Commentary – 3rd Quarter 2019

Performance

For the quarter ended September 30, 2019, the Small Cap Select Value Strategy depreciated -1.29% gross (-1.50% net of fees) versus a loss of -2.40% for the Russell 2000 Index and a loss of -0.57% for the Russell 2000 Value Index. Year-to-date, the Strategy appreciated 17.29% gross (16.56% net of fees) versus gains of 14.18% and 12.82% for the respective benchmarks.

Macroeconomic Review

In September of last year, President Trump decisively intensified the trade battle against China with the publication of “US Section 301 Final List 3,” outlining additional tariffs on a broader swath of goods. Since late last summer, small capitalization stocks (as measured by the Russell 2000 Index and the Russell 2000 Value Index) have declined by about 15% while the large cap S&P 500 Index remains slightly higher. Domestic-orientation was expected to shield small cap companies from potential tariff-driven overseas weakness. But it has become clear that increased trade actions have extended that pressure to the domestic economy. At the moment, recession forecasts have frequented news headlines along with debates around “stall speed”, the lowest level of growth which the economy can sustain.

At quarter’s end, macro datapoints were undeniably gloomier than at the start. Chief among these are the manufacturing indices—those which directly correlate with the impact of tariff actions upon the production of goods. Though the US purchasing managers index (PMI) appeared to stabilize earlier in the year, it turned downwards following additional tariff actions and has now marked two months below a reading of 50 (seen as contractionary). Similar PMI measurements in the Eurozone have continued eighteen months of freefall readings, with Germany marking a reading of 41.7 in September and linked quarter GDP of -0.1% in Q2. Taken together, export-driven Germany is likely entering recession.

In response, The Federal Reserve is attempting to extend the economic expansion, with two 25 basis point cuts during the quarter. While the Fed forecast no further rate cuts for the year, Chairman Powell stated “we’re prepared to be aggressive” if the economy weakens more. Market expectations are rising for a third cut by the end of the year based upon interpretation of recent data. In its deliberation, the Fed appears to be balancing the impact of trade sanctions against a relatively healthy U.S. consumer.

While we acknowledge the classic warning signs of recession have appeared, among them a period of yield curve inversion, we are less quick to conclude such an event is imminent. One of the key reasons remains the consumer and the services industry, which together, represent about two thirds of the economy. Similar PMI readings for the non-manufacturing industry remain above 50, or in expansionary mode. Likewise, the consumer remains quite healthy: wages are rising, consumer spending growth is solid (registering +4.7% in Q2, the largest growth in four years), household debt as a percentage of disposable income is as low as it was in 2001, gasoline prices remain low, and initial jobless claims have shown no indication of rising from the lowest levels in decades. In short, we believe the economy continues to grow at a decelerating, but positive rate.

After a very strong start in the first half of the year, the portfolio lagged the Russell 2000 Value benchmark by 72 basis points gross but outperformed the Russell 2000 by 111 basis points gross. Relative to the Value index, technology remained our strongest source of outperformance by a significant margin. Our technology holdings were driven by positive fundamentals and a renewed interest towards value names within the optical sector, a software special situation case (discussed below), and strength in consumables-based semiconductor suppliers (as demand trends hold steady, despite a delayed recovery in semiconductor capital equipment spending). As for laggards, three sectors contributed to half of our underperformance: consumer, REITs and healthcare. Within consumer, most of the drag came from an earnings miss at Ethan Allen Interiors Inc. (-8% portfolio total return for the quarter). REITs were beneficiaries of the sharp intra-quarter decline in interest rates, yet our continued underweight position did not allow us to participate. Within healthcare, an earnings miss at long-term holding ICU Medical, Inc. (-37%) contributed the bulk of the drag.

Leading Contributors

Infinera Corporation (INFN) designs and builds network equipment for optical transport, which is the high-speed transmission of data in the form of light waves. After the stock declined last quarter on account of new order delays resulting from the Coriant acquisition, investors were then given a sharp boost of confidence that the integrated company is beginning to take shape. This past quarter, bookings grew 15% sequentially and a new product design moved into the critical “tape-out” stage of manufacturing. In addition, Cisco Systems Inc’s acquisition of Acacia Communications, Inc, a chip supplier to the optical industry, has reminded the industry of the paucity of independent, vertical manufacturers (unique to Infinera). We continue to believe in the significant earnings leverage of the combined company, backed by the secular driver of data consumption.

