The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
The last time we touched base it was in July. While only a short while ago, it seems like an eternity with all this market volatility and news flow. Could you give us an update on what has happened over the third quarter and where the fund stands year-to-date (YTD) for 2020?
Based on how the Fund has performed, it has clearly been an eternity for us also. We take our job very seriously and have a lot of pride in what we do, and this has been very difficult period. We underperformed the benchmark, the Russell 2000 Index, for the third quarter and trail YTD. To summarize, our positions just aren’t firing. We would bucket the shortfall into four parts: 1) early cycle challenges tied to fund construction, 2) biotechnology exposure, 3) headwinds from defensive posture and 4) struggle with stock selection, especially at the top of the portfolio.
Of this shortfall, we would characterize nearly half as based on process, which is not terribly unexpected. Clearly early cycle can be a challenge, and if biotechnology rips, it can clearly create a headwind. This isn’t to say that we expect to lose under these circumstances, but rather recognizing the fact that both dynamics could present challenges due to our process. We tend to have larger size, lower volatility, lower beta, higher quality and while exposed to biotechnology, we are likely to be underweight because of the binary nature of many of the companies. For perspective, our peers also tend to be underweight this segment, so currently while underweight, we are generally right in-line with the average core manager.
The remainder of the shortfall is tougher to digest and is poorly timed, rather than providing an offset to early cycle and biotechnology, this compounded the problem. There is no sugar coating it: we were too slow to react to the all-in stimulus the government was providing and we really thought this pandemic was going to cause much bigger problems. Hence, our more defensive posture, as well as our stock selection has been a headwind, which is very clear at top of the Fund. Historically, this has not been the case.
Can you elaborate, please talk more about stock selection discuss the challenges at the top of the portfolio?
First, many of the type of stocks we have owned and the sectors we were overweight coming off the bottom have hurt us because they were too conservative. We have migrated as this has become more evident, but the damage was already done, and we moved too slowly. Examples are being overweight consumer staples too long and owning steadier service companies in industrials, or a data center rather than a higher growth software company. This is an environment that is embracing greater growth and risk and generally has not been how we have been built, especially considering we were late in this economic cycle and economic growth has been lackluster.
Second, we hurt ourselves by selling or trimming names that were working too early based on being concerned about valuation. This was another mistake as valuation has not been the focal point in this market, and good growth stories continue to rise to even higher valuations. Great examples of this that we owned would be Enphase Energy, Inc. and Generac Holdings, Inc. We identified these plays on energy storage very early but sold shares in Enphase and trimmed Generac when they were up in excess of 100%, and when valuations were multiples of historical ranges. While that was not the right maneuver, it is difficult to estimate how long this continues.
The top 20 holdings of the portfolio have been over a 500 basis points (bps) drag on performance YTD. We would suggest there are multiple disappointments for a variety of reasons. There are several names which, while not a drag YTD, were up way more and have cooled off recently for one reason or another. Examples of this would be Switch, Inc., Knight-Swift Transportation Holdings Inc., Chemed Corp., Encore Capital Group, Inc., and 2U, Inc. There are others that just seem stuck like Encompass Health Corp, and then there are several that have just been poor performers like Cardtronics, Inc., TreeHouse Foods Inc. and Coherent, Inc.
So, what do we do? n a number of cases, we have been selectively adding to these top positions. If we believe in something and can see catalyst to be proven correct in a reasonable time horizon, it only makes sense to do so. Overall, there hasn't been tremendous turnover at the top of the portfolio, but we have trimmed some names where we are less clear of a catalyst, or where they are not as well set up for the current environment.
Our biggest disappointment by far YTD has been Cardtronics, which has cost over 250 bps. By adding to the name in March, it further compounded the performance headwind as this stock fell like many in mid-March, but has not recovered since that time, unlike others. We can only speculate why it has not worked because it hasn’t been numbers, but it would appear there clearly is concern that cash is going away or at least being greatly diminished by digital payments. However, we just don’t think that is correct and it has not born out in the numbers, but the stock has clearly felt that controversy. While we are confident that this will be proven out favorably over time, it just seems like too much of a headwind to be a top holding like it has been. As a result, we have reluctantly trimmed Cardtronics until it becomes clearer that there is greater proof the company can grow share with its ATM network and transactions can accelerate.
