The first quarter of 2017 was a relatively quiet one for small-cap stocks, with the Russell 2000 rising 2.5% and the Russell Microcap Index up only 0.4%. After an unusually strong fourth quarter that saw the small-cap index rise nearly 14% after the November 8 presidential election, it perhaps isn’t surprising to see the market take a “breather” and digest recent gains.
From a sector perspective, the first quarter was the mirror opposite of the fourth quarter: generally speaking, the best-performing areas in the fourth quarter were the worst-performing ones in the first, and vice versa. Post-election, financials and energy sectors did substantially better than the rest of the market; both, however, declined in the first quarter. Healthcare, which was the lone declining sector in the fourth quarter, was far and away the best-performing one in the first (+12.5%). [See chart to the right].
Our continued underweight to healthcare stocks impacted performance of the Punch Small Cap Strategy in the first quarter of 2017, and our strategy lagged the benchmark, gaining 0.3% while the Russell 2000 rose 2.5%. From both an investor behavior and a valuation perspective, we continue to find it difficult to stomach the heady prices and capital inflows into this area of the market and are having difficulty finding investment ideas with a sufficient margin of safety.
We are, however, finding interesting opportunities in the financial and industrial areas, and we detail several recent additions to the portfolio in the paragraphs that follow.
Our top contributor to performance in the first quarter of 2017 was EW Scripps Company (SSP, $1.9 billion market cap), the sixth-largest television broadcaster in the country by number of stations owned.
Following a year (2016) when many broadcasters underperformed (SSP was up only 1.7% compared to a 21.3% return for the Russell 2000 Index), this group has started 2017 with a bang (SSP +21.3% vs RTY +2.5%). In 2016, concerns over shifting television viewership, as well as disappointing election spending on television advertising, contributed to underwhelming performance by both broadcast companies as a whole and their stocks. Following the election, however, there has been renewed excitement over the possible positive effects of relaxed regulations on television station ownership—which we believe could make broadcasters significantly more profitable—as well as a return to industry consolidation that took a hiatus last year. Already in 2017 we have seen news surface of a potential mega-deal in the purchase of Tribune company (NYSE: TRCO) by Sinclair Broadcasting (NDQ: SBGI).
We continue to like the broadcasting business in general for its cashflow characteristics and for the value that we think television still has for many viewers. We like Scripps in particular for their long track record of creating value in media, for their conservative capital management, and for their progress in shifting the business model to digital.
Our second-best contributor to performance in the year was a relatively new holding, Par Pacific Holdings (PARR, $750mn market cap), an oil refinery concern whose investment case we detailed last quarter.
In February, we sat down with company management at their Houston headquarters and came away excited about the opportunities that the company has to deploy capital by buying small refinery operations around the country and utilizing their over $1 billion in corporate net operating losses (NOLs). Perhaps the biggest takeaway from our meeting was management’s opinion that the “story” of Par Pacific remains relatively complicated and underappreciated by many investors, resulting in an attractive valuation, because the company never had a formal IPO and has only raised outside equity once. We think that, in time, as the company executes its strategy and gains more of a following, the investment case should become easier to understand.
The third-largest contributor to performance in the year was one of our largest holdings, Capital Southwest Corp. (CSWC, $270mn market cap), a Dallas-based business development company (BDC) that makes debt investments to private middle market companies.
Capital Southwest is distinct from most other public BDCs (of which there are approximately 40 in the U.S.) for three reasons: one, the company is internally managed whereas most BDC’s are externally managed; two, a majority of the company’s assets were in cash until very recently; three, the shares continue to trade at a 10% discount to net asset value (NAV) while most of the peers trade at premiums. Capital Southwest has no analyst coverage, and we think this lack of surveillance has contributed to undervalued shares. We last sat down with management in November in Dallas and came away feeling good about their ability to underwrite sensible debt deals despite a somewhat frothy credit environment.
Our largest detractor from performance in the quarter was communications equipment maker Digi International (DGII, $320 million market cap), a company that makes embedded components and networking equipment to wirelessly connect a wide variety of things to the internet, including NASA satellites, Doppler radars, and the international space station.
In November, Digi received an unsolicited offer from Belden Corp (NYSE: BDC) to acquire the company at $13.82 per share, a 33% premium at the time. Digi management quickly rejected the offer, and since then Belden has been oddly quiet about their further intentions. Shares of Digi have slowly drifted down from the offer price during this period of silence. We don’t know what the odds are that a deal eventually gets done, but we are happy owning Digi shares on their own merits as 40% of the market cap is in cash (with no debt) and the new management team has done an impressive job reinvigorating the once-sleepy company.