Cloudera, Inc. (CLDR) provides software, developed on a base of open-sourced code, to analyze enormous data sets transacted in the IT cloud. Already considered a “busted IPO”, a confluence of negative events brought the stock tumbling as the remaining growth investors exited in force. Following the acquisition of peer Hortonworks, Inc, the company revised down expectations as a merged product suite was delayed, the co-founder and longtime ceo exited the company, and customer churn spiked with the alignment of the two business models. Though traumatic, many of the issues appeared transitory to us. Based upon our experience with software business models, we believed the stock was trading at a trough valuation, and so we established a modest position. We patiently expected the planned release of the updated software suite to provide a catalyst near the end of the year. Quite unexpectedly, Icahn Enterprises established an 18% position in the following month and placed two members on the board, also citing the company as undervalued.

AAR Corp. (AIR) provides various outsourced services to airline operators, from maintenance, repair and overhaul to supply chain management. In reviewing our portfolio’s potential exposure to the Boeing 737-MAX earlier this spring, we returned to AAR (a former holding of ours, whose stock had fallen out of favor since we had exited the position). After a year of responding to rising labor rates, the stock marked a low as investors broadly shunned aerospace stocks in response to headlines of the 737-MAX tragedy. We reasoned that if new planes were to be delayed, older planes would be used more excessively in the interim, requiring heavier maintenance operations. Some aspect of this thesis was present in last quarter’s earnings, along with two other dynamics. First, efforts by the company to ensure a ready supply of labor appear to have stabilized earlier issues. Secondly, the company is making sizeable headway in building a supply chain distribution business which also includes the profitable refurbishment of parts garnered from jobs performed in the maintenance business lines. We believe these efforts will lead to a recovery in organic growth, which is not reflected in the stock’s modest valuation.

Leading Detractors

Patterson Companies Inc. (PDCO) is a distributor of dental and veterinary consumables and capital equipment. A new CEO is finishing up his second year (the CFO, his first year) of shepherding a difficult and protracted turnaround following the termination of an exclusive distribution agreement with Sirona Dental (now a division of Dentsply Sirona Inc.), an event that predated his tenure. Management has brought about stability in revenue and segment margins, even pursing balance sheet actions that lowered debt levels by 20%. However, investor patience for signs of operational recovery has been strained given a series of management teams at the helm during this period of erosion. We do believe this management team is rebuilding a more focused company and point out that the six percent dividend yield supports waiting for signs of traction.

Meredith Corporation (MDP) is a creator of national and local lifestyle content delivered across digital, print and broadcast media. Two years ago, the steadily growing company catapulted itself forward with the acquisition of Time Inc and began an ambitious turnaround process of divesting a sizeable basket of properties, cutting costs, repaying debt and restarting growth. As the company closed out on its first full year of the combined entity, it lowered guidance for the coming year, admitting its goals were too high to be realized within the time frame first proposed to investors. Though cost synergies have been achieved as planned, the divestiture process was prolonged and yielded lower proceeds than anticipated. In addition, the company conceded that the legacy Time assets had degraded somewhat. Thus, it will require more time and resources to put the business back on track. While we do not look favorably on management teams who make such miscalculations, we acknowledge that the business has begun to track to a healthier trajectory. Similarly, the current stock valuation has approached a level that one might consider as distressed, offering sizeable upside potential for patient investors.

PICU Medical, Inc. (ICUI) is a medical devices company exclusively focused on IV therapy products. As a long term holding, we were first drawn to the company’s history in needleless connectors and custom IV kits. Since that time, ICU has significantly grown its business, expanding market share and deepening vertical integration by acquiring its primary customer, Hospira. Given the highly regulated nature of the IV business, the company proved to be the beneficiary of a broad industry shortage of IV fluids brought about by limited supply at peers: a hurricane-driven facility outage at one and downtime related to regulator-imposed critical maintenance at another. What was not clear at the time was the degree to which the business became inflated during that interim period of 2018. With the past quarter’s earnings report, the company has now completely lapsed that period, making that aberration clear. Management lowered guidance as the business has currently settled at a lower baseline than had trended during the shortage year. Likewise, the condition of the acquired Hospira business required more effort to optimize than anticipated. As the company finishes the integration process by optimizing manufacturing and distribution (which proved delayed due to the demands of the industry shortage), we fully expect the company to again post impressive metrics around margins and cash flow, a potential not reflected in the current stock price.

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 believe will 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.