Commentary – 3rd Quarter 2018

Performance

For the quarter ended September 30, 2018, the Small Cap Value Strategy returned 0.25% gross (0.10% net of fees) versus a gain of 1.60% for the Russell 2000 Value Index. Year to date, the Strategy has appreciated 5.17% gross (4.72% net of fees) versus 7.14% for the Russell 2000 Value Index.

Macroeconomic Review

As we move towards the end of the calendar year, the economy continues to signal domestic strength. Chief among these positive statistics is the unemployment rate, which has declined to 3.7%, the lowest level since the Vietnam War. Yet, despite tight employment conditions where many companies cite talent acquisition as a strategic concern, hourly earnings growth and inflation remain at modest levels, which we believe supports the case that the economy is not overheating. Corporate tax reform has boosted earnings growth and contributed to a general willingness to increase business investment. Likewise, the ISM Non-Manufacturing Index, which also encompasses orders and business activity, marked the highest expansionary reading since mid-2005.

Stock indices, however, ended the quarter on the retreat after marking all-time highs earlier this summer. The impact was far more pronounced for small capitalization stocks. Reflecting to the start of the year, the Trump Administration’s opening of a two-front trade war—in China and North America—prompted investors to reallocate towards domestically-focused small caps, which are perceived to be more insulated from such matters. We were supportive of the insulation thesis and felt it provided a reason to remain bullish. Yet in the final days of the quarter, the Trump Administration rather quickly resolved the war on one front as NAFTA was restyled the US-Mexico-Canada Agreement (USMCA). Largely perceived by investors and companies as having “dodged a bullet”, the new agreement should allow for minimal disruption to existing supply chains and provide reasonable protections, rather than the punitive repudiations implied by earlier rhetoric. With this achievement, and its contemplation as a template for China, small caps lost their perceived competitive advantage over their larger, global brethren. We do remain concerned about the prickly sparring with China, predominantly over trade issues, recognizing both the exposure of technology supply chains and the threat to US consumers through higher price levels. We continue to proactively anticipate potential exposure among our holdings.

A few companies have already preannounced lower than expected results for the third quarter citing slower sales into China, tougher restrictions at Chinese customs, and higher raw material costs. With the US economy continuing to perform well and the Fed maintaining its rate hike path, investors have begun to question, “Can it get any better?” as sales growth slows, and margins become squeezed by higher input costs (tariff impact on materials, oil as well as labor). The upcoming mid-term elections also add to this uncertainty, thus extending the environment where valuation metrics have been less relevant, with growth/momentum factors outperforming value. On this point, the performance between the lowest and highest P/E stocks is the widest it has been since 1999.

In the third quarter, sector allocation was a positive benefit to the Strategy’s performance due to our overweight position in the stronger performing Industrials and Consumer Discretionary sectors while being underweight weaker performing sectors such as Consumer Staples, Energy and Financials. Strong stock selection within Industrials was driven by rebounds at John Bean Technologies and ABM Industries, both of which posted strong second quarter results proving issues perceived as weakness in the first quarter were temporary, as well as continued solid performance from ITT and KBR. Our real estate stocks also continued to post positive contribution after a very strong second quarter. Healthcare REITS, Sabra and CareTrust, benefitted from strong execution after repositioning their property portfolios while Seritage refinanced its debt and fully funded its current development plans. ATI Technologies led performance within Materials as the company is seeing an increasing mix to the higher growth, higher margin aerospace end market while driving its more commodity flat rolled business towards $100mm in EBITDA.

Unfortunately, the macro uncertainties of trade, tight labor markets and rising interest rates impacted stock selection within the Consumer Discretionary, Financials and Healthcare sectors. Trade issues have slowed auto sales in China leading to weakness in Visteon and Modine while Varex has experienced delays in orders from Chinese medical imaging customers for its CT scanner engines. Concerns over tighter labor led to margin pressure at restaurants, hurting Del Taco and Denny’s. And fears of higher rates, despite a flattening yield curve, has punished homebuilder TriPointe Group along with bank stocks. Lastly, within Technology, missteps in the integration of an acquisition by Diebold and Extreme Networks led to underperformance.

