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Our firm has managed the Punch Small Cap Strategy since our founding in 2002. This strategy’s objective is long-term capital appreciation. We do this by investing in some of the smallest, least-followed publicly traded companies where we think opportunities to find undervalued securities are greatest.
We are value investors, and across all the Punch strategies we seek to protect against permanent loss of capital. We like to find solid businesses and buy them at valuations that we feel provide a meaningful margin of safety. If we do this consistently, when something goes wrong, the businesses in the portfolio can still survive and eventually thrive when the environment normalizes.
We believe that a few factors are causing some of our favorite companies to be punished more than others in this environment. During the past three months:
The COVID-19 pandemic is likely impacting every business across the world in some way. A small fraction of companies may benefit in the near term. The vast majority of companies are like people going through this pandemic, their businesses have no choice but to adapt. Some will have to do so rapidly. Companies with relatively stable demand (or demand that they can recoup) are best positioned to drive shareholder return. Those with deferred demand will need to find ways to defer costs and maintain enough liquidity on their balance sheets to get to the other side of the crisis. Our strategy has always favored businesses with entrenched customer bases (which should leave demand relatively intact or only deferred), strong balance sheets, and strong management teams.
We are not being Pollyannaish with respect to COVID-19 and its near- and long-term implications for businesses. Our investment team is hard at work having lengthy conversations with the management teams of the companies in our portfolios. While conversing with management is a regular part of our research process, in recent weeks we have put this this practice into overdrive. We have had dozens of conversations daily with companies. That said, we recognize that the world has changed in the last three weeks, which means that a conversation from a month ago may already be quite stale.
Over time, we believe the market will reward small cap companies, even though our strategy lagged the Russell 2000 Index during the quarter. Sector allocation was a main reason for the underperformance. The Punch Small Cap Strategy was underweight in the healthcare sector and overweight in the consumer discretionary sector. As you might expect during a pandemic with social distancing as the only near-term solution, healthcare was a top performing sector, and consumer discretionary was one of the worst. The companies in the Russell 2000 healthcare sector tend to be some of the most speculative with little current earnings power. With our focus on downside protection, we are content to underweight companies with these characteristics.
A majority of the consumer discretionary companies in the Punch Small Cap Strategy have characteristics that make demand largely deferred (housing-related, cars, golf equipment, etc.) but not lost (for example, we do not own any restaurants). We believe, with time, our companies will regain much of their near-term lost revenue, have the balance sheets to sustain themselves, and even gain market share during this pause in economic activity. We maintain our belief that we have positioned the portfolio well to survive the present economic damage.
Comparing our strategy to the Russell 2000 Index, it becomes apparent that:
Par Pacific Holdings, Inc. (PARR, $381 million market cap) was a detractor in the quarter. Par Pacific owns refineries, energy infrastructure, and gas stations in Wyoming, Washington, and Hawaii. The company’s strategy is to focus on geographically isolated markets where it can build a durable competitive advantage. Washington was an early hot spot for the US COVID-19 outbreak, and a decrease in Hawaiian tourism and related air travel caused near-term challenges for the company. We believe the reduction in demand for energy is temporary, and its advantaged locations allow Par to be well positioned when the economy normalizes. Today, the company trades at approximately 60% of its book value with substantial cash on hand and access to further liquidity through credit lines. In addition, it has no near-term debt maturities and very few debt covenants. We are also encouraged that management is buying stock in the open market during the downturn. While not naïve to the short-term risks, we think Par Pacific will rebound and has an aligned and capable management team to lead it through a challenging period.
Callaway Golf Company (ELY, $962 million market cap) manufactures and sells golf equipment and apparel. Our ownership stake was another detractor for the strategy. Consumer discretionary stocks as a whole did not do well in the quarter, and Callaway was no exception. Golf has not completely gone away during our sheltering-in-place because it is one of the few sports that is compatible with social distancing. We believe recent decreases in equipment demand will likely be regained as their customer base tends to be loyal, and they refresh their equipment regularly. Our larger near-term concerns are the lifestyle apparel segment and debt taken on in 2019 to finance a related acquisition. We are comfortable with the company’s overall capital structure and their ability to navigate through the downturn. Most of the company’s debt does not mature until 2026 and does not have financial maintenance covenants. With a business diversified from both a geographic and segment perspective, strong brand recognition, and a loyal customer base, we remain invested in the company.
