Fourth Quarter 2020

Small Cap Commentary | Q4 2020

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Overview

The fourth quarter of 2020 was one for the record books, as the Russell 2000 Index of small cap stocks posted its single best quarter ever, rising 31.4%. This performance exceeded both the S&P 500 Index of large cap stocks (+12.1%) and the popular NYSE FANG+ Index (+16.9%).

For the year, the Russell 2000 Index returned 19.9%, also ahead of the S&P 500 Index return of 18.4%. After lagging large caps for the entire year, at some points meaningfully, small cap stocks pulled ahead in the last month of the year. 2020 was the second consecutive year of gains in excess of 20% for small caps.

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Attribution

The Punch Small Cap Strategy returned 31.1% in the fourth quarter, trailing of the benchmark return of 31.4%. Our underperformance was primarily the result of sector allocation, while security selection was a contributor to total return.

For the year 2020, the Punch Small Cap Strategy lagged its benchmark, with a 15.6% total return compared to 19.9% for the Russell 2000 Index. Both security selection and sector allocation were detractors for the year.

The most glaring performance factor in the small cap market in 2020 was the significant and unprecedented outperformance of growth stocks compared to value stocks (+34.6% vs. +4.6%), although this trend reversed itself in the fourth quarter when value outperformed growth (+33.3% vs. +29.6%).

Many of the companies that gained the most attention were direct beneficiaries of the global pandemic and the resulting government lock-down orders around the world this year. Fueled by near-zero interest rates, many of these beneficiaries went from irrational valuations before the pandemic to absurd valuations today.

While we do not focus exclusively on value, we do have a concerted value bias. We want to own businesses that are high quality and can grow over time, but we seek to acquire companies when their share prices are depressed. Coming into 2020, our opinion was that the popularity of growth stocks was overextended; today it appears to be more stretched than even during the tech bubble of 1999-2000. As growth stocks have outperformed recently, we have chosen not to participate in the performance derby in an effort to control risk. We are hopeful that the fourth quarter marked a turning point in this cycle and, as the economy normalizes and interest rates rebound over the coming years, these factors may become tailwinds for our strategy.

 

Bottom Contributors to Performance

 

During a strong quarter for the markets, longtime holding LendingTree, Inc. (TREE, $3.6 billion market cap) was the largest detractor from performance. As a reminder, LendingTree is an online platform that connects consumers with access to various financial products including mortgage loans, credit cards, auto loans, and insurance quotes. Despite posting better than expected results in the quarter, shares traded lower after the company released a disappointing outlook for the fourth quarter.

Throughout the pandemic, lenders’ hesitancy to extend credit to consumers has impacted the business. Some banks are waiting to issue loans until they have a better understanding of the ultimate impact that COVID-19 will have on consumers. LendingTree has diversified into offerings like mortgages, auto and student loans, and insurance, so they can more efficiently connect borrowers with willing lenders. Additionally, the company’s mobile offering has continued to attract new consumers because the platform makes accessing services easy and convenient. We believe LendingTree’s diversified portfolio coupled with strong secular trends driving personal finance to digital channels position the company well to navigate the near-term headwinds.

The second largest detractor during the quarter was Phibro Animal Health Corporation (PAHC, $786 million market cap). We took an initial position in this provider of livestock nutrition and animal health products in the summer of last year believing that the company has a portfolio of high-quality products and significant growth opportunities in emerging markets.

The African Swine Fever outbreak in 2019 pressured sales and had driven their shares lower. Phibro has more recently been affected by COVID-19, as developing countries struggle with meat production and consumption. (However, the most recent quarter showed promise with improving demand.) Despite these two unfortunate events, management has invested into new products that we expect to become meaningful to sales in the coming years. We believe the company is set up to return to attractive growth and normalized margins as economies reopen and new product rollouts gain traction. Valuations across the peer group today are substantially higher than Phibro’s, and we believe investors are giving little credit to this under the radar stock given its recovery opportunity.

Commercial furniture manufacturer Kimball International, Inc. (KBAL, $442 million market cap) was the third largest detractor after announcing a large acquisition of commercial furniture designer and manufacturer, Poppin, Inc., simultaneously with its third quarter results. Kimball has been hit especially hard by the pandemic, as two of its three customer verticals are commercial offices and hospitality. The company decided to use a majority of its cash to acquire Poppin under the expectation that the new business will be a growth driver and Kimball can leverage Poppin’s digital platform across existing brands.

