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What a difference a quarter makes. At the start of the fourth quarter, small cap markets were standing on a solid return of 11.5% for the year. Despite trade wars, tariffs, Fed tightening, and plenty of political dysfunction, small caps seemed to shake off worries and march onward and upward. On October 1st, all of that changed. By the end of the quarter, the Russell 2000 had fallen 20.2% in three months.
This past quarter was the sixth-worst quarter for the Russell 2000 since 1979 and the worst December for small cap stocks since 1940 (source: Furey Research Partners). For the year, the Russell 2000 declined 11.0%.
While many prognosticators and talking heads have offered explanations for the swift decline we just experienced, we believe that, at its core, this downdraft was the result of worries over a classic Fed mistake by an inexperienced Fed Chair, compounded by momentum trading and year-end tax-loss selling. These technical factors likely accelerated the year-end declines and may have contributed to the quick snap-back we have seen already in the opening weeks of the new year.
So where do we go from here? If history is any guide, the forward 1-, 3-, and 5-year returns for small caps following terrible quarters is quite good (see conclusion for details). What is more telling, in our opinion, is that we have seen company insiders “step up to the plate” and commit personal capital in record amounts by buying shares in the open market. According to Bloomberg, the total value of monthly insider purchases by small cap companies spiked in the fourth quarter (see chart below). We believe this is a powerful indicator of value—that executives who know their businesses best are willing to risk personal capital in their shares at these valuations. We regularly screen for companies with significant insider buying as we believe it is one of the most powerful signals of investment opportunity, and when we see insiders buying en masse, we sit up and take notice.
The Punch Small Cap Strategy declined 21.1% in the fourth quarter, slightly worse than the 20.2% decline for the Russell 2000. For 2018, the Punch Small Cap Strategy outperformed the benchmark by 0.4% and was down -10.6% compared to -11.0%. Since inception the strategy has returned 9.3% annually compared to 7.4% for the benchmark.
In 2018, performance was largely driven by individual security selection (+315 basis points) while sector allocation was a drag (-199 bps). Our continued underweight to the healthcare sector (4.8% average weight vs. 16.1%) and a slight overweight to the energy sector (5.9% vs. 4.3%) both went against us in the year, as healthcare stocks in general were down only half as much as the index while the energy sector was the worst-performing group for the second year in a row. We continue to have extreme difficulty finding higher quality companies with value-priced shares in the healthcare arena. In energy, there is an abundance of them. Our underweight in the technology sector (8.9% vs. 14.9%) also hurt performance as this group was roughly flat on the year.
In general, the benchmark Russell 2000 continues to be comprised of many lower quality stocks that have led performance over the past several years. As of December 31, 33% of Russell 2000 companies were unprofitable on an earnings per share (EPS) basis. The median debt level for these companies was 3x debt/ebitda, a record (see nearby chart). Our focus on operationally profitable companies with strong balance sheets is at odds with this makeup of the index today.
The largest detractor from performance in 2018 for the Punch Small Cap Strategy was business services provider Deluxe Corp. (DLX, $2.2 billion market cap), a company that is rapidly transitioning from its legacy check printing business to faster-growing small business services. Since CEO Lee Schram took over in 2006, the company has harvested the cash flow from its declining check business to acquire and grow small business services like website hosting, marketing services, and financial technology. Today, check printing is less than half (roughly 40%) of the company’s total revenues.
There are two primary reasons for the decline in Deluxe stock in 2018. The first was the surprise announcement in April that Mr. Schram would be retiring from the company. While the loss of a tenured leader with a strong track record sometimes signals bigger problems, we do not believe that is the case here. In November, the company announced that Barry McCarthy, an executive from First Data Corp (FDC) who ran several of that company’s larger divisions, would be his replacement. We think it is a positive sign that the company was able to attract a high caliber CEO in relatively short order.
The second reason for the performance in 2018 was disappointing results in one of Deluxe’s divisions that provides data-driven marketing for financial institutions, as bank customers delayed marketing spending given the challenges in mortgage lending recently. This slowdown caused management to push out their expectations for organic growth for the company from 2018 to 2019, which many investors see as a key “inflection point” for the transformation strategy.
