Commentary – 4th Quarter 2019

Performance

For the quarter ended December 31­, 2019, the Small Cap Select Value Strategy appreciated 11.51% gross (11.29% net of fees) versus a gain of 9.94% the Russell 2000 Index and a gain of 8.49% for the Russell 2000 Value Index. For the full year 2019, the Strategy appreciated 30.79% gross (29.71% net of fees) versus gains of 25.53% and 22.39% for the respective benchmarks.

Macroeconomic Review

What a difference a year makes. As we exited 2018, markets tumbled over worries about rising interest rates, slowing economic growth, an escalating trade war and an aging bull market. The Federal Reserve Board, however, reversed course in its monetary policy by cutting rates, fueling strong stock market gains across most sectors. At its December meeting, the Fed held interest rates steady and signaled no appetite to raise them soon. After lowering rates at three previous meetings to buffer the U.S. economy from the effects of trade tensions and a global slowdown, Fed officials voted unanimously to leave the Fed Funds rate between 1.5% and 1.75%. Moreover, the Fed indicated rates would remain unchanged through 2020 with a 2% inflation target. Underpinning the Fed’s apparent confidence in U.S. economic growth was the strong November jobs report showing a better than expected 266,000 workers added to nonfarm payrolls. Together with upward revisions to October payrolls, was a drop in the unemployment rate to 3.5% and higher, though still benign, wage growth, a harbinger of healthy consumer spending.

As we look forward to 2020, we would expect some deceleration in U.S. gross domestic product growth from its current estimate of 2.3% for 2019, compared with growth rates of 2.9% in 2018 and 2.4% in 2017. Moreover, the first stage trade deal between the U.S. and China, announced in mid-December, should foster a rebound in corporate capital investment and business spending on software, research and development, which was constrained by U.S./China trade tensions. The limited agreement calls for China to purchase more products from American farmers and other exports. In return, the U.S. put the brakes on new tariffs set to take effect on December 15. The worst of the manufacturing downturn is likely over as evidenced by the November Purchasing Managers Index (PMI), which increased to 50.3, rising for the fourth consecutive month, though the Institute for Supply Management Index (ISM) has remained weak.

Monetary easing by Global Central Banks, meanwhile, should support the economic cycle well into 2020 and beyond. The European Central Bank, Bank of Japan and the Fed are all expanding their balance sheets aggressively. Against this backdrop, we believe equities should continue to deliver decent, albeit muted, returns in the year ahead. While overall valuations have been stretched, the value trade is still in the early innings, following more than a decade of underperforming growth. Small cap stocks have also been lagging behind their larger counterparts in the stock market for three years in a row. Earnings growth will be the critical driver of stock returns in 2020. The global growth recovery in capital expenditures should benefit many of our industrial technology holdings, which have sustained slowdowns in their order books as the inventory correction has rippled through the supply chain, partially attributable to the trade war with China.

Companies in our portfolio like Advanced Energy Industries, Inc. (+48% portfolio total return for the quarter) and ONTO Innovations Inc. (+12%) are beginning to report a bottoming in orders tied to semiconductor capital equipment. Oil and Gas companies have also been hard hit by China trade fears since weakening global growth negatively impacts commodity prices at the margin. Most of our energy holdings rallied into year-end as WTI crude oil rebounded to $60 per barrel. Our energy holdings remain the most undervalued sector within our portfolio: Companies such as land driller Patterson-UTI Energy Inc. (+23%); drill bit producer Apergy Corp. (+25%); Permian Basin exploration companies Matador Resources Co. (+9%), Centennial Resource Development Inc. (+2%) and Parsley Energy Inc. (+13%). Expectations for stronger global economic growth have pushed U.S. interest rates higher, with the ten year U.S. Treasury rate at 1.92%, up from 1.52% earlier this year. Our regional bank holdings also stand to benefit from a stronger economy, and loan growth with higher rates, as widening net interest margins provide relief from rate compression. Among our holdings are CenterState Bank Corp. (+5%), with a footprint in Florida and Georgia, Dallas, TX based, Veritex Holdings Inc. (+21%), which focuses on middle market corporate lending in attractive, growing markets, and Valley National Bancorp. (+6%), a New Jersey franchise that should benefit from the recent accretive acquisition of Oritani Financial Corp., which extends its market share within New Jersey.

Lastly, we would expect a continuation of merger and acquisition activity to positively impact performance and generate alpha within our portfolio since we have had 13 takeouts in our portfolio over the past 18 months at significant premiums to our cost basis. Globally, 2019 is already the sixth-best year of the past 20 with 26,000 announced transactions, totaling $2.73 trillion, compared with $3 trillion in deals in 2018.

Leading Contributors

Darling Ingredients Inc. (DAR; +47%) is a global leader in converting animal byproduct into usable specialty ingredients for a variety of applications, from animal feed to pharmaceuticals. A few years prior, we established a position in the name, viewing the stock as undervalued on account of a new avenue of growth: biodiesel derived from animal fats and sourced from a vertically integrated model. As process feasibility was demonstrated, along with operating profitability, the company embarked on an expansion plan to nearly double capacity for biodiesel and subsequent years saw this joint venture contribute nearly one third of overall profitability. In the current quarter, the stock shot higher as profitability at the biodiesel joint venture is returning to peak levels. The firm expects to run at full capacity for the next year until current additions double output, yet again. Following the earnings call, Congress also approved another round of the “Blenders Tax Credit”, which benefits Darling, given its use of renewable fuels. While the stock has performed quite well, we believe the contribution from diesel has yet to peak.

