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In a quarter that felt more volatile than it was, the small cap Russell 2000 benchmark fell a mere 0.08% between January 1st and March 31st and logged its first negative quarter in two years. It may come as a surprise that, based on average daily price changes, the first quarter was slightly less volatile than average over the last twenty years (source: Furey Research Partners). It appears that last year’s calm waters were the anomaly, not the rougher seas of 2018.
Despite the quarter’s turbulence, the growth and momentum cycles appear to be firmly intact. Growth stocks did better than value among small caps in the first quarter (+2.3% for the Russell 2000 Growth Index compared to -2.6% for the Russell Value Index), and for the fourth time in the past five quarters, healthcare stocks outperformed the index.
From a sector perspective, it is interesting to note that among the worst-performing groups were real estate (-8.1%), utilities (-6.4%), and telecommunications (-4.9%). All three tend to have above-average correlations to interest rates and have served as a sort of “bond proxy” throughout the past few years. As rates rose due to inflation fears in the first quarter, these groups suffered..
The Punch Small Cap Strategy produced a total return of +2.4% in the first quarter (net of fees), largely driven by stock selection (+302 basis points). Sector allocation was a drag on the portfolio (-48 basis points). As fundamental, bottoms-up investors with a relatively concentrated portfolio (48 holdings), we would expect that, over time, individual stock selection should drive most of our performance.
In the first quarter, our performance was driven by our overweight to industrials—our third largest sector in the portfolio today—and strong security selection in technology. We had one takeover in the portfolio in the first quarter which was an e-commerce supply chain company acquired by a consortium of private equity funds.
Energy was the worst performing sector in the quarter (down 11.4%, on the heels of an 18.6% downdraft in 2017), and we continue to be attracted to this beleaguered area of the market. We added to our largest energy holding (more below) and maintain a close watch list of exploration and production (E&P), service, and infrastructure companies whose shares have been affected by this industry downturn..
The largest detractor from performance in the first quarter was television broadcaster E.W. Scripps Company (SSP, $980 million market cap). Scripps, one of the largest owners of local television affiliates in the country, is a company in transition after longtime CEO Rich Boehne retired last year, and Adam Symson assumed the reins as CEO. Symson is a younger executive who cut his teeth in the television business and most recently ran Scripps’s digital division.
We believe that the big opportunity today for television broadcasters like Scripps is the rewriting of the 42-year-old Federal Communications Commission rules (effective November, 2017) which previously disallowed ownership of multiple TV stations in the same markets. The economies of scale that come with owning multiple stations in the same market are compelling, as there’s potential for significant operating margin expansion over a larger revenue base. What’s more, it may not require capital on the part of broadcasters to capture this scale, as station owners may simply “swap” stations with each other for mutual benefit. While the process to either acquire or swap stations has yet to begin, we believe that, when it does, there will be a re-rating of the entire industry. In the meantime, we’ve noticed some frustration on the part of investors that consolidation is not happening more quickly, and this sentiment may be weighing on shares industrywide. The Dow Jones Small Cap Broadcast Index declined by 7.5% in the first quarter.
The management transition at Scripps, coupled with the frustrating pace of M&A in the industry, has attracted the attention of activist shareholders. In February, Scripps holder GAMCO Asset Management nominated three directors to the board at the annual meeting to be held in May. We will be watching the proxy process carefully and believe that the one thing that both sides agree on is that the value of the company’s assets are significantly higher than the market capitalization today.
Entertainment company Drive Shack Inc. (DS, $320 million market cap) detracted from performance in the first quarter, possibly in sympathy with weak results at public company comparable Dave & Busters (PLAY, -24% in Q1), but we added to the position in anticipation of the April 8th opening of Drive Shack’s first driving range entertainment concept in Orlando, Florida. The concept is largely modeled after Top Golf which now has 42 locations in the U.S. and U.K. We believe that this emerging industry of golf entertainment has room for two national players, with Top Golf and Drive Shack rapidly building out a network of locations in major metro areas around the country.
Drive Shack has publicly stated that they can self-finance 15 locations with existing capital and cash proceeds from the sale of their portfolio of 28 owned golf courses. With an up-front cost of $25 million, management projects that each Drive Shack location will produce a “mid-to-high-teens” return on capital, and they believe they can build between five and 10 sites per year.
