Mid Cap Value Strategy

September 2019

THE MARKET ENVIRONMENT
Recession – a word that strikes fear in the hearts of economists and investors alike – became a frequent topic of conversation in the third quarter. Alarm arose when the 2-year and 10-year Treasury yields inverted, which many fear signals a weakening economy. While economic pundits argue that the yield activity alone does not point to a downturn, the last five 2-10 inversions eventually led to recessions.

The curve inversion came amid a cascade of discouraging economic news. The U.S. economy grew only 2% (annualized) in the second quarter, which was far lower than the 3%-plus growth rates realized over the past year. Manufacturing activity shrank in August for the first time since August 2016. Also in that month, job growth fell short of expectations with downward revisions of July and June data as well. Consumer confidence declined to a three-month low level in September, prompted by unrelenting anxiety over trade wars, and the Federal Reserve decided to cut key interest rates in both July and September. Fed Chairman Jerome Powell stated that while the economy remained strong and unemployment low, “there are risks to this positive outlook.” 

In a surprising move, the Business Roundtable (a consortium of chief executives from the country’s top businesses, including Apple, IBM and JPMorgan Chase) released a “statement on the purpose of a corporation” that outlined a fresh perspective for the role of a company. The declaration counters the prevailing Milton Friedman-based economic view that the only job of a business is to make money for shareholders. Instead, the statement promises to consider the interests of all stakeholders, including customers, employees, suppliers and communities, and was endorsed by 181 of 193 Roundtable members. Some CEOs intimated that the philosophical shift stemmed from an increased public focus on corporate responsibility.  

Looking forward, we acknowledge that there are several factors that will influence both the economy and markets. While not a welcomed event, we know that a recession is a natural part of a market cycle. That is why, when considering whether a company is a suitable investment, we look for a durable revenue stream that can withstand periods of slow macroeconomic growth. We also scrutinize management teams and look for those that recognize the role of all stakeholders alongside shareholders in building successful businesses. We think this approach can work to strengthen company fundamentals and provide greater shareholder rewards in the long term. 

 

THE PORTFOLIO
Top Performers:
Ally Financial’s second-quarter total revenue and earnings per share surpassed market expectations. Results were good, by our standards, with total revenue that reached $1.55 billion, which reflected growth of 6% from the prior year. Earnings per share rose 17% to $0.97, driven partly by a 7.5% reduction in shares outstanding. Retail deposits grew 21% (total deposits increased 18%), while retail customers grew 23%. Deposits now account for over 70% of the company’s total funding sources. Net income advanced nearly 67%, which we found impressive. We took particular note of management’s commentary about future net interest income trends. Unlike many other banks, Ally Financial’s reinvestment rate from automotive financing is higher than its current portfolio yield, which we think positions the company to achieve greater net interest income through the second half of 2019. 

Qorvo’s fiscal first-quarter revenue ($776 million) and earnings per share ($1.36) far outpaced market expectations. We think management is doing a very good job taking charge of factors under the company’s control, despite some challenges from unsettled trade disputes. Qorvo’s business looks solid to us heading into a potentially major 5G-related handset replacement cycle. We also expect benefits from an acceleration in non-handset segments, such as internet of things growth, and from continued potential share gains in the high-end bulk acoustic wave market. Lastly, management issued second-quarter revenue and earnings per share guidance in excess of market forecasts. 

Masco reported second-quarter revenue that undershot market expectations, while earnings per share were ahead of forecasts. It appears that results were better than the market feared, while we viewed the company’s quarterly performance as average. Organic revenue growth was unchanged from a year earlier, primarily driven by weakness in the international plumbing and cabinetry markets. However, despite softer revenue from cabinets, division margins were the best Masco has seen in a decade and management expects low single-digit full-year sales growth. Management also anticipates slightly slower full-year revenue growth in plumbing (+1-3%) given the low single-digit declines that have occurred in international markets. We were pleased that total earnings increased 5% and grew across all divisions. Later in the quarter, Masco increased the quarterly shareholder dividend payment by 12.5% and announced a new program to buy back up to $2 billion worth of shares.

Bottom Performers:
Along with other exploration and production companies, Centennial Resource Development’s share price came under pressure in the third quarter. The company was also adversely impacted by multiple negative analysts’ notes downgrading the company. However, Centennial’s second-quarter earnings report beat consensus production estimates by 6% and also beat the market’s expectations for adjusted earnings ($170 million vs. $155 million). Management increased production guidance for 2019 by 8%, while lowering guidance for operating expenditures (-12%) and general and administrative costs (-16%). The company also called out well production activity as now showing a 10% improvement over 2018. Drilling time has gone down 15% year-over-year, completion time has come down 25% year-over-year and total capital efficiency improved 5% year-over-year. Despite some challenges in the short term, we like that Centennial has already managed to optimize its wells in the Permian Basin beyond what previous operators were able to achieve. We believe that as the company pinpoints new target zones and fine-tunes well designs for its acres, it is advantageously positioned to build upon its early successes into the future. 

Under Armour’s share price fell significantly after the company released its second-quarter earnings report. We think the market overreacted as we viewed results as satisfactory. Revenue growth of 1.4% (+3% in constant currency) slightly missed market forecasts. Revenue in North America declined 3.2%, owing to reestablishing the company’s full price premium model after a couple years of using price discounts to clear inventories, and we see this as a temporary situation. Concurrently, international revenue grew 13.3%. We were pleased that Under Armour’s gross profit margin again expanded (+170 basis points) and selling, general and administrative expenses grew modestly (+2%). If these trends continue, we believe the company can return to acceptable profitability in coming quarters. While management left full-year revenue growth guidance unchanged (+3-4%), the composition was updated to include a slight decline in North America compensated for by low- to mid-teens growth in the international markets. 

Lear preannounced its second-quarter earnings results and also trimmed full-year earnings guidance by 15% in July, which proved disappointing to investors. In our estimation, the seating segment performed well, with margins up 60 basis points quarter-over-quarter. However, e-systems revenues are projected to decline 5%. We met with management later in the third quarter to discuss both the seating and e-systems segments. Overall, the team’s confidence in seating is exceptionally strong and CEO Ray Scott is optimistic that new talent in e-systems will turn the segment around. Seating recently underwent a series of major model changes over the past few quarters without missing a beat and its dollar market share grew from 17% in 2013 to 23% today. The team is confident the company is on the cutting edge of seating design for both electric and shareable vehicles and believes that 28% dollar market share is achievable over the next five years. We continue to believe Lear is significantly undervalued relative to its normalized earnings power. 

During the quarter, we initiated a position in Agilent Technologies.

Past performance is no guarantee of future results.

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