Mid Cap Value Strategy

March 2019

THE MARKET ENVIRONMENT
Despite episodes of volatility that occurred over the past three months, key U.S. indexes ended higher for the first quarter, extending what most identify as the longest bull market in history. While some have argued that indexes temporarily dipped into bear territory since the financial crisis recovery began in March 2009, no one can dispute that both the Dow Jones Industrial Average and the S&P 500 Indexes have more than quadrupled in value from 10 years ago. 

For several years, it seemed as if financial market and economic growth would continue unabated. However, the positive tide may be turning as some leading economic indicators are showing signs of weakness. Even though manufacturing sector job growth at the end of 2018 was the highest it had been in the last 30 years, factory production during the first quarter reached the lowest level since 2017. Contrary to market analysts’ forecasts of gains, manufacturing output fell in January and February due to pressures of trade disputes and slower global growth. Monthly building permits also fell in excess of market projections. In addition, the Treasury yield curve recently inverted, which many believe points to an impending recession. Furthermore, according to FactSet, an above-average number of S&P 500 constituent companies that issued first-quarter guidance are expecting negative earnings per share. After assessing current conditions, the Federal Reserve left key interest rates unchanged and stated it does not foresee raising rates through 2019.

While some near-term indicators might appear troubling, other crucial economic measures remain on steady ground. Unemployment is still at historically low levels and in February wages grew 3.1% from a year earlier, the fastest pace since 2009. Concurrently, we continue to see evidence that companies are working to strengthen underlying fundamentals, which may lessen the impacts from some immediate negative trends. Yet we acknowledge that many unresolved issues (e.g., lack of a trade agreement with China, possible increased auto tariffs, fallout from Brexit) could spark a touch of fear in the market. If so, market factors may lead to deeply discounted share prices of fundamentally sound companies and we stand ready to capitalize on the additional investment opportunities this scenario would provide.

THE PORTFOLIO
Top Performers:
Tenet Healthcare’s fourth-quarter earnings results exceeded market expectations on CEO Ron Rittenmeyer’s continued efforts to cut operating expenses. Adjusted earnings ($684.0 million vs. $666.1 million) beat analysts’ estimates, while fiscal-year 2019 guidance for the figure bested consensus expectations as well. Guidance for 2019 earnings per share was also in excess of market outlook. We like that Tenet has a history of smart capital allocation, including significant share repurchases at what we consider cheap prices. In our view, the company is taking the right steps to improve performance, adding to our confidence in the investment.

Ellie Mae agreed to be acquired by Thoma Bravo for about $3.7 billion ($99 per share) in cash. We decided to liquidate our position and redeployed the proceeds to purchase shares of other holdings.

Liberty Broadband holds a nearly 25% stake in Charter Communications and Liberty’s share price rose after Charter reported strong fourth-quarter results. Charter’s year-over-year revenue rose 5.9% and adjusted earnings (excluding mobile revenue and operating expenses) advanced 7.6%, which was the highest rate since the second quarter of 2017. Both metrics outpaced market projections. Subsequently, some market analysts increased share price targets for Liberty Broadband, which helped boost its share price even higher. As we have previously expressed, owning shares of Liberty Broadband provides us with a less expensive way to own Charter. We believe that the cable business has become a much higher quality, internet connectivity-centric business and that this dynamic is underappreciated by the market. In many markets, Charter has the only fiber-rich network capable of providing consumers with the high internet speeds they increasingly demand. Competitor efforts to enter the market have proven uneconomic due to the fractional penetration available to new entrants. Thus, barriers to entry are quite high, providing a long runway for growth for the incumbent cable operators. We have great respect for the management teams and think shareholders will continue to be rewarded by their stewardship.

Bottom Performers:
Centennial Resource Development’s fourth-quarter earnings report fell short of analysts’ expectations. The company was also negatively impacted by the revision of 2019 capital expenditures and production guidance as investors were concerned there was a greater drop in production than capital expenditures relative to consensus. CEO Mark Papa cited parent-child well development issues, though these will likely affect all operators in the Permian Basin over time. All things considered, we believe Centennial is now trading at an even larger discount to our perception of its intrinsic value given its best-in-class management team and its operations in premium acreage.

Qurate Retail’s share price dropped sharply following the release of its fourth-quarter earnings report in late February. The HSN acquisition has, thus far, produced disappointing results while various international QVC assets also underperformed. In our view, the stock looks very inexpensive as share repurchases and expected HSN synergies alone should drive earnings per share higher in 2019. We believe the company is an above-average retailer with little investment needed to support growth. We continue to believe the valuation for Qurate remains attractive, offering a compelling reason to own.

As was largely the case with e-brokers in the U.S., E*TRADE was negatively impacted by the yield curve moving lower in March. In our view, the company’s fourth-quarter earnings results were solid as net new assets increased 4.3% and helped drive a 15% year-over-year increase in revenue. Operating leverage and cost control drove 30% adjusted earnings growth, while earnings per share more than doubled to $1.06 in the fourth quarter. In addition, E*TRADE repurchased 10 million shares (or 4% of the float), adding to our confidence in management’s commitment to adding value for its shareholders. We think that while the company may face some short-term obstacles, its long-term outlook is promising.

During the quarter, E*Trade, LivaNova, ManpowerGroup and Masco were added to the portfolio. Ellie Mae, Flex, and Foot Locker were final sales.

Past performance is no guarantee of future results.

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