Commentary – 3rd Quarter 2019

Performance

For the quarter ended September 30, 2019, the Small Cap Value Strategy declined 2.28% gross (-2.39% net of fees) versus a loss of 0.57% for the Russell 2000 Value Index. For the year-to-date period, the Strategy is up 17.90% gross (17.41% net of fees) compared with 12.82% for the benchmark.

Macroeconomic Review

Similar to last quarter, what appeared to be a flattish market environment was anything but flat. The strong run-up in the market in June, with the Fed posturing it would cut rates for the first time since 2007, continued into July with the S&P 500 reaching all-time highs. However, flaring trade negotiation tensions with President Trump raising tariffs and accelerating the implementation of tariffs on all remaining goods coming from China. precipitated the downdraft in the markets. Small caps and value stocks were hit harder as the Russell 2000 Value and Russell 2500 Value Indices were down 5.58% and 4.87%, respectively, for August. Concerns about such a strong blow to the fragile global economy led to cooler heads with the delay in the tariff hikes, a return to trade talks, and increased confidence of another rate cut at the September Fed meeting. Small caps rebounded in September, up 5.13% and 4.58% for the Russell 2000 Value and Russell 2500 Value Indices, respectively, versus 1.87% for the S&P 500 Index. As the market hit new highs, valuation factors began to matter again, and value finally started to outperform growth.

Positively, consumer confidence, as measured by the University of Michigan’s Consumer Sentiment Index, stayed 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 ticking up in August to 63.2% — a level that matches recent highs posted in early 2019. On the negative side, lackluster job gains in August, with nonfarm payroll growth well below expectations and the ISM U.S. manufacturing Purchasing Managers’ Index declining for a second straight month with the September reading of 47.8%, the lowest since June 2009. It is difficult to determine how the GM strike, Boeing 737MAX grounding and inventory reduction from accelerated foreign purchases prior to the tariff enactment are affecting the latest ISM reading, but market has clearly become a tad more cautious as we head into third quarter earnings season.

Two other non-economic issues that had been simmering in the background have recently emerged – the push to impeach President Trump and the recent attack on a major Saudi oil production site. The whistler-blower complaint regarding communications with the Ukrainian President has ignited more controversy and momentum for a House led impeachment investigation. Although approval from a Republican-led Senate would be necessary for a Presidential impeachment, it is anyone’s guess how such proceedings could impact U.S. equity markets. And even with the restoration of capacity at the Saudi facility faster than expected and no retaliatory response against Iran, we are reminded of the fragile relationship between Iran, its Middle Eastern neighbors and the U.S. For now, the market has looked past these two issues, but both add a new element of risk to the markets.

Portfolio Review

In the third quarter, the portfolio underperformed the Index as positive sector allocation was offset by negative stock selection. The portfolio performed in-line with the Index for the first two months of the quarter, but could not keep up with the strong, macro-driven rally of over 5% in September. Sector allocation contribution resulted from our underweight the worst performing sector, Energy, and our overweight in the Consumer Discretionary and Technology, the second and third best performing sectors in the Index, respectively. As we mentioned earlier, we did see a rotation back to value as investors searched for ideas that had lagged in the strong up market. This return to rational, fundamental investing led to buying demand/recognition of several our neglected, restructuring stories whose stock prices were de-risked, already building in worse case scenarios. In Energy, which was down 21% for the quarter, our exposure to higher quality companies like Parsley Energy (PE – down 11%) and Delek US Holdings (DK – down 10%) added to positive stock selection. Also, Nexstar Media Group, Inc. (NXST – up 2%), which was trading at a 20% free cashflow yield, recently closed on its acquisition of Tribune Media and raised guidance leading to outperformance versus the Communications Services sector which was down 5.5% for the quarter. Other large contributors were Visteon Corporation (VC) and Invacare (IVC). Visteon jumped 41% in the quarter as auto sales and production rates held up better than expected and investors began to look past this transition year as growth returns in 2020 when a number of new projects ramp. Invacare was up 45% as management posted solid 2Q results building confidence in its turnaround efforts.