Infinera Corporation (INFN; +46%) designs and builds network equipment for optical transport, which is the high-speed transmission of data in the form of light waves. Emerging from a difficult acquisition integration period, the earnings potential of 2018’s Coriant acquisition is finally coming to the forefront. Notably, the company is recovering from disappointing earnings and rebuilding a pattern of matching guidance. Earnings are on track to improve and the company is executing upon merged product designs, moving some from the laboratory into production. As such milestones are met, investors should grow more confident in the substantial synergies which had been forecast at the time of the deal, chief among them being ten percentage points of gross margin accretion.

Lumentum Holdings Inc. (LITE; +48%) manufactures optical and photonic products, previously operating as a division of JDS Uniphase prior to being spun out about five years ago. We became owners of the stock when Lumentum acquired our holding of Oclaro Inc, offering their equity as currency for a portion of the deal price. As the deal closure was coincident with the market swoon in December 2018, we saw the stock as exceptionally undervalued at that point and chose to take the equity, even adding to the new position. Not only did that allow us to remain exposed to the valuable Oclaro indium-phosphide fab assets, sized about half of the merged company, but we also gained the market leader in 3D sensing as smartphones begin to adopt that technology. The stock outperformed in the quarter as Oclaro deal synergies continue to deliver upside and telecom and optical end markets remain strong.

Leading Detractors

Plantronics, Inc. (PLT; -26%) has long manufactured high-quality headsets used in environments in which communication is critical. Following last year’s transformative acquisition of Polycom Inc, the company now sells a broad portfolio of devices, from headsets to desktop phones to video conferencing devices. These products are poised to benefit from the secular upgrade cycle underway in the enterprise, transitioning from legacy wired devices towards cloud-based communications. The stock has been a long term holding of ours but we scaled back the position following the initial accretion-driven deal euphoria as we anticipated the integration process to prove problematic, based upon our experience of having formerly owned Polycom stock (prior to it being taken private). As these expectations came to fruition during the first few post-merger quarters, the stock was halved. At that level, the long-term goals of the company were attractive and undervalued, leading us to add to the position. However, we proved too early as the company announced one final integration fix this quarter which substantially lowered guidance and shocked investors. Though it was the right move for the long- term health of the firm, the clean-up of slow-moving legacy product in the channel will lead to a gap in sales until replenished with new product in the beginning of the year. The renamed Poly is early in a new product cycle and the company has historically demonstrated an ability to generate meaningful levels of free cash flow. We expect this aspect will highlight the undervalued nature of the stock.

Hexcel Corporation (HXL; -10%) develops and manufactures lightweight composite materials which can replace a variety of metal structures, most notably within modern aircraft design. Following a decade in which revenues doubled for Hexcel, Boeing’s 737-MAX disaster this past spring heralded an expected pause for those companies supporting the supply chain of that plane model. Initially, industry supply chains continued at an unchanged pace of production as extended backlogs were worked down. But given the extended delay by regulators in returning that plane to service, interim production rates have begun to be lowered. As a result, and not alone across the industry, Hexcel lowered revenue growth rates by two percentage points while efficiencies enabled the company to hold their earnings targets. We have held on to our position as the revenue reduction matched what we anticipated last spring and we see this issue as a temporary setback to the secular trend in the usage of composite materials. Notably, passenger miles have not been affected by the tragedy last spring and new planes will be needed to service improving demand. As a leader in composites, Hexcel benefits from production at either Boeing or Airbus and should not suffer a sustained impairment.

Supernus Pharmaceuticals Inc. (SUPN; -14%) is a specialty pharmaceuticals company focused on drugs addressing the central nervous system. Spun from Shire nearly fifteen years ago and still headed by the founder, the company has two main drugs which are nearing the end of patent protection, explaining the low valuation of the stock at our investment. Offsetting this are two items: a handful of trials and FDA submissions for new usage cases of the same approved molecule and a cash balance sized at nearly half of the market capitalization of the stock. While some investors voice concern about the cash being wasted in desperate pursuit of an acquisition, we would note the demonstrated restraint by the company across these past years, waiting for the right sort of acquisition target. Likewise, we believed that little-to-no valuation was given for the potential approval of new use cases, centered on two cases that could markedly improve the earnings profile of the company. However, the stock was impacted when the company announced a failed trial for the lesser of these new-use-cases. We added to the small position as we saw this as an overreaction, given how early stage the trial was and how little analysts had outlined its potential. Since then, the stock has begun to recover, also aided by a restatement of some of that trial data which now suggests statistical significance and a potential for resubmission to the FDA.

Outlook

We remain committed to building a portfolio of high quality names, which has been confirmed by the level of takeout activity in our portfolio in recent years. Similarly, we are judicious toward the prices we pay, taking advantage of market-driven opportunities to build positions in new holdings that we expect to serve excellent risk-adjusted returns across another market cycle.

In conclusion, thank you for your investing alongside us in the Small Cap Select Value Strategy. We appreciate your confidence and trust.