that performance to pockets of weakness within sectors exposed to trade, specifically China, starting a broader move downward among stocks. As these tariff rates were slated to double with the start of the New Year, headline relief came early in December with a cooling of political rhetoric towards China and an agreement between the two heads of state to postpone the next level of tariff increases for three months while negotiations took place. It is possible that the U.S. and China will soon reach a trade agreement, as evidenced by China’s conciliatory gestures such as resuming its purchase of American soybeans, lowering duties on U.S.-made cars, and announcing it was cutting tariffs on 700 items to boost imports by $30 trillion. Trade talks between mid-level representatives for China and the US went smoothly in early January, the first discussions since President Trump declared the 90-day truce with the next round to be held at the end of January in Washington.

Along with trade disputes, which disrupt the flow of goods and raise costs within the economy, the second dominant focus of investors has been the Fed’s tightening of monetary policy. In a rare display of political pressure against the Fed’s independence, President Trump challenged the policy of continued rate hikes and, in doing so, heightened market expectations of a firmly dovish shift by the Fed. In the last meeting of the calendar year, the Fed raised rates once more and provided a generally dovish message about the path of future increases, while lowering the inflation outlook. Fed Chairman Powell pointed to generally strong economic conditions, but markets traded down further on the narrative that a more accommodating stance had been wanted. In doing so, the continuing positive read on the domestic economy is being overlooked. The U.S. unemployment rate, at 3.7%, is near a record 50-year low, with wages rising about 3.1%, while core inflation is 2.2%. The Fed is tightening, but, adjusted for inflation, the real Fed Funds rate is only about 25 basis points. Prior to the start of the last eight recessions, going back to 1960, the real Fed Funds rate was no less than 2 percent. The Fed has a long way to go before it truncates economic growth. At its December meeting, the Fed lowered rate increase expectations to two in 2019, delaying both towards the latter part of the year. This also allows for incoming data to potentially justify delaying such increases.

Within a quarter that saw our benchmark index move from a correction (down ten percent) to bear market territory (down twenty percent since the summer highs), the portfolio lagged. Despite strong stock selection in Utilities, Energy and Healthcare, execution and perception issues at several companies within Financials, Industrials, Real Estate and Consumer Staples detracted. NRG Energy continued to accrete value through its restructuring program (more detail below) while American Waterworks and Evergy’s consistent performance in a volatile market led to outperformance within Utilities. Positive stock selection in Energy and Healthcare, the two worst performing sectors, also contributed. Missing expectations impacted us in Financials as Bank of the Butterfield came in with a lower deposit base, PacWest had a lower than expected net interest margin and lower fee income, and Synovus announced it would acquire FCB Financial when many investors felt Synovus itself was going to be sold. The Industrial space was impacted as John Bean Technologies saw food technology orders being pushed out and our two aircraft lessors, AirLease and AerCap, suffered from the misperception that the China trade war would hurt their business. Similarly, our Real Estate holdings, Sabra, Howard Hughes and Ryman Hospitality were impacted from fears of the Fed’s actions lowering valuations. Lastly, after posting a better than expected third quarter, Spectrum Brands missed their fourth quarter and lowered guidance as it needs to reinvest for growth. The company sold their battery business to Energizer and instead of selling its appliance business which was being shopped, opted to sell their Global AutoCare business also to Energizer reducing leverage and opening the possibility of a large stock buyback.

Leading Contributors

NRG Energy, Inc. (NRG) is an independent producer of electricity and a seller of retail energy in deregulated markets. The company continues to benefit from the restructuring plan which started over a year ago, reshaping the company for better visibility, more stable earnings and higher cashflow.  This included selling off non-core assets to reduce debt, simplifying its capital structure with the sale of its ownership in NRG Yield, and other operational improvements to enhance margins. Management has successfully executed this plan, producing significant cash that is now being redeployed through accelerated share repurchases.

