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June 8, 2017

PMV May 2017 Month In Review

Macro

The market continues its upward trajectory, with large caps and growth leading the way.

The markets continued their relatively quiet ways in May despite political and economic headlines. In fact, market volatility remains historically low and the VIX actually fell below 10 for the first time since 2007. An outlier last month was the volatile energy market, with oil prices down nearly double-digits since March and the energy sector following suit given concerns over supply growth. Despite the drag from energy, the equity markets continue their upward trend in 2017 on top of stellar returns last year, with the Russell 3000 up 7.7% YTD through May.

Last month was a continuation of the growth and momentum fueled market we have seen YTD. In fact, according to Bespoke Investment Group, top performers in the S&P 500 during May included stocks with higher growth profiles, larger market caps, and more international exposure. Case in point, the Russell 1000 Growth Index is up +13.6% YTD, over 4x the return of the Russell Mid Cap Value Index. For a disciplined value manager like Reinhart that seeks under-followed quality stocks, this environment is clearly a headwind in the short-term.

Earnings

Largely quiet end to Q1 earnings, but Mid Cap loses ground in May.

There are a few themes hindering our relative returns: 1) Consumer Discretionary (biggest portfolio overweight) where sub-par retail results continue to pressure other consumer names. We own business models well-positioned for the internet threat (services, restaurants, auto suppliers), but the market sees problems in retail with weaker traffic, so all stocks in consumer have been penalized of late; 2) Health Care overweight has also hindered performance to a lesser degree with lack of visibility on legislation; 3) finally, we have taken risk out of the portfolio this year by selling higher beta names which have hit our price targets (Lam Research, Ashland, FMC, Synopsis). We believe this is the right course of action given valuations, but a more conservative portfolio tilt has negatively impacted performance in an increasingly momentum-based market. Importantly, we plan to maintain our valuation discipline and are resisting the urge to trade-down in quality.
Closing out Q1 earnings, EPS reports were largely better than expected in May. Jones Lang LaSalle, Sabre Corp, Cognizant Technology, Fidelity National, Cigna Corp and Ryman Hospitality all reported good quarters, driving each stock price higher. The interesting thing about this list is how many of these companies had some issues investors were worried about, making it even more meaningful to report good results. Whole Foods reported in-line results but announced several major positive changes, including a 3-year plan to reduce costs by $300M, five new board members, a 29% dividend increase, and $1.25 billion stock buyback.

Conversely, EPS results at Archer Daniels Midland and U-Haul were weak. Investors expected UHAL to slow development on storage units, rein-in spending on rental fleet growth, and generally begin to reap the rewards of prior investments with higher cash flow. However, this quarter showed it will take more time to play out.

While the first two weeks of May were better from a relative performance standpoint as PMV finished Q1 earnings, the underperformance of the last two weeks was largely driven by macro factors discussed above – including the indiscriminate consumer sell-off, lack of legislative visibility within healthcare, interest rates drifting lower, and lack of beta in a momentum-fueled market.

Portfolio

Working hard to find new ideas.

In terms of portfolio activity, we made three major moves in the portfolio this month. Fitting with the theme of taking risk out of the portfolio, last month we sold Lam Research and purchased Aramark. We also purchased STORE Capital, the first traditional REIT in the portfolio in several years.

With Lam Research, we had raised our PMV several times and the stock has continued to charge higher this year. The company reported strong Q1 earnings and has clearly demonstrated that their production methodology is critical to semi equipment manufacturers utilizing the latest technology (FinFET, 3D NAND) to adopt even smaller geometries for mobile applications.  But most of the good news seems to be priced in now, so we sold our remaining position – a +110% gain over 21 months.

Conversely, we purchased more defensive Aramark, as the business model is very consistent with 95% recurring revenues and food in particular having low levels of cyclicality.  77% of profits now come from food service (sports stadiums, hospitals, universities, business outsourcing) and 23% from uniform rentals.  In recent years newer management has reviewed contracts and practices to optimize operations and profitability, which has depressed organic growth (pruned contracts) and margins (new system investments).  But revenues should re-accelerate in 2H’17 with improved cash flow and higher ROIC expected as well.

Finally, regarding STORE Capital, although our portfolio is still underweight real estate by ~500bps, this transaction does narrow that sector gap with the benchmark.  Sale-leaseback transactions create a proven business model for the company with an average lease term of 14+ years and +1.9% escalators built-in.  Triple-net track records have proven to be recession resistant and STOR is well positioned with their predominantly service-based tenant list.


The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable. All expressions of opinions are subject to change without notice in reaction to shifting market conditions.  All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness.  Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied on as financial advice.