Third Quarter 2016

Small Cap Commentary | Q3 2016

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Overview

In the third quarter of 2016, small-cap stocks got their performance revenge on large-caps, with the Russell 2000 rising 9.0%.  This was significantly better than the S&P 500 return of 3.9%.  Year-to-date, the Russell 2000 has now gained 11.4% (vs. 7.8% for the S&P 500), and from their mid-February nadir small-cap stocks are up over 30%.

What was somewhat unusual about the third quarter was that gains were led by the most cyclical sectors of the market: technology (+16%), materials (+12%), and energy (+10%), all of which did better than the index.  Some commentators have noted that it is uncommon to see such a strong rally in economically-sensitive industries this late in a market cycle.

We believe that over the past three years, investors have clearly preferred safe, boring, dividend-paying stocks over more pro-cyclical ones.  Going into the third quarter, it was the most defensive sectors that had done the best: consumer staples (+51%), utilities (+39%) and healthcare (+39%).

We think this is a reflection of a “credit crisis” mentality that still permeates many investors’ outlook.  Energy (-58%), consumer discretionary (+6%), and producer durables (+8%) have all lagged meaningfully.

The result of this performance disparity, as we have noted before, is a gaping difference in valuations between these two groups of stocks.  Cyclical stocks remain as cheap as they have been on a relative basis in over a decade.

Our exposure to the more defensive groups, many of which we consider to be expensive and vulnerable to higher interest rates, is much lower than average today.  We are significantly underweight healthcare (-9.3%), real estate (-6.7%), utilities (no exposure), and materials (-2.7%).

We are, however, overweight several of the more cyclical groups that we consider to be depressed, cheap, and out-of-favor.  Our largest over-weighted groups are financials (+8.3%), consumer discretionary (+7.5%), and industrials (+5.8%).

We believe that a stock is only as “safe” as the price you pay for it, and when the stocks of non-cyclical businesses get bid up to lofty levels, the risk of investing is magnified. 

A final observation about the third quarter was the significant reversal in performance by the smallest public companies relative to the largest.  For the past several years, the trend has clearly been the smaller a company’s size, the worse its performance.  Large caps outperformed small-caps, and small-caps outperformed micro-caps.  In the third quarter, microcaps finally got their due, rising 11.2% (compared to only 9% for the Russell 2000 as a whole).

The Punch Small Cap Strategy has always favored smaller companies, even within the small-cap universe.  The median market cap of the strategy today is $570 million, below the $750 million of the Russell 2000 and significantly below the $1.8 billion of the average small-cap mutual fund.  Approximately three-quarters of the portfolio’s holdings are under $1 billion market capitalization.

We believe that the structural inefficiencies that make investing in small-caps attractive are most common and most pronounced among these smallest of public companies.  It stands to reason that companies with the fewest sell-side analysts writing research reports on their stock, the smallest institutional shareholder bases, and the least press coverage would have the least efficient stock prices.

While this subset of the small-cap asset class has lagged the past couple of years, we think that the record of history shows that, over time, those investors willing to roll up their sleeves and dig into lesser-known companies will be rewarded.  Indeed, the smallest decile of public companies has outperformed the largest by two-to-one over the past seventy-five years.

Initiations and Exits

We initiated two new positions and exited one in the third quarter, ending the quarter with 45 total positions.

In July we added software technology company Carbonite (CARB, $415mn market cap) to the portfolio after meeting with the company’s relatively new CEO, Mohamad Ali (no relation to the deceased boxer).  Carbonite was a hot 2011 technology IPO that quickly fizzled; five years after its debut, the stock price sat at roughly half its opening bid.  New management, a new strategy, and an attractive acquisition have changed the company’s story significantly, and we think the market has yet to grasp the magnitude of these changes.

Carbonite provides cloud backup services on a subscription basis to both consumers and small- and medium-sized businesses.  Since the service is so critical, its customers are quite loyal, creating both sticky and highly profitable revenues to the company.  While the company does have several close competitors, we think the company’s size, track record, and reputation give it an edge in this niche market.

“Broken IPOs” are a good source of ideas for us, and we routinely look for such companies that have gone public to much fanfare but subsequently fail to match lofty expectations. Typically the resulting fallout is a bevy of frustrated investors and intense selling pressure. When a valuation that has gone from “on fire” to “out cold,” there is an opportunity for more dispassionate investors to assess the company, its prospects, and its valuation more rationally. Carbonite is a perfect example.

