Commentary – 1st Quarter 2019

Performance

For the quarter ended March 31, 2019, the Small Cap Select Value Strategy appreciated 15.57% gross (15.33% net of fees) versus a gain of 14.58% the Russell 2000 Index and a gain of 11.93% for the Russell 2000 Value Index.

Macroeconomic Review

Stocks posted their strongest first quarter in over a decade. 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. 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 two primary fears which gripped the market in December—escalating trade disputes and steadily rising interest rates—abruptly turned around in the first quarter. Firstly, U.S. and Chinese officials placed a stay on added tariffs while negotiating towards a solution. Concurrently, earnings reports continued to reflect the absorption of inflation (provoked by an initial round of tariffs last fall) via pass-through pricing. In still another dramatic reversal, 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). With both of those exogenous threats receding, the focus returns to economic growth, albeit at a moderating pace.

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 U.S. 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%.

To start the year, the portfolio posted solid outperformance of over 300 basis points to the Russell 2000 Value Index and we were most pleased to mark positive relative performance in each month of the quarter. The positive contribution spread broadly across sectors, with almost half attributed to our tech and industrial holdings. Within industrial names, standouts were those exposed to recovering oil prices and the potential positive impact upon drilling activity [CIRCOR International, Inc. in particular (+53% portfolio total return for the quarter)]. U.S. oil is off to its best start to a year since 2002 amid efforts by major exporters to curb supply. Oil prices rose 32% in the first quarter, bouncing back after hitting their lowest level in 18 months in December. Amongst our tech holdings, the brightest star was the cash acquisition of portfolio holding Versum Materials, Inc. (+82%) by Merck KGaA of Germany, at a significant premium to our cost.

Sector offsets to performance were few this quarter, sourced about even between our cash holdings (flat returns in a rising market) and REITs (real estate investment trusts). Though the latter has represented a growing portion of the index, we have held only modest exposure to the sector through special situation holdings on account of our view of rising rates imposing a drag on fundamentals. With the telegraphed pause in rates by the Fed, such names within the index outperformed the benchmark average and our underweight of this sector proved a drag.

Leading Contributors

Versum Materials, Inc. (VSM) produces high purity materials and capital equipment used in the process of semiconductor manufacturing. Spun from Air Products & Chemicals, Inc. in late 2016, the company is a peer to the exceptionally well-run Entegris, Inc. (+28%), a core holding of ours. We were attracted to the scarcity value of the asset and the recurring, high-margin nature of the business. In January, Entegris made an all-stock offer to acquire the company, which would have formed the only public midcap consumables pure-play. A month later, Merck KGaA of Germany made a competing cash offer for the company and Entegris effectively raised its bid with its subsequent disclosure of added expected cost saves. Ultimately, a still higher cash bid by Merck tilted the final ownership of Versum, despite the cleaner strategic fit with Entegris, and resulted in a double on our investment.

ProPetro Holding Corp. (PUMP) (+83%) provides well completion services, namely hydraulic fracturing, to energy exploration and production (E&P) companies operating in the Permian Basin. The market downturn last fall provided our opportunity to establish a position in this best-in-class operator, as commodity prices were anticipated to stabilize and rebound, following coming OPEC actions to restrain supply. What separates ProPetro from its struggling peers is the competitive advantage gained through dedicated relationships with some of the strongest E&Ps in the region as they seek to methodically develop well inventory. This thesis was solidified in the quarter as strong earnings were coupled with a transaction that assumed the in-house completion business of Pioneer Natural Resources Co., along with a dedicated ten-year contract. As the industry continues to add to the inventory of uncompleted wells, we expect the firm to remain the provider of choice while adhering to a pattern of financial discipline.

Leading Detractors

Centennial Resource Development, Inc. (CDEV) (-20%) is an energy exploration and production (E&P) focused on the Permian Basin and led by a team of leaders, reconstituted from alumni of EOG Resources, Inc. In a sector where investor transparency of asset quality can be opaque, our confidence was made firm by the reputation of CEO Mark Papa. This underscored the reasonable valuation for a firm that was tracking towards tripling oil production in three years, without significant debt leverage. We greatly appreciated Papa’s blunt realism when speaking of the industry, as it served to counter the frequent unbounded optimism of too many management teams. However, as the calendar year closed with a slowdown in energy prices and the industry suffering bottlenecks in the Permian, Papa opened the year with, perhaps, too blunt of a message: having lost confidence in a sustained commodity price recovery, Centennial shelved those long-held growth targets and massively disappointed investors. Though the selling pressure was intense, we believe the market will come to realize it has undershot the value of the company as it reconsiders the potential free cash flow generation in a slower growth environment. With rising acquisition activity in the Permian (breaking news on Anadarko Petroleum Corp.), investors may come to acknowledge the value of Centennial’s land, which sports efficiency potential due to acreage situated for long laterals.

Natus Medical Inc. (BABY) (-25%) has made products traditionally associated with neonatal care (from hearing tests to cooling blankets). The company diversified into neurological care and, more recently, acquired a new technology that promises to disrupt the hearing aid fitting market, much the way the CEREC system did in the digital fitting of dental crowns and veneers. After setting a goal, only two years ago, to double the company in size, Natus hit a rough patch of slowing growth which served to highlight the lack of integration undertaken and the need to cull lower returning products. We have begun to build a position in the company, seeing notable upside potential from both the restructuring and the laser-scanning hearing aid fitting technology, longer term.

Outlook

Overall, we continue to view the portfolio as a collection of high-quality names, positioned for excellent risk-adjusted returns across a market cycle. In conclusion, thank you for your investing alongside us in the Small Cap Select Value Strategy. We appreciate your confidence and trust.