We believe the acquisition provides an opportunity for Kimball to diversify its customer base and quickly add new technology to help the company through the pandemic. With its net cash balance now largely spent, the combined business has elevated risk and opportunity in the coming years. Since speaking with management and conducting due diligence post acquisition, we are comfortable with the Poppin acquisition and will be monitoring its integration closely in the coming quarters.

 

Top Contributors to Performance 

B. Riley Financial, Inc. (RILY, $1.1 billion market cap) was the Punch Small Cap Strategy’s top performing investment during the quarter. B. Riley is a diversified financial services platform with operations across capital markets, retail liquidations, and valuations and appraisals. During the quarter, the company benefitted from strength across most of its business lines but especially from its capital markets division. As a result of the strength, B. Riley pre-released results reporting that it expects to generate earnings per share of approximately $4.20 in the fourth quarter and $5.25 for the year (compared to the stock’s year end closing price of $44). The company remains under the radar with zero analyst coverage, and insiders remain the largest shareholders owning over 20% of the company. We think B. Riley will continue to see tailwinds across several of its verticals. It also has a demonstrated track record of deploying capital into attractive opportunities. It remains a top holding for the Punch Small Cap Strategy.

Sleep Number Corporation (SNBR, $2.3 billion market cap) was another top contributor in the quarter. The company is a leader in the premium mattress market and benefitted from consumers renewed interest in upgrading their home furnishings. As a vertically integrated retailer, Sleep Number was well-positioned to sell both online and in its own stores meeting customers where they were comfortable. Health and wellness trends continue to benefit Sleep Number. In addition, it has room to grow its market share to drive future growth, and the company is building from a stable level of business thanks to its loyal customer base (over 40% of its revenue comes from repeat purchases and referrals). We believe the company remains an attractive investment opportunity.

Online marketplace Etsy, Inc. (ETSY, $22.4 billion market cap) is a poster child beneficiary of the change in consumer habits due to COVID-19. Etsy achieved triple-digit revenue growth as people turned to Etsy while shopping at home. While a portion of the revenue growth came from pandemic-related needs (like masks), we believe Etsy will continue to benefit from the increased attention its platform garnered. Consumer habits likely changed permanently due to the events of 2020, and customers realized Etsy can be used for a wider variety of goods. Investors kept buying the stock, and its stock price rose five-fold from its March lows. The company’s addition to the S&P 500 Index (a first for the Punch Small Cap strategy) also led to a significantly broader investor base.

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Portfolio Activity

In the fourth quarter, we added two new positions and exited three, bringing the total number of positions to 44. Portfolio turnover in 2020 was 27%.

We generally review all small cap spin-offs because of behavioral opportunities typically associated with these transactions. We often see selling pressure from funds which, due to their mandates, are not able to own the spun company, making the shares artificially cheap. Arcosa, Inc. (ACA, $2.7 billion market cap) was spun from Trinity Industries, Inc. (TRN, $3.0 billion market cap) in November 2018. Arcosa is an infrastructure conglomerate with businesses in construction products, energy equipment, and transportation products. We have been following ACA since the spin and took a position in the fourth quarter.

Spin-offs are usually made up of the less desirable assets of a company and may have excess debt on the balance sheet. In the case of Arcosa, Trinity released high-quality assets with a low-debt balance sheet. Another distinctive aspect to Arcosa was that half of the board of directors from TRN left to be on the newly formed ACA board. In its relatively short life as an independent public company, Arcosa management has proven their ability to execute on organic and inorganic initiatives. We like ACA because it has demonstrated its ability to shift from a complex business to a more simple one. As a result, it should get more investor attention and perhaps, along with it, a higher multiple.

In prior commentaries, we have discussed our use of a “red team” and a “green team” as part of our research process. In this effort, half of our investment team argues the bull case for a stock, and the other half argues the bear case. This practice has proved to be a significant gatekeeper for the portfolio. We ran Franchise Group, Inc. (FRG, $1.3 billion market cap) through our “red team/green team” diligence, and it resulted in our taking a position in the company. FRG rolls up asset-light businesses in the retail sector with value-pricing dynamics and franchise potential. Given the contrarian nature of retail today, Franchise Group has plenty of acquisition opportunities, and the company has strong cash flow characteristics to support them. Management owns 30% of the company and is taking a “private equity approach” to cost reductions. We believe, over time, growth in FRG’s operations will help drive a franchise multiple for the stock and a higher valuation for shareholders. While we wait for franchise operations to develop, management has committed to growing the dividend, currently at 4.81%. Our red team/green team approach led us to believe we have few reasons not to own this stock, and we are optimistic about the outcome.