Denny’s Corporation (DENN) owns and operates the Denny’s restaurant brand. The company reported a solid quarter with a positive 1% growth in system wide sales despite a tough fourth quarter for most restaurant stocks. The more exciting news, which led to a one day 20% share price increase, was that the company announced plans to move to a 95% franchised model, up from 90% currently. It will use the proceeds from selling these company owned restaurants to franchisees to buy back stock. We are pleased the market has rewarded them with a higher multiple for further de-risking their business and becoming a more asset light model. We applaud the announcement, as moving to a more franchised model has been a very successful investment theme for the Strategy over the years.

Lamb Weston Holdings, Inc. (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 since its spin-off from ConAgra Foods, 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, driven by investors’ belief that the underlying dynamics facing the company remain favorable.  In addition, some U.S. QSRs, like McDonald’s reported good earnings and impressive same-store sales numbers during the quarter.

Leading Detractors

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 their higher exposure to emerging markets. The long lead times in ordering commercial aircraft offset these issues as AL does not lock in the lease rate until the plane is delivered. Also, it is very easy to place planes from order termination or early lease termination given the high demand. A few emerging market airlines filed for bankruptcy recently and the aircraft lessors easily re-leased these aircraft within thirty days given the increasing demand for air travel from the growing middle class.

Parsley Energy, Inc. (PE) is an oil and natural gas exploration and production company operating in the Permian Basin in Texas. PE declined during the quarter mostly in-line with the steep drop in WTI oil prices since the start of November along with concerns about Permian basin midstream takeaway capacity. The company has been increasingly focused on operating and growing within cashflow at these lower oil price levels. In the fourth quarter, management announced it would drop two rigs immediately and set the 2019 capex budget 21% below street estimates in an effort to limit its outspend of cash flow in 2019 to under $250mm at $50 per barrel WTI oil. This was a welcome development that puts the company on a path to start generating free cash flow in 2020, or sooner should there be a rebound in WTI oil prices.

John Bean Technologies Corporation (JBT) is a technology solutions provider to the food, beverage and air transportation industries. Its largest division, FoodTech, designs, manufactures, and services food processing systems for the preparation of meat, seafood and poultry products, ready-to-eat meals, packaged foods, juice, dairy, fruit and vegetable products. AeroTech supplies gate and ground equipment solutions to airlines, airports, the military and defense contractors. JBT has been a volatile stock over the past couple of quarters and the fourth quarter proved to be no different. The company has seen very good revenue growth in the aero side, however, the food side has been more challenging. A few large food orders were pushed out of from shipping in the third quarter and will now ship in the fourth quarter. In addition, there is some concern about margin pressure due to tariffs on the raw materials as well as the lack of any new announced acquisitions.

Outlook

While market participants are now regularly considering worst-possible outcomes, we believe that some of this recent narrative was negatively reinforced by temporary factors: tax-loss selling after a long bull run, hedge fund liquidations, high-frequency trading and indiscriminate selling by passive vehicles (take, for example, the $22 billion XLF Financial Select Sector SPDR ETF, which registered near record outflows on par with those leading into the much more ominous financial collapse in 2008). The volatility from the selloff led to little differentiation amongst equities and often, the small cap, less liquid names suffer disproportionately creating great values for the patient investor Likewise, broad market valuations have contracted towards five-year lows with the S&P 500 forward price to earnings ratio (P/E) under 15x, a level not seen since 2013, which contrasts sharply from the 20x P/E at the start of 2018. Within this context, we see opportunity to establish new positions in companies—those with management teams with proven track records of improving their businesses or possessing ‘hidden’ assets. Many excellent small cap companies are now selling at decade low valuations and we are selectively screening for bargains. Though the market can create short term perturbations within the portfolio, our focus is set towards longer term opportunity. Investors must remind themselves that stocks represent real ownership in companies and holding companies that are increasing their quality over time, will deliver satisfactory returns. We believe our experience of operating within similar environments will again prove rewarding. Given the way 2018 has closed, with sharp market moves amidst rapid news headlines, we do not expect the coming year to be an easy one. But we are optimistic about the potential opportunity and we value the trust which you have placed in us as investment managers.

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