Markets push higher in January, but volatility returns as inflation expectations re-priced.
Simply looking at overall returns, market performance in January looks to have mimicked a stellar 2017 market environment, with the S&P 500, Russell 3000 and NASDAQ all posting >5% returns for the month with growth continuing to outpace value. Indeed, Merrill Lynch noted in mid-January its Bull & Bear market indicator surged to 7.9x, the highest level in almost five years. In addition, Bloomberg noted that just three weeks into the year, the value of announced mergers totaled $152 billion, the highest for the same period since 2000, as a massive U.S. tax overhaul, strong global growth and rising stock markets are drivers of CEO confidence. Needless to say, optimism was running rampant, as one key speaker at Davos called the global equity environment “jubilant”.
However, as we exited January and moved into February, risk assets underwent a sharp pullback. Equities sold off and volatility returned, triggered by interest rates as markets repriced inflation expectations higher (see graph below). Amid accelerating wage growth, which increased 2.9% in the January jobs report (the strongest y/y gain since June 2009), interest rates have continued to move higher which may be returning risk aversion to the equity markets. While we continue to believe economic fundamentals remain strong, we also welcome a return of volatility after an elongated period of monetary easing by the Fed. We believe recent market and economic dynamics (rising rates, tax reform, growth vs. value mean reversion) have created an environment that could serve as a relative performance tailwind for our Private Market Value discipline.
Portfolio outperforms in January on solid start to Q4 earnings and mean reversion trade.
The Mid Cap PMV portfolio started off 2018 where it left off in December, continuing to gain nice ground on the Russell Midcap Value Index, due to two main factors: 1) a largely positive start to fourth quarter earnings and, 2) a reversion-to-the-mean trade with strong price moves in our most undervalued stocks. Starting with earnings, Citizens Financial reported a clean beat and raise quarter, while Gentex posted a top and bottom line beat driven by accelerating U.S. shipment growth. F5 Network also posted a better than expected quarter on the back of service revenue, despite product revenue declining for a second straight quarter. Conversely, Invesco posted mixed results on higher anticipated 2018 expenses due to acquisitions and MiFID costs. Perhaps a bigger driver of the portfolio’s strong relative performance in January was the continuation of a reversion-to-the-mean trade from mid-November. In fact, looking back at the 10 biggest laggards (and many of our cheapest names) mid-way through Q4 (11/15/17), those stocks on average have since rallied over 20% through the end of January. Although it is too early to call a shift back to value investing or loss of market momentum, we do believe mean reversion is returning to the market this year as interest rates move higher.
A little of everything…a few sales, a new purchase, and an energy swap.
With regard to portfolio activity, the major moves last month included the sale of Spirit AeroSystems (valuation) and Sabre Corp. (fundamental), along with the purchase of healthcare REIT, Ventas, and a swap within the energy sector. Spirit AeroSystems was sold as it exceeded our PMV (generating >100% gain in 22 months). Ultimately, we believe future upside is limited as margins will always be ‘managed’ by their dominant customer, Boeing, under long-term contracts. Conversely, Sabre Corp. was a fundamental sale as our confidence level waned and concerns grew about several issues, including the capital intensity of the business, market share trends, technology offerings, and upcoming contract renewals. Although the company may still qualify as a quality franchise, we currently have several key unanswered questions and exited the position.
In terms of new buys, we purchased Ventas, a healthcare REIT with a portfolio of senior housing and medical offices. The stock has underperformed the broader market by 40% since June 2016 – partly due to rising interest rates, and partly due to concerns about U.S. senior housing supply growth (which we believe is peaking). Management has a proven track record of superior growth and capital deployment, divesting the company’s skilled nursing facilities and reinvesting in medical offices, hospitals and life sciences. In addition, we swapped into a new energy position, National Oilwell Varco (“NOV”), after Helmerich & Payne (“HP”) rallied in recent months. NOV is the dominant equipment supplier to drillers like HP, with strong offerings in rig systems, wellbore technologies, production and supply chain integration. NOV has consolidated the industry with 50%+ share, and we believe is the clear technology leader in software, data analytics & automation in an increasingly complex world of advanced drilling techniques. Margin upside potential is substantial via cost reductions and restructuring as the company adjusts to a footprint only 35% of peak energy levels. Ultimately, NOV’s free cash flow should accelerate meaningfully given low capex levels, working capital work-downs, and margin recovery.