Our second largest detractor from performance was CECO Environmental Corp (CECE, $360mn market cap), a manufacturer of air pollution control equipment and specialty pumps.
In mid-January, the company abruptly announced the resignation of its longtime CEO, Jeff Lang, the architect of the company who had successfully acquired and integrated several large acquisitions since joining in early 2010. We believe that many investors had a favorable impression of Mr. Lang and his track record—ourselves included—and his abrupt departure took many by surprise.
Unsurprisingly, though, when the company reported its fourth quarter results in March, the numbers were disappointing and included a significant write-down of goodwill related to a prior acquisition. Write-downs and disappointing earnings seem to indicate that all was not well at the company and while the previous CEO was an excellent acquirer of businesses, he was perhaps not stellar at driving growth in a larger combined entity.
We met with the interim CEO of CECO at an industry conference in March following the fourth quarter earnings release and came away feeling hopeful that a refreshed management team and strategy can drive organic growth at the company (a missing piece of the puzzle under previous management). The company’s core end markets of power plants, industrial manufacturers, refineries, and energy pipelines are healthy and, importantly, CECO has a large installed base of equipment and a long history and reputation for reliability and quality that drives recurring aftermarket sales and new equipment installations. The company could generate 10% of its market cap in free cash flow this year, which we think makes the shares more than reasonably priced.
A significant detractor from performance, for the second quarter in a row, was Destination XL Group (DXLG, $140mn market cap), a retailer of men’s big-and-tall clothing. We extensively detailed our rationale for continuing to hold the shares last quarter, and since then the retail environment has only worsened. There were more retail bankruptcies in the first quarter of 2017 than there were in all of 2016 combined. Clearly, the “Amazon effect” is having a profound impact on the way Americans shop, especially for everyday items like clothing and accessories. We think there are reasons to believe that the niche of men’s big-and-tall has some immunity to the onslaught of online shopping, but at this point we are in “wait and see” mode, unwilling to commit further capital until we see convincing evidence that the business model is indeed intact. DXL management has communicated to investors that they believe 2017 will be the “inflection point” in their business when capital investments in new stores should slow and free cash flow should grow significantly. We are inclined to believe them but are taking a “trust but verify” approach as the sands of the retail landscape are shifting quickly.
We initiated two new positions and exited one in the first quarter, ending with 48 total positions.
The first new position was LSC Communications (LKSD, $830mn market cap), one of the largest providers of print services in the country, with over $3 billion in annual sales. The company was the book, catalog, and magazine division of printing conglomerate RR Donnelly (RRD) until it was spun out in September of 2016, concurrent with the formal split of the parent company into three separate, independent companies.
It should come as no surprise that print services, in general, is a slow-decline industry that is being disrupted by the secular shift toward digital media. However, LSC has several attractive characteristics. First, the company is in several of the more stable categories of the print industry, and we estimate that nearly half of LSC’s revenues are growing organically today. Second, LSC operates in a duopoly with Quad Graphics Corp (NYSE: QUAD), a similarly-sized peer that is stable and rational, which is positive for industry pricing and profitability despite its secular growth headwinds. Finally, the company generates significant free cash flow and is appropriately leveraged, with only 2x debt-to-EBITDA. We estimate that the company could fully pay off its debt within five years if it devoted free cash flow solely to debt reduction.
We believe, spin-offs can create interesting investment opportunities as there is often a lack of information and analysis around these newly-public companies, as well as forced selling pressure that can depress shares. LSC shares these characteristics as well as a couple others that piqued our interest. Book and magazine printing is an unsexy business that is widely known to be in decline; we believe there is a stigma associated with a business like this that contributes to a compelling stock valuation: LSC sports a 20% free cash flow yield and a 4% dividend yield (that can easily grow over time). Also, when the company was spun out of RR Donnelly, the parent company retained an approximately 20% equity stake that needed to be divested in relatively short order. This overhang and imminent equity offering translated into a nearly 40% decline in shares from the day of the spin-off up to the day of the stock offering. It was at this depressed level that we initiated our position.
We have met and talked with LSC management several times since their separation from RR Donnelly and have been impressed by their track record and strategy. We think it is relevant that the CEO of RR Donnelly, when given the choice, chose to move to smaller LSC to become its CEO, and we certainly like the provision in his employment contract that requires him to own stock in the company worth five times his annual salary.
The second new position we added to the portfolio in the first quarter is Bar Harbor Bankshares (BHB, $500mn market cap), a community bank based in Bar Harbor, Maine, with $1.8 billion in total assets.