We exited three positions in the fourth quarter. The first, in early October, was BioSpecifics Technologies Corp. (BSTC, $550 million market cap), a profitable pharmaceutical licensing firm with relatively new management and a strong balance sheet. It’s main licensing partner, Endo Pharmaceuticals (ENDP), acquired the company in October for $88.50 per share in cash. While the acquisition premium was meaningful, we were disappointed in the outcome, as we thought that the company was poised for significant growth in the years ahead.

In November, we exited energy services firm Select Energy Services, Inc. (WTTR, $600 million market cap) on deteriorating fundamentals in the business with a poor near-term outlook. We initially invested in the company in 2018 because we believed that the company’s core water infrastructure services had competitive barriers to entry and that new customers and contracts provided for meaningful growth opportunities. The company also had no net debt and a thoughtful management team. As the global pandemic of 2020 upended the energy industry, we believe that Select fared better than many but has still had its business and prospects for growth permanently impaired.

Finally, in December, we exited communications services provider SPOK Holdings (SPOK, $230 million market cap). Our investment in the company dates to 2016 and our original thesis was that, as the leading provider of paging services in the U.S., SPOK management was milking its legacy cash cow business to invest in new, higher-growth communications software products that would be sold to its existing customer base of large hospitals. We believed that this transition was underappreciated by investors and that the market value of the company did not appropriately reflect the value in these new products. Unfortunately, mismanagement of the growing software business, along with years of significant investment in new products, has led to disappointing results, and we have lost confidence in management’s ability to pivot the business. Despite involvement from several activist investors and an outside bid for the company in early 2020, entrenched management has fended off shareholder efforts to create value and instead remains focused on continuing its current failed strategy.

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Conclusion

Mark Twain once remarked that “history doesn’t repeat itself, but it often rhymes.” While 2020 stands alone in in the annals of modern history with little historical precedent, aspects of this era do not look all that different than past episodes for investors. One such “rhyme” is the performance of small cap stocks before, during, and after the economic recession of 2020.

Going into 2020, large cap stocks had outperformed small cap stocks for over ten years. In the twelve months leading up to February 2020 (the official start date of the current recession according to the National Bureau of Economic Research), large cap stocks delivered a total return of 21.4% compared to only 9.2% for small cap stocks, and in the three years before the recession, large cap stocks returned more than twice that of small caps (49% compared to 23%).

In 2020, pressured by recession fears and COVID uncertainty, smaller companies bore the brunt of declines because they tend to be more cyclical, less diversified businesses. They also did not benefit as directly as larger companies from Federal Reserve intervention during this recession.
It was not until the fourth quarter that this relative performance improved dramatically, and by December 31st, small cap indexes had completely closed the gap. In the fourth quarter alone, small cap stocks more than doubled the return of large caps (+31% vs. +12%). For the full calendar year, the Russell 2000 Index of small cap stocks produced a total return of 19.9% compared to the S&P 500 Index’s return of 18.4%. While small caps entered the year as one of the worst-performing asset classes, they exited as one of the best.

Over the past thirty years, the U.S. economy has experienced four recessions: 1990-91, 2001, 2007-09, and 2020. In the twelve months before the onset of each of these recessions, large cap stocks outperformed small caps in each instance by an average of over 8%. During recessions, all stocks tend to decline in value, although small cap stocks have historically declined slightly less. The stock market tends to be forward-looking, and part of this performance may be explained by investors anticipating an end to the recession before it officially ends.

Perhaps most interestingly, small cap stocks tend to continue their outperformance in the twelve months after a recession officially comes to a close. In all three historical episodes since 1990, small caps had a total return that was 7% better than large caps (9.9% average return compared to 2.8%) during the following year. Over the three years subsequent to the end of a recession, small caps continued to outperform large caps, and by a wide margin (20% on average). As the economy repairs itself, these smaller companies benefit disproportionately from the rising tide of economic activity and access to capital markets.

Over long periods of time, small cap stocks have historically produced superior returns to large cap companies, albeit with higher levels of volatility. Having just gone through a cycle where small cap stocks produced inferior returns for several years, history may be indicating brighter days ahead.

 

 

 


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.
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.
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.
Company specific information referenced in this commentary is compiled from a variety of sources including SEC filings, quarterly and annual reports, conference calls, conversations with management teams and Bloomberg LP.
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 return.