In September we also took an initial stake in Texas-based homebuilder Green Brick Partners (GRBK, $411mn market cap).  Green Brick operates in two primary markets—the Dallas/Ft. Worth metro area, and Atlanta—and builds a range of house types, from townhomes to luxury homes.  The company is unique in its operating model in that they have equity stakes in several smaller builders in their markets rather than owning the building operations outright.  This equity participation incentivizes both capital and operating efficiencies and effectively creates partnerships with local builders who have the reputation and local know-how to succeed.

The history of Green Brick is informative and we believe a real competitive advantage in this industry. The company is majority-owned by three entities: Greenlight Capital (David Einhorn),  Third Point LLC (Dan Loeb), and CEO Jim Brickman.  Mr. Brickman is a Texas native and real estate developer who worked closely with Mr. Einhorn to uncover improprieties at public company Allied Capital, much of which was detailed in Mr. Einhorn’s 2007 book Fooling Some of the People All of the Time.

We think that, because it is a controlled company with relatively low float, Green Brick has yet to gain much attention from either sell-side analysts or buy-side investors. The company over 5,000 land lots that were acquired during the credit crisis at distressed prices by Mr. Brickman and Greenlight Capital, and the current valuation of the company does not reflect this embedded value. What’s more, the homebuilding sector has not seen a meaningful pickup since the end of the credit crisis eight years ago and should this sector finally show signs of life, stocks like Green Brick could shed their discounted valuations.

Also in September we exited long-time holding Syntel Inc (SYNT, $3.5 bn market cap).  Syntel has been in the portfolio continuously since 2005, and has been a strong contributor to performance.  The company provides business process outsourcing (BPO) to major corporations in the U.S., primarily through its labor centers in India.  Its largest and longest clients include such behemoths as American Express, State Street, and Fedex.

Way back in 2005, two things initially attracted us to Syntel.  The first was the undeniable secular trend by major corporations towards moving low-value labor expenses to low-cost geographies around the world.  The second was the stickiness and profitability of these services to the companies providing them.  Once a company like American Express decides to shift large chunks of its operations and labor force overseas, outsourced services become embedded into the processes of the company, and it becomes extremely difficult to undo.

The result is high returns on capital for premier providers like Syntel: over the past decade, the company has produced returns on equity between 25% and 40% and has compounded book value per share by over 23% annually.

As you might imagine, this success over the years has attracted attention, and the company now has a dozen sell-side analysts following the stock and a market cap that puts it solidly in the mid-cap sector.  We took the opportunity ahead of a large special one-time dividend to exit the stock after having trimmed in several times already over the years.

Outlook and Conclusion

Not long ago, several members from our research team took a day trip down the Mississippi River to visit a small publicly-traded furniture manufacturer in Iowa.  As we do with many companies we are seriously researching, we had an afternoon of meetings scheduled with the executives of the company, followed by a tour of the nearby upholstered furniture plant.

After the usual introductions and pleasantries with the CEO and CFO, we casually asked how often they hosted investors like us.  “You’re the first ones to visit us in nearly five years!” was their reply.  When we hear that from a company, it tends to get us excited, in much the same way that a beachcomber might when his metal detector starts beeping over a clump of sand.  While the beeping alone doesn’t tell us what lies beneath—it could be a dime or a diamond bracelet—the simple fact that we are one of the few to take notice is significant.

We design our research process specifically to look for the types of companies like the furniture manufacturer in Iowa: unknown, out-of-favor, under-researched, and sometimes hard to get to (the nearest airport was three hours away).  Performing due diligence research that others are unwilling or unable to perform is a real competitive advantage.  It is also increasingly rare in a money management industry focused on gathering assets and reducing costs.

While the market has not rewarded these types of investments lately (smaller, lesser known companies), we think that this trend in and of itself is creating interesting opportunities for those investors still willing to do the “dirty work” of finding and researching under-the-radar companies.

Over the past ten years, the smallest decile of publicly-traded companies has produced an annualized return of just 5.0% (see chart on the next page).  This is one of the lowest figures going back to the 1930s, and has historically been a trough level.

What this means is that small-cap investors have had the wind in their faces for much of the past ten years.  Returns have been subdued, and investor enthusiasm is predictably low.  As contrarians, we get excited about statistics like these because they are the ideal conditions for planting seeds in hopes of returns in the years and­ decades ahead.

Disclosure:

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 may 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.

Punch & Associates claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS® standards.  Please refer to the attached Composite Profile and Schedule of Performance for information regarding Punch & Associates’ compliance with GIPS® standards.

*Inception of the Punch Small Cap Equity Strategy was March 31, 2002. **CTR represents the contribution to total attribution.

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 andy@punchinvest.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.