Drive Shack has also been a company in transition over the past couple of years, as this former real estate investment trust (REIT) has moved away from distressed debt investing and toward becoming a pure play entertainment company. In the process, the company changed its name from Newcastle Investment Corp., dropped its REIT status, and internalized its management structure. Now that the first Drive Shack location is officially open, we think that investors will better understand the company and pay more attention to it.
Refinery company Par Pacific (PARR, $780 million market cap) ended the quarter as our largest energy-related holding after we added to it on weakness, as energy was the worst-performing sector in the quarter. As we have detailed in past commentaries, Par Pacific was originally a defunct E&P energy concern with over $1 billion in net operating losses (NOLs) that investor Sam Zell recapitalized in 2012. Today, Par Pacific has multiple refinery locations in addition to a network of convenience stations on the island of Oahu and assorted logistics assets in both Hawaii and Wyoming. At today’s valuation, these assets produce an attractive 10% free cash flow yield.
In addition, the company has a 42% equity interest in a Colorado-based E&P company that is something of a “hidden asset.” We think that this asset could represent a meaningful portion of the market value of the company today and will likely be monetized over the next couple of years.
The two top contributors to return in the quarter were both technology companies. Online consumer marketplace Etsy Inc. (ETSY, $3.4 billion market cap) was the largest contributor and continues its turnaround under new leadership. We believe that Etsy maintains an enviable edge over other online retailers given its sizable community of buyers and sellers and the network effects commensurate with a marketplace business. Marketplace revenues accelerated for the first time in nearly two years in the fourth quarter, and margins expanded nicely. Despite its valuation today, we think that the strategic value of the platform—and the growth potential for this once-broken IPO—warrant Etsy as a continued holding in the strategy. What’s more, the new CEO and the new CFO (whom we know and respect as the CFO of a previous portfolio holding) have been on the job for less than a year, and we believe that more meaningful improvement in the business is ahead.
The second largest contributor to performance in the quarter was Techtarget Inc. (TTGT, $550 million market cap), a long-time holding for the Punch Small Cap Strategy. We have been shareholders of the company since 2012. Techtarget operates a network of business-to-business (B2B) online marketing websites aimed at IT professionals. With articles, reviews, whitepapers, and customer data, the company provides sophisticated buyers of technology with the resources they need to find, research, and ultimately decide on which providers to select. We believe that Techtarget is one of the largest B2B technology marketing platforms today, and its unique content library, data on buyer behavior, and relationships with the largest IT advertisers in the world all create a competitive advantage that is not easily replicable.
We believe that the business model is also highly attractive from a financial standpoint, with one-third of revenues being subscription-based, incremental operating margins over 50%, and new, rapidly-growing products representing half of the business. We are also fans of Techtarget’s management team which has bought in over 40% of shares outstanding through both dutch tender offers and open market repurchases over the past decade. Part of the reason that this company has been so shareholder-friendly, we believe, is that insiders hold half of the stock. We like to see shareholders’ interests aligned with those of management and directors.
The third largest contributor to performance in the first quarter was Callaway Golf (ELY, $1.6 billion market cap), the well-known branded manufacturer of golf equipment. We recently had the chance to sit down with their CEO, Chip Brewer, and their CFO, Brian Lynch, to get an update on the game of golf and on Callaway, more specifically. Maybe it’s because we just finished Masters weekend, but we thought it would be fun to include a few snippets from our conversation (paraphrased):
Callaway’s core strength has always been in our brands. We were built on innovation, and that is what golfers know about us. We have re-committed to product innovation and are focused on giving golfers better products at premium prices.
We firmly believe that the “gloom and doom” story that the media has put out around golf is wrong. Participation has stabilized, interest in the sport is growing, and junior golf is at its highest levels ever. Specific to the golf equipment industry, now that there has been significant consolidation among competitors, the business is healthier today than at any time since I’ve been in the industry.
The year 2017 was a phenomenal year for our driver business, and the “jailbreak” technology in the Epic driver is truly breakthrough and allowed us to capture the #1 driver position for the year. So far in 2018, we are seeing solid sell-through for Rogue drivers and irons at retail.
We added one new position (Kimball International) and exited one (CECO Environmental) in the first quarter, ending with 48 total positions in the Punch Small Cap Strategy.
Kimball International (KBAL, $640 million market cap) is an Indiana-based manufacturer of furniture for office, residential, hospitality, and healthcare markets. While the company has been public since the early 1980s, for many years it was a quasi-private company that did not engage with outside shareholders and had a dual-class share structure that kept its founding family firmly in control. Kimball had many of the hallmarks of an insular company with little interest in shareholder accountability, including lavish executive pay, several private jets, and sub-par operating margins. Wall Street returned this treatment with apathy, and the company was, for many years, an “orphan” of the public markets.