Despite these surprises in 2018, we believe that the core investment thesis for Deluxe remains intact, and we are excited to hear from the new CEO as to what his priorities for the company will be. Deluxe generates significant free cash flow, has reasonable debt leverage, and pays a 2.5% dividend. We believe that the company gets relatively little attention from Wall Street (only 3 analysts) and trades at an attractive 16% free cash flow yield largely because investors still associate the company with its legacy check printing business, which (unsurprisingly) is in secular decline. With new leadership and a refreshed strategy that may be more heavily focused on fintech, we are excited about the prospects for the company over the coming years.
A notable laggard for the year was Green Brick Partners Inc. (GRBK, $450 million market cap), a regional homebuilder and land development company with operations in Dallas, Atlanta, Colorado Springs, and Vero Beach, Florida. Despite strong operational performance in 2018, the stock performed mostly in-line with the public homebuilders (the Russell 2000 Homebuilding Index was down 38% in 2018) on widespread fears of a weak housing market, higher mortgage rates, and persistent cost inflation. We think these fears have pressured the stock to historically cheap valuations (9x p/ estimated earnings and 0.97x p/b).
We believe that the U.S. continues to be underbuilt for single-family housing in many markets, especially fast-growing metro areas like Dallas and Atlanta that are seeing an influx of residents and employers. Green Brick has 30% net debt-to-equity, strong land lot positions, and heavy insider ownership—strengths that should allow the company to weather challenges in the marketplace and even acquire other regional builders at attractive valuations.
Golf entertainment company Drive Shack Inc. (DS, $290 million market cap) was also a detractor from performance for the year, although two announcements in the fourth quarter make us particularly excited about the prospects for the company today. In November, the company announced a new CEO and CFO to replace the former management team from Fortress Investments. What is notable about new CEO Ken May is that he spent 5 years at Topgolf Inc., the leader in the golf entertainment industry with approximately 50 locations worldwide. At Topgolf, Mr. May oversaw the construction of roughly half of the company’s locations, and we think this experience will be invaluable as he executes a growth strategy at Drive Shack.
Second, the company announced its newest development location on Randall’s Island, adjacent to Manhattan. We believe this location will raise the visibility and popularity of the golf entertainment concept and Drive Shack brand. This brings the company’s total announced locations to six, with thirty in the pipeline. Several more are slated to open this spring, and we will be paying close attention to their performance.
Today, Drive Shack shares trade for less than the value of the cash and securities on the balance sheet and, with only one sell-side analyst covering the company, we continue to believe its growth prospects remain significantly underappreciated.
Our top contributor to performance in 2018 was online marketplace ETSY Inc. (ETSY, $6.6 billion market cap), a company that has thrived under new management and a renewed strategic direction. We have detailed our investment thesis in previous commentaries and remain excited about the prospects for Etsy to become the go-to online marketplace for handmade goods. While there may be strategic interest in the company at some point, we think that there are enough levers for management to pull (branding, pricing, technology) to keep organic growth going for some time.
Our second largest contributor to performance was Capital Southwest Corp (CSWC, $360 million market cap), a business development company (BDC) based in Dallas, Texas. Capital Southwest was a company in transition under new management when we first purchased the stock back in 2016 when shares were trading at a substantial discount to book value. As management has deployed capital, the dividend per share has lifted from 4 cents per quarter to 36 cents, and we believe that the dividend may go higher as the company remains under-levered with ample dry powder to invest. Management has done an outstanding job making mostly first-lien loans to middle market companies and today the portfolio has no loans on non-accrual. This internally-managed BDC trades at 102% of book value, which we believe is still below its fair value.
Two of our top five contributors for the year were healthcare companies Addus Homecare Corp (ADUS, $800 million market cap) and U.S. Physical Therapy (USPH, $1.3 billion market cap). The strong performance of these two companies, and their current valuations, highlight some of the reasons why we are struggling to find compelling values in this sector today.
Addus Homecare and U.S. Physical Therapy are both healthcare services providers, an area of the healthcare space that we prefer because such businesses tend to be more consistent and predictable than medical device or pharmaceutical ones and tend to be less prone to technological disruption. Addus provides in-home personal care to the elderly and those with chronic medical conditions, while U.S. Physical Therapy operates a national network of therapy clinics. Both companies have track records of growth, profitability, and free cash flow, and neither has meaningful debt.