Leading Contributors

John Bean Technologies Corporation (JBT) is a technology solutions provider to 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. The company, which has been successfully consolidating the highly fragmented food prep industry, stumbled, posting first quarter results lower than expected due to higher installation costs, weaker product mix and operational inefficiencies at some locations. The company addressed the installation issues and announced a new restructuring program to improve margins by 200 basis points by the end of 2019. Strong second quarter results proved that first quarter issues were temporary as the stock regained all that was lost in the previous quarter. We believe that the company is well positioned to be a major beneficiary of rising global middle-class demand for safer foods.

KBR, Inc. (KBR) has been transforming its business mix over the past few years by acquiring more stable Government Services businesses to offset its lumpier, legacy Engineering & Construction (E&C) business. The company reported solid 2Q18 results and increased its full year 2018 EPS forecast, also making several positive announcements demonstrating a return to growth in the E&C business. The company’s Hydrocarbon Services segment won a contract to construct a methanol plant in Louisiana, and it also announced an agreement with Conoco Phillips to jointly develop low to mid-scale liquid natural gas (LNG) solutions. Investors appear optimistic regarding several potential awards for both businesses that will be announced over the next few months.

is a leading manufacturer of highly engineered critical components and customized technology solutions for the energy, transportation and industrial markets. The company announced strong 2Q18 results, as its Industrial Process segment has seen an inflection in orders for its pump business. CEO, Denise Ramos who has received mixed reviews from analysts, announced she will be stepping down at the end of the year. Her replacement, Luca Savi, the company’s current Chief Operating Officer, has a proven background having turned around the operations at the company’s two largest segments.

Leading Detractors

Extreme Networks, Inc. (EXTR) provides network equipment for wireless and wireline networks. The company has grown revenues by more than fifty percent following two fortuitous acquisitions: the networking assets from Avaya out of bankruptcy proceedings and Brocade IP Networking, disgorged from the larger Avago/Broadcom acquisition. Yet shareholders and analysts became frustrated as management’s forecasting ability proved to be sloppier than that to which investors had grown accustomed. In response, we collapsed our downside price targets as the company attempted to right size businesses at both divisions. While we believe the acquisitions—acquired at very modest valuations—have strengthened the firm, propelling it into a larger customer set with much greater scale as a clear number three in the industry, we ultimately sold our position on the perception that the stock will remain in the “penalty box” until management regains investor confidence.

Visteon Corporation (VC) designs, engineers and manufactures one of the broadest automotive cockpit electronics portfolios and is at the epicenter of the connected car revolution. Key products include instrument clusters, infotainment systems as well as autonomous driving systems. The company reported second quarter results that were below analyst expectations and lowered its forecast for the full year due to lower North American production plus a temporary slowdown in Europe which is currently undergoing a change in emissions standards testing. This coupled with negative sentiment toward auto stocks in general, amid trade war fears impacting China volumes has led to further stock price weakness. However, we believe that results should improve once the company starts delivering on its high margin backlog of business it has won over the last few years. The company has also been aggressive at buying back shares, recently completing a $400 million buyback program, and announcing a new Board authorized $500 million buyback program.

Del Taco Restaurants, Inc. (TACO) develops, franchises, owns, and operates Del Taco quick-service Mexican-American restaurants. The stock has been under pressure as investor concern has been focused on labor cost inflation, especially in their California dominated company store base. A second concern has been the negative traffic at company owned stores, which is believed to be a result of a high level of discounting by larger quick serve (QSR) players. Further, delivery has been a strong growth driver for many of their peers and TACO will not have full delivery available to its California store base until late 2018. We expect this will aid traffic going forward, and we continue to believe the company is well positioned with its unique “fresh” menu offerings and has ample growth opportunities outside its core West Coast roots.

Outlook

As we look to the end of 2018 and beyond, we do not think that the recent weakness is the start of a larger decline. That is not to say that a correction may not occur. We simply don’t perceive the conditions that would lead to a 40-50% drop like we saw in the 2000-2003 and 2008-2009 time periods. Our outlook remains balanced. On the positive side the economy appears to be on solid footing, and this should benefit corporate earnings. On the political side, while there is a lot of noise, the Trump Administration appears to be making some progress on trade and security. On the negative side, some of that progress seems to come in “a one step back and two steps forward” manner. Other concerns include the remarkably easy credit market conditions, the likely impact of higher rates on US government budget deficits, and what we see as slightly elevated valuations for stocks.

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