Mid Cap Value Strategy

June 2019

THE MARKET ENVIRONMENT
Despite fears about new tariffs and trade wars that caused mid-quarter market volatility, key U.S. indexes posted gains for the full second quarter of 2019. Notably, the S&P 500 and Nasdaq Composite indexes reached record highs during the period owing to a few developments that investors viewed positively. After some on-again, off-again talks between the U.S. and China, there was strong optimism that the two countries would finally arrive at a trade agreement. It was widely reported that Presidents Donald Trump and Xi Jinping would meet at the G-20 economic summit (after the quarter concluded) to work out trade details, and investors were pleased that progress was being made. Concurrently, in response to Mexico’s increased efforts to mitigate illegal immigration into the U.S., Trump suspended plans to increase tariffs on imports from the country. In addition, the Federal Reserve left key interest rates unchanged at its quarterly meeting and hinted that rates may be cut in the future (if economic conditions warrant), a move that investors appear to favor.
 
Meanwhile, we were pleased to learn that investors directed $14.4 billion into global equity funds during a one-week period in June, which marked the largest inflow over the prior 15 months, according to a report issued by Bank of America. Likewise, U.S. equity funds attracted $17.8 billion, which was the most invested in 14 weeks. We found this news especially encouraging as it looks as if market investors have regained some confidence, at least for now, in equity investing. We hope this trend will continue because we believe that putting capital to work in this way could lead to solid future benefits.
 
As veteran investors, we recognize that future events may erase past gains. There are still significant issues that could affect market sentiment in the immediate term, such as rising tensions between the U.S. and Iran, concerns surrounding the impending presidential election, and even fallout from extreme summer weather events. Of course, consequences of these and other unforeseen events are unknown. However, our approach is to take such incidents in stride while we continue to look for opportunities these circumstances often provide. Our priority is to always put the needs of our investors first and use our expertise to deliver tangible benefits over the long term. 

THE PORTFOLIO
Top Performers:
Arconic’s first-quarter revenue of $3.54 billion met market expectations, while earnings per share of $0.39 exceeded market forecasts by about 10%. Revenue grew 3%, driven by volume growth across all business segments along with price increases in aero engines and fasteners with new contracts repriced at higher rates. Earnings (excluding one-time items) and earnings per share rose 15% and 26%, respectively, while margins expanded 120 basis points. Management also raised its guidance for full-year earnings per share and adjusted free cash flow. Following $700 million in share repurchases (about 7.5% of shares outstanding) in the first quarter, the company announced a plan to repurchase $200 million worth of additional shares at an accelerated pace. Notably, CEO John Plant and another director bought $1.1 million and $500,000 worth of stock, respectively, in the quarter. Even accounting for Arconic’s recent price increase, its shares are still trading at a healthy discount to our estimate of intrinsic value. 

Liberty Broadband holds an over 20% stake in Charter Communications. As a result, Liberty’s share price often moves in response to happenings at Charter. Late in April, Charter posted positive first-quarter earnings results, which included total revenue growth of 5.1% and total adjusted earnings growth of 4.2% (driven by cable segment earnings of +7%) from a year earlier. The strong earnings advance was driven by accelerating broadband subscriber net additions and margin expansion of 112 basis points, while capital expenses also declined 27% year-over-year. Management’s commentary called for fast-paced growth throughout 2019 and continued margin expansion stemming from decreasing non-programming costs, despite an increasing subscriber base. Cable companies in the U.S. are benefiting from strong demand for high-speed internet access, and in many markets, Charter currently has the only fiber-rich network capable of providing internet speeds that align with that demand. We believe the company is favorably positioned to grow its business and expand its market presence as new market entrants would need to invest considerable capital to compete. In addition, we like that an investment in Liberty affords us a cheaper opportunity to own Charter. 

Herc Holdings released first-quarter results that were acceptable, in our view. Total revenue rose 10.3% (to 475.7 million), equipment rental revenue advanced 2.3% (to $377.6 million) and earnings (EBITDA) rose 7.2% (to $142.3 million) from the prior year. Volumes were weaker than we had expected. However, management stated that the volume slowdown was expected due to timing issues from a few major projects that were pushed out to later in the year. We were pleased that pricing increased 3.8%, and management expressed confidence that pricing will remain strong for the next couple of quarters. In addition, expenses were well controlled as selling, general and administrative costs fell slightly more than 1% and free cash flow grew 25% from a year earlier. Management reaffirmed earnings and capital expenditures guidance for the full year. We are optimistic that positive performance trends at Herc Holdings should continue and our investment thesis for the company is unchanged.

Bottom Performers:
Escalating investor concerns surrounding plans by some Democratic U.S. presidential candidates to implement a “Medicare for All” policy (which would create a new federally financed health care system) pressured share prices of managed care providers, including Tenet Healthcare. Some health care suppliers argued that such a plan would destabilize the country’s health system and have a severe impact on the economy and jobs, all without fundamentally improving access to health care. We contend that even if a candidate in favor of universal health care is elected, implementing this plan would require a large-scale and protracted legislative change. In the meantime, Tenet’s first-quarter results included total revenue, earnings and earnings per share that exceeded market forecasts. However, underlying results in the hospital segment were mixed as same-hospital net patient service revenues grew 1.9% and net revenue per adjusted admission rose 1.3%, while net operating revenue from hospital operations fell 2.2% and total admissions declined 0.1% from a year earlier. Even so, management’s guidance for the second-quarter and full-year periods were largely in line with analysts’ estimates. Late in the quarter, the company announced a new multi-year agreement with Aetna (a CVS Health company) to provide members with ongoing in-network access to all of Tenet's hospitals, emergency centers, outpatient centers and other services. We think that while Tenet may face some short-term obstacles, its long-term outlook remains promising. 

Chesapeake Energy’s first-quarter revenue and earnings (before exploration expense) fell short of market expectations. In addition, management reduced guidance for full-year earnings and increased guidance for capital expenditures, which weighed on its share price. We subsequently sold our shares in favor of other names that offer better upside potential. 

LivaNova preannounced first-quarter sales of $250 million, which fell short of analysts’ expectations. The weakness was driven by neuromodulation, growing only 2% compared to market estimates for 12% growth. This shortfall was due to the launch of a new epilepsy drug, which doctors must test on patients prior to moving forward with LivaNova’s Vagus Nerve Stimulation (VNS) device. Importantly, Medtronic’s competing device has had little impact on VNS’s growth and we believe the new epilepsy drug will produce only a temporary headwind for LivaNova. While the company lowered full-year 2019 guidance, positive clinical data on LivaNova’s sutureless surgical aortic valve Perceval® provided a boost for the company in May. Overall, we appreciate the company’s management team and its progress growing the business and pipeline. Coupled with plans for direct-to-consumer advertisements, we believe LivaNova can sustain growth for years to come.

During the quarter, Apergy and Diamondback Energy were added to the portfolio. Axalta Coating Systems, Chesapeake Energy and News Corp were final sales.

Past performance is no guarantee of future results.

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