Commentary – 4th Quarter 2019

Performance

For the quarter ended December 31, 2019, the Small Cap Value Strategy increased 7.71% gross (7.58% net of fees) versus a gain of 8.49% for the Russell 2000 Value Index. For the year 2019, the Strategy is up 26.99% gross (26.31% net of fees) compared with 22.39% for the benchmark.

Commentary

The old adage, “Don’t fight the Fed” remains true. With the Fed on hold given the dovish bias for 2020, plus the outlook for renewed growth in trade/capital spending as the uncertainty is lifted with Phase I of the China/US trade agreement, the market posted another strong quarter in a row. The environment was a complete reversal of the fourth quarter last year. 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 lagged 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 as essentially all of the performance gains in 2019 were driven by multiple expansion (valuation). The global growth recovery in capital expenditures should benefit many of our industrial 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. Consumer Discretionary should also do well with the strong employment outlook while Financials should benefit from loan growth and yield curve steepening. Lastly, we have seen an uptick in merger and acquisition activity, which we expect to continue into 2020, as further clarity in trade, the economy and eventually, the US Presidential election take hold.

Portfolio Review

Sector allocation effect benefitted the portfolio this quarter as we were under-weight the worst performing sectors, Utilities, Real Estate and Financials, and had a slight overweight to Technology and Healthcare, the top two performing sectors in the Russell 2000 Value index.  Our perennial overweight to Industrials also benefitted the portfolio as this sector was the fourth best performing in the quarter. 

From a stock selection standpoint, the confidence in the economic upturn led our Industrial holdings to outperform the index by 380 basis points.  In Healthcare, senior housing operator Pennant Group jumped 120% on its recently spin-off from CareTrust REIT, Wright Medical Group was up 48% as it agreed to be acquired by Stryker, and Invacare increased 20% after posting strong results demonstrating the company is on track with its turnaround.  In Communications Services, Nexstar Media was up 15% as the integration of the Tribune acquisition is proceeding ahead of plan and many expect a strong Presidential political ad spend year in 2020.  Unfortunately, execution issues at four companies plus owning the more value-side of Tech (best performing sector up 21%) more than offset the positive selection mentioned above.  Del Taco and Modine Manufacturing within Consumer Discretionary, Sensient Technologies in Materials and CareTrust REIT in Real Estate all had issues impacting them over the past two quarters.  Del Taco (down 23%) has been slow to implement new technologies to capture the growth from the food delivery channel (GrubHub, Uber Eats) resulting in lower than expected same store sales growth.  Modine (down 32%) lost focus on its core business while trying to sell its non-core auto segment and CareTrust REIT (down 11%) has had lingering tenant issues (skilled nursing operators) as it integrated acquired properties into its portfolio.  Sensient (down 3%) has been hampered in its restructuring efforts of its Flavors division due to a slowdown at its customers.  It lowered guidance for the second quarter in a row as uncertainty from BREXIT, tariffs and a delay in the turn in the cosmetics market pushed out new product offerings.  We continue to monitor these holdings and believe the business fundamentals remain intact despite these temporary setbacks.

Leading Contributors

KBR, Inc. (KBR) has transitioned from an engineering and construction (E&C) business to a government service business under new CEO, Stuart Bradie, which led to its recent reclassification from the Industrial to the Technology sector. KBR had a strong year in its Government Services segment securing more business than expected under the LOGCAP V military base contract. With the reclassification and Government Services a larger mix of the total company, the company has received a higher valuation versus the core E&C peers. In addition, the company was able to complete the work on the Ichthys LNG contract which has plagued the engineering and construction side of the business for years.

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. With the reset in guidance, the company reported better than expected third quarter results with improving cashflow which management is using to pay off some of the debt it took on for the A&S acquisition. The resulting leverage reduction should improve earnings and likely give the valuation a lift.

Nexstar Media Group, Inc. (NXST), is one of the largest owners of domestic television broadcasting stations. The shares performed well as the company raised its cashflow expectations with the closing of the Tribune acquisition. The company sold fewer than anticipated stations required by the FCC to close the transaction yet received much higher than expected sales prices enabling Nexstar to delerage the balance sheet. Further, 2020 is expected to be a very strong political ad spend year with the upcoming Presidential election.

Leading Detractors

Del Taco Restaurants, Inc. (TACO) develops, franchises, owns, and operates Del Taco quick-service Mexican-American restaurants. The stock was weak after posting lower than expected third quarter results and lowering full year 2019 guidance. Despite new menu additions like the Beyond Meat platform, the company’s core Value Menu has not been refreshed in a while which has resulted in lower comp store growth. In addition, the company has been late in adopting new delivery services that has driven strong growth at its peers. With the launch of GrubHub and Postmates delivery in the fourth quarter plus tying this with promotions on their growing digital app base, the company has seen a pickup in traffic trends. Further, the company plans to revamp its Value Menu in early 2020 and expects to accelerate new store openings, both company-owned and franchise.

Modine Manufacturing Company (MOD) is a manufacturer of thermal management systems such as heat transfer systems and components for a variety of markets including on and off-highway vehicles, building/industrial HVAC systems and refrigeration systems. Strategically, management has been increasing the company’s HVAC mix via acquisitions and planned to further reduce its Vehicle exposure to less than 50% by selling the Automotive segment (40% of Vehicular sales). It will still retain the heavy truck and off-highway business. Weakness in the Vehicular market were well-known, however, mis-execution at Commercial/Industrial (CIS), and a prolonged sale of the Auto segment led the company to miss earnings two quarters in a row. With the sale of Auto expected shortly, a change in leadership at CIS plus a recently announced cost reduction program, we believe MOD will stabilize its growth and rerate higher as an industrial HVAC company versus a lower multiple auto parts supplier.

CareTrust REIT (CTRE), is a healthcare REIT focused on skilled nursing facilities (SNF) and assisted living and independent living facilities. CareTrust consistently set itself apart from peers by avoiding underlying tenant troubles but that came to an abrupt stop this quarter with problems in Ohio and Michigan.  The company is aggressively taking action by selling ten facilities (three in Ohio and seven in Michigan) while re-leasing or providing rent concessions for the remaining troubled facilities.  Once these actions are complete, the underlying portfolio will be much stronger from a quality and rent-coverage standpoint.  Management expects to get back on-track in short order with an attractive $100 million investment pipeline and arguably one of the best balance sheets (among peers) to support this growth

Outlook

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