Bar Harbor Bank is a conservative, well-managed community bank that mainly focuses on commercial and retail customers in northern Maine—a region with lower banking competition than many parts of the country whose primary industries are tourism, fishing (lobster), and agriculture (blueberries). The bank has excess capital, managed through the credit crisis virtually unscathed, and pays a consistent and rising dividend.
In 2015, the company announced its intention to deploy some of its excess capital by purchasing a similarly-sized New Hampshire community bank by the name of Lake Sunapee Bank. We think there are meaningful cost synergies for Bar Harbor management taking over the show at Lake Sunapee, and are excited to see what they can do instilling the operating and underwriting discipline of their own bank to a larger organization. In addition, both banks have wealth management divisions that, we believe, are underappreciated.
Our lone exit in the quarter was CorEnergy Infrastructure Trust (CORR, $420mn market cap), an energy-focused real estate investment trust (REIT) that underwrites triple-net-leases on oil and gas infrastructure assets, including pipelines and storage facilities.
Our initial investment in CorEnergy dates back to early 2015, a time when energy markets were in flux as commodity prices around the globe were falling. With a dividend yield over 8% and a stock price under stated book value, we thought the shares were being unfairly punished.
While the subsequent two years were anything but placid for the company and its stock price (shares fell 57% from peak-to-trough but fully recovered within a year), the fundamentals of the business withstood a terrible energy market quite well. Despite its two largest tenants going through bankruptcy proceedings, CorEnergy actually raised, not cut its dividend.During the first quarter, we decided that there were better opportunities elsewhere and exited the position.
Despite recent gains in the small-cap market post-election, we believe that there remain interesting opportunities for finding undervalued, underappreciated companies. Spin-offs, forced liquidations, companies with no analyst coverage, and the like are all parts of the small-cap landscape that are regular areas of interest to us. The additions to the portfolio this past quarter largely fall into those categories.
Regarding the market at large, we have two observations. The first is the potential effect of tax cuts on the valuation of small-cap companies. As the chart to the right shows (“The Potential Effect of Lower Corporate Tax Rates”, courtesy of Furey Research Partners), the boost to net income of hypothetical decreases in corporate tax rates could be meaningful—especially to more profitable industries and businesses. Although the ultimate outcome is anyone’s guess, tax reform appears to us to be one of the more concrete, and likely, proposed reforms to come out of the current administration.
The second observation is that, for small-caps as a whole, growth stocks have outperformed value in seven of the last ten years (the exceptions being 2008, 2012, and 2016, see table “Small Cap Performance: Growth vs. Value” below). Buoyed by falling interest rates and an improving economy, many lower-quality, unprofitable, and growth-oriented stocks have done well. In 2016, that trend dramatically reversed itself, and value stocks outperformed growth stocks by a wide margin (+32% vs +11%). While that trend has not continued so far in 2017 (the Russell 2000 Growth Index rose 4.6% while the Value Index fell 1.3% in the first quarter), we believe that at some point in the not-too-distant future, this cycle may turn again.
Punch & Associates Investment Management, Inc. (Punch & Associates) is a registered investment adviser; registration as an investment adviser does not imply a certain level of skill or training. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Information presented herein incorporate Punch & Associates’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. While efforts are made to ensure information contained herein is accurate, Punch & Associates cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.
Composite performance is shown net-of-fees and brokerage commissions paid by the underlying client accounts. Certain client accounts have directed us to reinvest income and dividends, while others have directed us to not reinvest such earnings. As such, performance data shown includes or excludes the reinvestment of income and dividends as appropriate, depending on whether the account has directed us to reinvest income and dividends. Past performance is no guarantee of future results, and investing in securities may result in a loss of principal.
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The reference to the top five and bottom five performers within the Punch Small Cap Equity Strategy portfolio is shown to demonstrate the effect of these securities on the strategy’s return during the period identified. The holdings identified do not represent all of the securities purchased, sold or recommended for advisory clients during the period of time shown. Past performance does not guarantee future results; therefore, it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Please contact Punch & Associates at email@example.com or (952)224-4350 to obtain details regarding the calculation’s methodology or to obtain a list showing every holding’s contribution to the overall strategy’s performance during the period of time shown.
Any benchmark indices shown are for illustrative and/or comparative purposes and have only been included to show the general trend in the markets in the periods indicated. Such indices have limitations when used for comparison or other purposes because they may have volatility, credit, or other material characteristics (such as number and types of securities or instruments represented) that are different from those of the Composite and/or any client account, and they do not reflect the Composite investment strategy or any other investment strategies generally employed by Punch & Associates. For example, the Composite for a particular client investment portfolio will generally hold substantially fewer securities than are contained in a particular index.
*Inception of the Punch Small Cap Equity Strategy was March 31, 2002. **CTR represents the contribution to total attribution.