RadNet, Inc. (RDNT, $533 million market cap) was another detractor in the quarter. RadNet operates over 300 outpatient diagnostic imaging clinics. The company’s operations were impacted meaningfully by COVID-19, as elective procedures were deferred. In addition, RadNet’s concentration in California and New York, which were especially affected, didn’t help. We believe RadNet’s business is an example where demand is deferred but not permanently lost. The company started conserving cash by furloughing employees in March, cutting executives’ pay, and putting planned investments on hold. There is some short-term optionality embedded in the business, as the company could dedicate certain facilities to help battle COVID-19, though those discussions are at an early stage. Prior to the pandemic, the company was below its debt covenant ceilings and had room to maneuver. Long-term, we believe the company should be well positioned: the industry dynamics continue to favor RadNet’s business model, and we feel it should be able to gain market share as one of the strongest industry participants.
During the quarter, the top contributor to our return was Spok Holdings, Inc. (SPOK, $203 million market cap). This healthcare communications company designs and sells software used in hospitals that allows doctors and nurses to communicate through several mobile modalities, a vital resource especially during the current pandemic. Over the past few years, Spok has harvested cash flow from their declining pager business to fund the development of an integrated software platform while also paying a steady dividend to shareholders.
Growth of the new integrated software platform has been slow and uneven, and as a result, the company has gotten little love from the market. At quarter end, Spok was trading at an undemanding valuation of 0.78x enterprise value-to-revenue while holding over $77 million of net cash. The strong cash flow created by the pager business, along with the opportunity to grow the software platform, attracted a third-party takeout offer during the quarter at $12 per share (a roughly 39% premium). While the board of directors unanimously declined the offer, interest from a potential acquirer and a net cash balance sheet encouraged investors during a volatile market.
Longtime holding, Novanta Inc. (NOVT, $2.80 billion market cap), was a top contributor to performance. This Massachusetts-based company engineers and sells complex components used in both industrial and medical applications. Almost four years ago, the business hired a new CEO who has successfully focused the business on niche, growth areas within the healthcare industry (including DNA sequencing and robotic surgery). Novanta and its valuable patent portfolio is difficult to displace because they design highly engineered components into their customers’ products and processes.
During a tumultuous and largely unforgiving quarter, Novanta’s shares proved to be resilient, as investors appreciated their medical end market exposure, clean balance sheet, and sticky customer relationships. While the valuation (at 22x enterprise value-to-EBITDA) at quarter end was rich, we believe that attractive end markets and a strong innovation pipeline position the company well to gain market share.
The third largest contributor was CSW Industrials Inc. (CSWI, $981 million market cap). This supplier of specialty chemicals and industrial products serves a diverse group of end markets including HVAC, plumbing, rail, and architecturally specified building products. The company has generated strong results in recent years, as it innovates new products, integrates once siloed operations, and layers on acquisitions to add scale. We believe that CSWI has become less cyclical overtime, as the specialty chemical business grows and customers use more products for repairs instead of new construction. For example, the company sells lubricant to the railroad industry that is used to extend the life of rails and reduce the need to replace expensive train parts. These characteristics, along with a reasonable valuation of 10.7x enterprise value-to-EBITDA, helped the shares hold up during a difficult quarter for the financial markets. Finally, the company has a strong balance sheet and ample liquidity to make it through even the most painful of economic downturns, leaving us to be optimistic about the opportunity for this business to exit the pandemic in a strong position.
We took a position in FARO Technologies, Inc. (FARO, $777 million market cap) in late January. FARO makes 3D laser scanners and trackers for measurement, inspection, and precision assembly alignment. We believe FARO plays well into the secular trends of factory automation, robotic assembly, as well as increased efficiencies in the construction and remodeling markets. The company has been on our watchlist for over five years, and we have been writing internal research on it since March 2015. After reinvesting in R&D and sales and marketing in 2016 and 2017, the company focused on refreshing their best-in-class line up of products. Despite the improvements, the company continued to struggle to drive meaningful sales growth. We doubled down on our research efforts once FARO’s new CEO, Michael Burger, started in June 2019.
Mr. Burger has a reputation of being a wonderful manager, and he has the track record to prove it. We know this first hand, because we have successfully invested with Mr. Burger in the past. Although FARO is a larger company than others he has managed, he now has a pristine balance sheet with $158 million of cash, no debt, and a strong brand name to boot. Burger’s strategic initiatives include increasing the company’s value proposition for customers and changing FARO’s go-to-market strategy. Before the COVID-19 crisis, management was targeting 20% EBITDA margins—more than double the previous year.
FARO has been through our disciplined research process. We think the company is well positioned to survive this crisis and thrive when it’s over. We added to our position in late March when investors were selling stocks indiscriminately.
COVID-19’s economic damage is real, but we recognize the market is forward looking and will eventually see past the current issues. History doesn’t repeat itself, but it rhymes. As with past market downturns, our approach is consistent.
We have executed these actions over the past few weeks, and we will continue to do so. At the same time, we are careful not to overreact during periods of extreme volatility. As always, we treat each investment as an ownership interest in a business, and in so doing, we maintain a multi-year view for the investment’s potential success.