While we like the higher-quality nature of these businesses relative to the rest of the healthcare sector (75% of Russell 2000 Healthcare companies produced no free cash flow last year), the valuations of these companies are becoming increasingly stretched, with free cash yields moving into the mid-single-digits. We have trimmed U.S. Physical Therapy multiple times since our initial purchase back in 2011, but are balancing current valuations with the ongoing consolidation and organic growth opportunities at both businesses.
The Punch Small Cap Strategy ended the quarter with 48 total positions after two complete exits and two new additions to the portfolio. Volatility in the small cap market in the quarter created some unique opportunities as valuations of several watchlist names came into what we believe are attractive ranges.
Our active share continues to be high at 98.0% and for 2018, portfolio turnover was 21.3%.
In October, we exited longtime holding J&J Snack Foods (JJSF, $2.0 billion market cap), a manufacturer and distributor of Slush Puppies and ICEEs, Super Pretzels, churros, and a variety of other branded snacks and desserts. Our initial purchase of J&J Snack Foods dates to 2005, when CEO and largest shareholder Gerry Schreiber was executing a strategy of acquiring distressed niche food products companies and turning them around to create a portfolio of snack products that could be sold to the same end markets of grocery, c-store, cafeterias, and sporting venues. Unlike many of its peers, the company has rarely carried net debt, never taken on a transformative acquisition, and always generated consistent free cash flow. Operational excellence and financial conservatism have been the hallmarks of the company for decades. We exited the shares in the quarter largely for valuation reasons and to fund the purchase of new positions.
In November, we exited Connecticut-based commercial bank United Financial (UBNK, $750 million market cap) for operational reasons. Our initial purchase dates to 2012 when the bank was called Rockville Financial (RCKB) and when it was a mutually-held thrift that converted to a publicly-traded commercial bank. We pay attention to many of these mutual holding company (MHC) conversions because they can present opportunities to acquire shares of an over-capitalized bank at an attractive ratio of tangible book value.
In 2014, Rockville merged with United Financial (UBNK) and began an extensive integration process that doubled the size of the bank to over $6 billion in assets. While returns on assets and on capital at the combined bank have improved since the merger, the integration process was anything but smooth and even today the bank’s results are inconsistent at best. Four years after the deal, management has still not hit their original merger profitability targets, resulting in a discounted market valuation that we believe is unlikely to improve.
In November we added Barings BDC (BBDC, $500 million market cap) to the portfolio, a business development company based in Charlotte, North Carolina that is externally managed by global investment firm Barings. From 2007 to 2018, the company was named Triangle Capital (TCAP) and managed by a different manager, but after running into performance and corporate governance issues was ultimately sold to Barings in a transaction that closed mid-2018. At that time, both the management contract as well as the BDC assets were sold, such that, at closing, the company’s assets were 100% cash. BBDC shares have persistently traded at a 20-30% discount to their book value throughout the year.
While corporate governance and management alignment are always areas of focus for us during the due diligence process, we pay particular attention to these items when researching business development companies (BDCs). Historically, these structures have been rife with high fees, poor governance, and returns that go disproportionately to managers, not shareholders. We believe Barings is different. Not only is the company’s management agreement one of the best we have seen in the industry, but there is also significant alignment of incentives. The manager purchased $100 million of shares at a premium to the market price and has continued to purchase shares in the open market; today, the management company is the largest shareholder and owns 26% of shares. Management has also executed shareholder-friendly actions such as a special dividend and dutch tender repurchase.
We see in Barings BDC an investment opportunity similar to our other BDC holding, Capital Southwest (CSWC). Both are portfolios in transition from old managers to new ones, with assets being primarily cash. Both trade at meaningful discounts to book values. And both also have below-average dividends that will likely increase as capital is deployed over time, which could be a catalyst for shares ultimately closing their discount to book value.
In December we added oil and gas company Riviera Resources (RVRA, $1.1 billion market cap) to our basket of energy stocks. Riviera is a special situation after having been spun out of energy company Roan Resources (ROAN) in August. Both companies were part of the former LINN Energy, an over-levered exploration and production company that went bankrupt in the energy downturn of 2014-15. We believe that Riviera Resources is a classic post-bankruptcy investment opportunity with little investor awareness, a mispriced stock, and a shareholder-friendly management team that is committed to returning capital to shareholders.
