Goldilocks economic period continues leading to further Growth vs. Value divergence
The U.S. equity markets continued their unabated march higher in July, as the economy entered the ninth year of economic expansion. While this is now the third longest period of economic expansion in U.S. history, it has also been one of the shallowest with ~2% annualized GDP growth. Coupled with low inflation, this has led to a goldilocks period of economic growth and low interest rates, resulting in record stock market highs and historically low volatility.
Last month was a continuation of the growth and momentum fueled market we have seen in 2017. In fact, the Russell 1000 Growth Index outperformed its value stock counterpart by over 1,200 bps YTD through July 31, 2017, the widest spread over that period since 2009. In addition, the Momentum iShare Index is up over 20% through July. Globally, according to eVestment, it is more of the same, as the median value fund around the world lagged behind the median growth fund by 700 bps in the first half of the year, on pace for the worst underperformance since 2007.
For a disciplined value manager like Reinhart that seeks under-followed quality stocks, this environment is clearly a headwind in the short-term. The market’s penalty for an EPS miss has been high regardless of valuation, and only the strongest momentum seems to be rewarded. Thus, it seems to us that expensive stocks keep getting more expensive (as long as the next data point is positive) and under-valued stocks keep getting cheaper (if any of the recent data points hint at weakness). Looking at recent stats on stock valuations in the Mid Cap universe, the valuation spread between the quintiles is definitely wider than normal. We have spoken in the past about how markets can be voting machines in the short-run but weighing machines in the long-run. In our opinion, this environment is voting machine dominated and short-term focused with little regard for valuations.
Our PMV philosophy and discipline leads us to high quality names in out-of-favor sectors, such as Health Care and Consumer stocks, where investors are “edgy” due to the myriad of factors impacting these industries. Many of our companies also face unique challenges that our analysis suggests can be overcome – whether it be changing technology, slowing end markets, regulatory issues or secular headwinds. In each case our research and valuation work suggests the risk/reward is quite favorable for the underlying stock; however, as we have discussed, investors seem to have a short-term myopic focus and little regard for valuations. This climate created some air pockets for several stocks in the portfolio during July. We will remain disciplined and apply our PMV strategy to not only “keep up” in low-volatility periods like this, but more importantly, protect capital when volatility returns.
Tough start to the quarter in July
The start to Q2 earnings has been choppy for our Mid Cap portfolio. While we did not have any blowups (15%+ decliners), a handful of EPS disappointments have resulted in a tough July. The list includes Northern Trust, Gentex, Interpublic Group, Universal Health, F5 Networks, Robert Half and DST Systems. Although the average miss / guide-down was only -2%, the average stock reaction was -8% for these names. In addition, Helmerich & Payne and Invesco reported in-line but still declined -4 to 5%. Conversely, many of our companies that beat expectations have barely been rewarded (Jones Lang LaSalle, Citizens Financial Group, BorgWarner, HealthSouth, and Archer-Daniels-Midland).
Portfolio remains relatively more concentrated in frothy market
Portfolio turnover remains relatively low vs. historical averages in a frothy market. We remain disciplined in selling holdings that reach PMV, for example, Fidelity National Financial.
We added a new name to the portfolio last month with the purchase of KAR Auction Services. In our opinion, KAR is a market share leader in whole car and salvage auctions, essentially operating in a duopoly in both segments. We believe there is a strong network effect with both businesses driven by vast buyer and seller networks, resulting in a high ROIC business with relative market share and margin stability. Fears over KAR’s leverage to auto-cycle (“peak SAAR”) and overblown credit concerns in their small finance division gave us the opportunity to step in to this quality franchise. We like the business as there is a secular tailwind within salvage (more distracted drivers = more accidents) and used car auctions should continue to increase as volumes typically lag peak SAAR by 2-3 years. And even in the face of a downturn, the business is much less cyclical than feared, which offers good risk/reward, in our view.