All of this began to change for Kimball in 2014. At that time, the company decided to split in two, separating the furniture manufacturing and the electronics manufacturing segments into independent public companies by way of a spin-off. At the same time, the company discarded its dual-class share structure in favor of a single class that put shareholders on a more level playing field with insiders. There was significant turnover in management, including a new CEO who remarked to us at one point, “A new day has dawned at Kimball.” Gone also were the private jets, executive perks, and poor corporate governance.
On the operating front, management also quickly moved to get financial performance from “worst” to “first.” After closing facilities and streamlining operations, operating margins have gone from under 3% in 2014 to over 8% in 2017, with a stated goal of double-digits in the near term. The company now boasts the best return on invested capital (ROIC) in the industry as well as the best balance sheet with no debt and nearly $80 million in cash.
While the commercial furniture industry is competitive and cyclical, we believe that the secular changes occurring today favor smaller players like Kimball. Gone are the days of expensive, large scale, cubicle work environments; instead, today’s offices resemble residential environments with soft seating, collaborative spaces, and flexible work stations. With unemployment falling and commercial construction booming, Kimball is enjoying the tailwinds of strong end markets.
The company has no analyst coverage and trades at below-market multiples of earnings and cashflow. We believe that, over time, more investors will wake up to the recent dramatic changes at the company, and the shares could receive a more appropriate valuation.
Early in the first quarter we exited industrial conglomerate CECO Environmental (CECE, $160 million market cap), which is an Ohio-based company with end markets in pollution control equipment, power generation, and specialty pumps. As we detailed last quarter, new management has not reacted with sufficient urgency to address challenges in their deteriorating markets, and after several in-person meetings with both the incoming CEO and CFO, we decided to exit the position.
When we exit a position, especially after a disappointing investment result, we like to perform a “post-mortem” on the holding and on our original investment thesis. We believe it is both a healthy and informative exercise in humility to scrutinize where we went wrong. As famed Fidelity fund manager Anthony Bolton said in his recent book, “Good fund managers should be humble and happy to make mistakes [emphasis added]; mistakes are an integral part of the job.”
With CECO Environmental, our original thesis was that a talented CEO was executing a series of acquisitions of underperforming, niche industrial businesses and that management was focused on re-energizing this old-line manufacturing company into a diversified, asset-light company with above-average margins and free cash flow.
While the company did execute several acquisitions successfully, it quickly turned out that the management depth required to integrate and maintain these disparate businesses was lacking, and organic growth remained elusive. A severe downturn in the power generation and refinery markets exposed the cracks in the strategy. These cracks were then compounded by turnover in the c-suite at precisely the wrong time. Debt-fueled rollups carry risks that should be monitored closely, including the ultimate level of leverage, the degree to which acquisitions are integrated, and the health of the business both pre- and post-acquisition.
In a fascinating article in a recent issue of Grant’s Interest Rate Observer, editor Jim Grant discusses at length the small cap Russell 2000 Index and what that benchmark looks like today. To summarize the theme of the article, he quotes renowned value investor Chuck Royce who says, “The index [today] is not a company you want to buy.”
According to Bloomberg, of the 1,985 companies in the Russell 2000 Index, one third of them were unprofitable over the last twelve months. The median leverage employed at these companies was 2x EBITDA, and 17.6% of companies do not even cover their interest expense with earnings before interest and taxes. What’s more, according to the Grant’s article, nearly half of the debt incurred by Russell 2000 companies is floating-rate.
In this environment of low interest rates and open capital markets, companies with no earnings, too much debt, and questionable financial profiles can actually do alright. In the first quarter, the one-third of Russell 2000 companies whose businesses are unprofitable outperformed those companies that were profitable. According to Furey Research, the stocks of loss-making companies rose 3.5% while those of profitable companies fell 1.3%.
In the Punch Small Cap Strategy, we focus on companies that have operating profits and conservative financial profiles. We want to own many of these companies for three-to-five years or longer, and we want them to be able to weather any economic storm. While the outperformance of low-quality companies lately has been a frustration for disciplined, value-oriented investors, we believe in the old Warren Buffet saying, “It’s only when the tide goes out that you find out who’s been swimming naked.”