Detractors for the portfolio came in two categories: those that missed quarterly expectations and those that beat but gave conservative guidance. These primarily affected us in the Industrials, Financials, Consumer Discretionary and Technology sectors. The companies that missed expectations were Altra Industrial (AIMC), Virtu Financial (VIRT), Cadence Bancorporation (CADE), and Modine Manufacturing (MOD). Altra (down 22%) saw weakness in its Automation & Specialty business, which it recently acquired from Fortive, resulting in the stock being down 22%. Virtu, (down 24%) missed earnings on lower market volatility as well as less than expected contributions from its two recent acquisitions. Cadence Bancorp’s earnings miss was due to lower net interest margins, slower loan growth and higher credit costs. Management hopes to offset these impacts with the integration of the State Bank Financial acquisition. Modine’s largest data center customer slowed its cap ex plans causing the company to miss estimates and lower guidance. The company is expected to announce the sale of its Auto business shortly transforming it into a more pure play HVAC company and given end demand for cloud computing, we expect this spend to reaccelerate in a few quarters.

Investor skittishness with the slowing economy and high market valuations led to profit taking in several our companies that beat earnings expectations but gave conservative guidance. John Bean Technologies (JBT) was down 18% and ABM Industries (ABM) was down 8% within Industrials, Bank of the Butterfield (NTB) was down 11% within Financials. Del Taco (TACO) was down 20% within Consumer Discretionary, and Verint (VRNT) was down 20% within Technology, all despite continuing good fundamental outlooks for their businesses.

Leading Contributors

Invacare Corporation (IVC), is a leading provider of mobility and seating solutions (wheelchairs) and home medical equipment for non-acute care settings. The company reported solid 2Q19 results with strong cash flows giving investors confidence in the company’s ability to execute a massive turnaround. Cost pressures from tariffs and reimbursement changes in its Home Medical Equipment business have been addressed and new product launches are slated for the second half of the year. Management remains committed to hitting its $85-105mm run-rate EBITDA target by 4Q20.

Sabra Health Care REIT, Inc. (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.

Visteon Corporation (VC), is an auto supplier focused primarily on cockpit displays and digital clusters. After lowering guidance and investor concerns about slowing auto demand during its first quarter report, the company posted 2Q19 results that were ahead of expectations and overcame two company specific manufacturing issues that negatively impacted 1Q19 results. Revenue also outperformed regional light vehicle production in China, an area that had made investors nervous coming into the quarter. The stock has continued to rebound as auto demand has remained solid while investors begin to look at 2020 for Visteon when new project wins begin to ramp.

Leading Detractors

Altra Industrial Motion Corp. (AIMC), is a diversified manufacturer of off-highway vehicle and material handling parts and systems. Due to the transformative acquisition of the Automation and Specialty (A&S) business of Fortive 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. The less commodity, but more cyclically exposed A&S business was impacted by higher customer inventory in the trucking market and a slower rebound from factory automation in Europe and China. Despite the shortfall, management still generated strong free cash flow to pay down $35mm in debt nod they also raised the expected synergies from the A&S deal.

Wright Medical Group, NV (WMGI), is a medical device manufacturer specializing in lower extremity (foot, ankle), upper extremity (shoulder, elbow, wrist) and biologic products to mechanically repair tissue-to-tissue and tissue-to-bone injuries. The stock was down 31% as the company missed second quarter expectation and lowered guidance for the year. The miss resulted from the loss of sales people in Lower Extremities to competition and the loss of the distributor network for its recent acquired Cartiva product. The company is aggressively rebuilding its salesforce and will now handle all Cartiva product sales internally. Management feels it can rectify this within a short time and reiterated their 2021 target of mid 20s% EBITDA margins.

John Bean Technologies Corporation (JBT), a leading provider or food and beverage processing equipment as well as air transportation equipment. The stock was a strong performer for the first half of the year after showing improvement from weak orders (mix), operational issues and trade war supply chain concerns that impacted the stock in the fourth quarter. The company beat 2Q19 expectations as management continued to make good progress on it restructuring programs, but orders, which can be lumpy, declined 12% y/y. The strong performance and near-perfect valuation led investors to take profits. We believe the story remains solid given the continued demand for food safety and aviation by the growing global middle class.

Outlook

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 gaining 1.4% 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 and mid-cap stocks. Large cap growth stocks continue to beat large cap value stocks and were the best performing style category. As a result of the strong market performance for the year, valuations have moved up from below average levels to above average levels. Valuations are not at dangerous levels, but the only segment where valuation is below its long-term average is Small-cap value. Mid-cap value is only a little above its long-term average. The rest of the market (large-cap, small- and mid-cap growth) looks well above historical averages. We have been discussing the attractiveness of value relative to growth and small-cap relative to large for some time. With performance and valuation gaps at extremes for both categories, we feel investing in small cap value is at a very attractive level.

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