Commentary – 1st Quarter 2019


For the quarter ended March 31, 2019, the Small Cap Value Strategy increased 17.07% gross (16.91% net of fees) versus an 11.93% rise for the Russell 2000 Value Index.

Macroeconomic Review

Major indexes have now recouped almost all of the losses sustained in the final months of 2018, when fears over a potential economic slowdown sent global markets tumbling. The two primary fears that pummeled the market in December—escalating trade disputes and steadily rising interest rates—abruptly turned around in the first quarter. First, U.S. and Chinese officials placed a stay on the second round of tariffs while negotiating towards a solution. Second, the Federal Reserve acknowledged market concerns by signaling a hold to further interest rate hikes for the year, citing a diminished inflation outlook and slowing global growth (namely Europe). A dramatic shift post the December 20th rate hike where the outlook was still for five to six hikes in 2019. Concurrently, earnings guidance and expectations were lowered further continuing to reflect a slower Europe, slowing China and the absorption of both rounds of tariffs via pass-through pricing. With both of those exogenous threats receding, earnings expectations rebased lower, and valuations more reasonable after the storm in December, stocks posted their strongest first quarter in over a decade. The focus returned to companies that can outperform in an environment of economic growth, albeit at a moderating pace.

Much of this year’s rally was driven by relief that central banks were backing off rate hike campaigns amidst slowing growth from the Eurozone to China. Consequently, long term interest rates have declined, with three-month U.S. Treasury bills slightly higher than the yield on ten-year U.S. treasury notes. Seen from this vantage point, the market paints a portrait of stability at this moment, balancing fading exogenous impacts with moderating economic growth, forming a reasonably positive environment for small caps.

The lingering question for stocks is whether this brush with fear has led to a change in the dynamics for global economies and how much could be trade-related impairment. Taking the manufacturing PMI (purchasing managers index) for the three main global economies, the most recent figures for March show stabilized, expansionary readings above 50 for the US and China (55.3 and 50.5, respectively) while the Eurozone marks thirteen months of sequential declines, ending in recessionary readings solidly below 50 (47.5 for the Eurozone and 44.1 for Germany). This representative snapshot overlaps similar narratives supplied by companies, underscoring the relative level of support for domestic-oriented small cap companies less dependent upon exports. U.S. nonfarm payrolls rose in March by 196,000, a strong showing. Wage gains eased with the unemployment near a 49-year low, at 3.8%.

The portfolio posted solid outperformance of over 500 basis points relative to the Russell 2500 Value Index in the first quarter and we were most pleased to mark positive relative performance in each month of the quarter. The positive contribution was primarily from strong stock selection. The Strategy outperformed in nine of the eleven sectors, with Tech, Healthcare, Industrials and Communications Services driving the majority. Within Tech, Versum (VSM) was our top performer, up 82% in the quarter. The company initially agreed to a stock merger with Entegris, but rival Merck KGaA emerged with a much higher, all cash offer. Being a spin-off from Air Products, Versum’s takeover is an excellent example of the how the spin-off process creates pure play companies that become very attractive acquisition candidates for larger firms searching for growth, especially in this low global GDP, low interest rate environment. With the Tech sector being the best performing sector in the index for the quarter, four of the remaining five tech names still outperformed with an average return of 33.5% vs 19.6% for tech sector index return. Invacare, which was a bottom 3 performer in 4Q18 (-70%), rebounded strongly (see more details below), up 95%, and along with continued excellent execution at Ensign Group and potential China trade relief at Varex, these three holdings added significant relative performance in Healthcare. The relative outperformance in Industrials was also broad based led by company specific factors as well as the trade and rate relief. Seven out of our nine holdings exceeded the industrial sector index returns with most up over 20% for the quarter. Both Welbilt and John Bean Technologies appear to have put the execution issues that plagued their companies in 2018 behind them. Lastly within Communication Services, Nexstar Media was a top 3 performer (see details below) on better than expected political ad spend and strong progress divesting assets to get final approval for the Tribune acquisition.