Riviera Resources owns upstream oil and gas assets in several geographic basins that are mostly mature, low-decline assets with high free cash flow. In addition, the company is investing in owned midstream assets including a processing facility and pipelines. We believe that, based on a series of asset sales by the company, the upstream assets are worth significantly more than the enterprise value of the company today, and no value is being given to the growing midstream business. The company has net cash and minimal debt, and has been repurchasing shares both in the open market and by a dutch tender offer above the current market price.
We met with management in Houston this fall and found their strategy and views on shareholder value unique and refreshing. Whereas many oil and gas companies are focused on growing their asset base, reinvesting cashflows, and expanding production, Riviera is actually doing the opposite: shrinking through asset sales, maximizing free cash flow, and returning capital aggressively to shareholders. In time, we believe the midstream assets could be separated to form a standalone company, which could unlock significant shareholder value.
Occasionally, on a slow day, a member of the investment team at Punch will unmute the television to hear CNBC interviewing a Wall Street strategist (yes, we should know better). The interviewer will ask about the investment environment. The response usually goes something like this: “Well, Joe…the Fed… blah, blah, blah…trade wars…blah, blah…Brexit…blah…Apple’s iphone sales…blah, blah.” And then they say something that is as close to nothing as you can get without actually saying nothing. They will say, “We are cautiously optimistic.” What does an investor do with that? The interviewee is seemingly saying, “Things might work out for y’all, but if they don’t…well, don’t blame me because I told you to be cautious.”
The table below shows this pullback as the sixth worst since the inception of the Russell 2000 Index in 1979. Not fun.
With the caveat that no one can predict the future, let’s examine past periods of stock market treachery. Below are the forward returns of the Russell 2000 Index following each of these awful time frames.
A down period for this index occurred only once during the year following the darkest hour. Nine out of the ten one-year periods saw a recovery with the average return of better than 31%. All of the returns were positive for the three-year period following these corrections. The average return five years later was more than 100%.
Many investors are sitting and examining their losses right now, hoping that things bounce back. You have probably heard that “hope is not a strategy.” This may be true, but while we can offer no assurances, the history reflected above points out that probability is on the side of the long-term investor. And probability favors buying (or, at a minimum, holding) at a time like this.
Fear is a natural human emotion, and nobody can be expected to be devoid of it. Education, experience, and discipline have taught us not to do what our fears tell us we should…which is sometimes, “run for the hills.” To the contrary, we have learned to fight our own fears and to do the exact opposite.
At Punch, we measure fear as a contrarian indicator in order to evaluate when opportunity might exist. In surveys like the AAII Bull/Bear Index and the elevated level of discounts on Closed End Funds, we are observing significant levels of fear on the part of individual investor right now. This is good for the buyer of some of the securities they are dumping.
Bad investors tend to extrapolate everything that is temporarily bad and ignore everything that is permanently good. Temporary bad things eventually get resolved or fade away in importance (we guess that’s why they are considered temporary), paving the way for more positive long-term fundamentals to affect security prices.
As far as our economy goes, we believe things are better than the headlines might indicate. Our banks are in great shape, we have low unemployment, low inflation, corporations that are growing and, with lower corporate taxes, more money to distribute to shareholders. We are not macroeconomists at Punch, but we talk to CFOs and CEOs of small- and medium-sized companies every day. There seems to be a disconnect between what we read on the front page of the Wall Street Journal and what we are hearing from the leaders of the companies we own. We tend to believe the people who are operating businesses where the rubber meets the road in this economy.
We have no idea what the coming weeks and months are going to look like for the markets. Whatever the markets bring, we will steadfastly do what we always do on your behalf: focus on identifying solid businesses run by committed management teams and attempting to purchase interests in these businesses at prices low enough to allow for imprecise outcomes. What makes our team “uncautiously optimistic” isn’t that we believe stocks are going start heading up quickly, rather we are uncautiously optimistic because we are finding these opportunities in greater abundance than we have found in several years.