Another disappointment is TreeHouse, which has cost us over 150 bps. While some of this pain has clearly been caused by poor communications by this company, much of what has happened has been misfortune. During typical recessions, private label food companies thrive and gain share as consumers tighten their belts and look for value to save money. This recession has been anything but typical. There was significant demand for food at home due to the lockdown which pressured private label more than branded due their smaller scale, and consumers were not price sensitive because they received stimulus from the government. While TreeHouse generated much more cash flow during this period than was expected, the optics of private label losing share to branded and the logistical pressures felt were not embraced by investors. To add to this, investors' desire for greater risk hasn't bode well for the consumers staples sector overall. While we now are slightly underweight consumer staples with TreeHouse being our only position in the sector, we have reduced our exposure to the name.
What shifts have you made to the portfolio since July?
We continue to migrate to greater risk, adding plays on a re-opening and a broader cyclical recovery. At the sector level, we added about 700 bps to the consumer discretionary sector, 50 bps to industrials, 25 bps to energy and health care. On the sell side, we sold about 200 bps of communication services, consumer staples, financials and information technology, as well as 65 bps of utilities. Some examples of names added would be Envista Holdings Corp., Boot Barn Holdings Inc., Triton International Ltd., Warrior Met Coal, Inc. and American Eagle Outfitters, Inc. Some examples of what we sold are First Solar, Inc., Cogent Communications Holdings, Inc., Vonage Holdings Corp., Integer Holdings Corp. and Bunge Limited.
Year-to date, the small-cap growth category is up roughly 15%, whereas small-cap value is down roughly 15%. Were we more value driven than growth driven? Are we now leaning toward more cyclicals?
It's very hard to assess what others are doing. Generally, some core managers tend to lean more towards value than we have historically. We attribute our trailing performance having to do with the type of stocks we own and how we were positioned early in the upturn. We have a concentrated product and the top of the portfolio wasn’t firing.
Fundamentals on the growth side generally are fine, but the question is how much are you willing to pay for it? If the market starts to care about valuation, the turn could be dramatic because the valuation discrepancy is dramatic. We are trying not to lean too hard either way and let stock selection drive performance. It is also important to remember the biggest difference between growth and value has much to do with the sector exposure in both indices. Growth has significant exposure to information technology and healthcare, while value has significant exposure to financials.
What would have to happen in the market for things to be beneficial for the portfolio?
We aren’t trying to manage the strategy to a specific market. This has certainly been a unique time in the market, where we had a two-month period where the market was down around 40-45%, and then a three-month period where the market was up around 60%. It has been a very strange period. We had a recession where personal income was actually up due to government stimulus.
We haven’t changed our stripes a whole lot. While we do try to adjust, the environment changed in radical fashion. Unfortunately, we also had some poor stock selection, which can certainly happen especially in shorter timeframes like this. We've been in an environment of extremes. If things calm down a bit, we think that would be beneficial to the strategy. If the market sells off some, we think we would most likely fare well in that environment. If the market rips up another 60%, that would probably be a challenge. If the market is more sideways instead of making such large swings in short periods of time, that would probably be a more suitable environment for the strategy.
Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This informa¬tion is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. The views are current through Oct. 14, 2020 and are subject to change at any time based on market or other conditions.
Risk Factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in small-cap growth and value stocks may carry more risk than investing in stocks of larger, more well-established companies. Growth stocks may be more volatile or not perform as well as value stocks or the stock market in general. Value stocks are stocks of companies that may have experienced adverse developments or may be subject to special risks that have caused the stocks to be out of favor and, in the opinion of the Fund’s manager, undervalued. Such security may never reach what the manager believes to be its full value, or such security’s value may decrease. The Fund typically holds a limited number of stocks (generally 40 to 60). As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s net asset value than it would if the Fund invested in a larger number of securities. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.
The Russell 2000® Index is a float-adjusted market capitalization weighted index that measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000® Index is a subset of the Russell 3000® and includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000® Growth Index and the Russell 2000® Value Index are float-adjusted market capitalization weighted indexes that measure the performance of the small-cap growth and small-cap value segments of the U.S equity universe, respectively. It is not possible to invest directly in an index.
Top 10 holdings as a % of net assets as of 09/30/2020: Switch, Inc. Class A 3.9, TreeHouse Foods, Inc. 3.6, Chemed Corp. 3.4, 2U, Inc. 3.3, Coherent, Inc. 3.0, Knight-Swift Transportation Holdings, Inc. Class A 2.7, Halozyme Therapeutics, Inc. 2.7, Encompass Health Corp. 2.5, TopBuild Corp. 2.4, TCF Financial Corp. 2.3.
Beta is a measure of a stock’s volatility relative to the movements in the overall market.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.