On the negative side, it was only the Consumer Discretionary and Energy sectors that underperformed. Lower than expected growth at Del Taco and a delay in the State of Florida adoption of their new math program for Houghton Mifflin (more detail below), dragged the Consumer Discretionary performance. While our Energy sector performance was pulled down by HighPoint Resources given the uncertainty of upcoming Colorado legislation placing tougher restrictions on drilling (more detail below).

Leading Contributors

Versum Materials, Inc. (VSM), a fairly recent spin-off from Air Products (APD), 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 (ENTG) for cash and stock. Afterwards, competitor Merck KGaA topped that offer with a $53 cash proposal.

Nexstar Media Group, Inc. (NXST) is one of the largest owners of television broadcasting stations. Shares performed well in the quarter after falling sharply at year-end. Nexstar has been reporting solid results over the last year as it took out cost from and integrated operations acquired from Media General. In addition, political advertising was very strong in the fourth quarter and helped to drive upside. Most importantly, the company has made significant progress toward completing the conditions necessary to close its acquisition of the Tribune Media stations. The Tribune deal should be nicely accretive to earnings over time.

Invacare Corporation (IVC) is a global leader in the manufacture and distribution of innovative home and long-term care medical products that promote recovery and active lifestyles. After having its flagship manufacturing plant shutdown under an FDA consent decree for several years, the Board brought in a new CEO turn the business around. The plan was on track until two exogenous things caused the company to miss third quarter results putting their $100mm EBITDA by 2020 goal at risk. This occurred at the same time the market was melting down in the fourth quarter driving the stock down a whopping 70%. While discussing earnings results this quarter, management demonstrated that they have gotten control over the exogenous issues (re-sourcing parts from non-Chinese vendors to reduce the tariff impact on their margins and the slowdown in medical equipment orders was due to a CMS change in distributor market share definitions). Also, management found additional cost saves in its restructuring program leading them to a new $85-105mm EBITDA target by year end 2020. Though still not out of the woods, this incremental confidence led to a 95% move in the stock in the first quarter.

Leading Detractors

Houghton Mifflin Harcourt Company (HMHC) is a provider of pre-K through 12th grade education solutions to U.S. schools.  Under a new CEO, the company has been positioning itself to benefit from the coming adoption cycle to refresh educational materials in a number of large states (Texas, Florida, and California), an event that will increase the addressable market for the entire industry.  Recently, the new Governor of Florida decided to eliminate all Common Core influence on the State’s standards thereby delaying its new math program adoption from 2019/20 to 2021/22. The stock was a strong performer in the fourth quarter (up 27%) running up in anticipation of adoption wins, but pulled back in the first quarter due the Florida delay pushing out as well as very conservative 2019 guidance from management. We believe the company has a strong opportunity to regain lost market share in a growing market, while also diversifying into less cyclical educational service offerings. Although the Florida delay mutes the amplitude of the 2019/20 adoption cycle, it does lengthen the cycle providing more stable free cashflow.

Columbia Banking System, Inc. (COLB) is a community bank headquartered in Tacoma, Washington serving the larger Pacific Northwest region.  Its shares retreated in the first quarter after the company reported slightly disappointing earnings.  While most drivers of earnings were good, expenses were higher than expected.  Furthermore, management indicated that this trend may continue as the company will be investing to retool its online presence and expand its digital offerings.  This led to downward revisions in earnings estimates on a stock that already enjoyed a premium valuation. 

HighPoint Resources Corp. (HPR) is an independent oil and gas exploration with primary acreage in the DJ Basin Wattenberg oil fields of Colorado. Underperformance during the first quarter was largely driven by uncertainty around possible new state regulation being pursued by the Democratic state legislature which could potentially hamper oil & gas production in Colorado. Recent drafts of the legislation suggest there will be more local control around permitting which should leave HPR largely immune from any concerns since the company’s acreage is located almost entirely in the rural areas of Weld County which would suggest minimal hindrance from local officials in the area. We feel passage of any legislation will bring certainty that should lift the stock price. HPR should also have more data from wells completed on the acreage acquired in the Fifth Creek transaction, which has to date had higher oil cuts than its legacy acreage.

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.