Sound Shore Portfolio Commentary
March 31, 2019
Global stock markets rebounded to start the year as investors were encouraged by central banks’ pausing on interest rate hikes and solid corporate earnings. Participation was broad with all 11 S&P 500 sectors solidly in positive territory. While the market appeared to incorporate a Goldilocks, “just-right” outlook, skepticism was still evident as suggested by the bond-proxy real estate investment trust (REIT) stocks gaining 18% in the quarter – finishing just behind the top performing technology sector of the S&P 500.
The Fund’s return was led by eight holdings, from five different sectors that were up 20% or more for the period: Alexion Pharmaceuticals, Applied Materials, Citigroup, First Data, Lennar, Mondelez, NXP Semiconductors, and Thermo Fisher Scientific. These stocks outperformed as they continued to execute and win in their respective end-markets. Their gains marked a sharp contrast to the fourth quarter of 2018 when stocks sold off sharply and indiscriminately. As has been the case since Sound Shore’s 1978 founding, our contrarian investment process focuses not only on valuation, but also on the adaptability and sustainability of company business models.
Disruption is a term often used today to describe companies and industries facing substantive transition. However, it’s really nothing new…change and adaptation have been continuously altering the landscape for winners and losers. For example, in his 1942 work titled Capitalism, Socialism and Democracy, economist Joseph Schumpeter coined the term “creative destruction” to illustrate how innovations punish less efficient ways of doing business. By keeping our antennae up and looking for disruptive change – at the company, industry, and sector levels – Sound Shore believes we can identify sector winners led by managements building long-term value.
Sound Shore’s best first quarter contributor, electronic payments firm First Data Corporation, provides a great case study. First Data is a legacy card processor that is adapting and successfully competing in one of the fastest changing consumer markets. We invested in First Data in 2016 when its shares were valued below 10 times earnings and after it had underperformed. In contrast to Wall Street's bearish consensus at that time, our research indicated that First Data's plans to improve its traditional merchant acquiring product and reduce debt would create significant value. At the same time, management was looking to the future and making substantial investments into its mobile / point of sale brand, Clover. Today, Clover is a value enhancing, high growth franchise with one of the largest installed customer bases of any mobile payments technology. In January, First Data agreed to be acquired by another Fintech firm for a significant premium and the stock finished the quarter with a gain of 55%.
Media giant Comcast is another change beneficiary that performed well for the period, advancing 17%. We restarted our Comcast investment during the volatile fourth quarter of 2018 when it was attractively priced below 14 times earnings with an 8% free cash flow yield. While fierce media competition and the potential for cord-cutting are well known threats to Comcast, these same trends also turn out to be opportunities if managed well. For example, our due diligence concluded that many “over the top” rivals, in fact, need Comcast’s broadband service to supply content to their own customers. Symbiotically, Comcast’s NBC and Universal studios are delivering entertainment programing beyond its own cable system via over the top platforms. Comcast’s first quarter gain was well ahead of both the market and it’s lagging communication peers. Driven by fourth quarter earnings that confirmed broadband and cable subscriber growth, significant free cash, and copious dividends and buybacks, we see further upside potential.
Meanwhile, specialty pharmaceutical holding Alexion rose 38% for the quarter after the company reported solid earnings and positive new drug developments. A leader in the market for orphan drugs that focus on ultra-rare and life-threatening diseases, Alexion’s extensive research and development platform is driving innovation. We were able to purchase the stock at a below normal 14 times P/E with sustainable cash flow from long-dated patents and a promising pipeline.
Among our market laggards was recently-added Sensata Technologies, which makes sensors and controls for industrial applications. We started the position in January at a below normal 11 times earnings, and after the stock had trailed the market for a long period due to its auto end-market exposure. Versus low expectations, Sensata is on the front line of the next generation of autos, delivering computing power, safety and environmental systems as the industry upgrades current models as well as electric and autonomous vehicles. We believe management’s disciplined capital allocation should consistently grow earnings per share and improve returns on capital. Given the opportunity to significantly expand its content per vehicle as EV/AV production proliferates, we think the stock has a compelling risk/reward profile.
With the S&P 500 close to its last peak and valued at 16.4 times earnings, it should be no surprise that almost every investor meeting we have includes a discussion about whether Sound Shore is still able to find attractive investment candidates. Our answer is “yes,” and as confirmation we highlight both the preceding stock discussions, and also the 12.5 times average price-earnings multiple for Sound Shore’s portfolio.
Echoing that point, and more broadly, we refer to the exhibit below which illustrates the near record gap that has recently opened up between the most and least expensive quintiles of US stocks, based upon P/E. Importantly, this graph reflects valuation only, and not stock performance. What we find instructive is today’s extreme valuation divergence, which implies investors are crowding into the most expensive parts of the market. That said, while our contrarian value process steers us away from the most expensive parts of the market, we are careful to invest considering both valuation and the sustainability of underlying businesses and industries. Sound Shore’s four decades of long-term investing – covering more than half of the exhibit’s time period – has proven that sticking to our investment discipline over full cycles has been critical to our methodically taking advantage of these opportunistic periods.
RECORD VALUATION DISPERSION
All of the multiple expansion is in the most expensive part of the market
The chart above shows the median trailing PE ratio of most expensive and least expensive quintile of MSCI US constituents as of 12/31/17.
Source: Ken French Data Library, Bernstein Analysis
The Standard & Poor’s 500 Index is an unmanaged index representing the average performance of 500 widely held, publicly traded, large capitalization stocks. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. It is not possible to invest directly in an Index. “Best-in-class” is solely the opinion of Sound Shore Management, Inc. and is subject to change. Those companies that hold leading market share positions, strong growth potential, historically good profitability, and management teams known for integrity and good corporate governance are generally considered to be “bestin-class.”
An investment in the Fund is subject to risk, including the possible loss of principal amount invested. Mid Cap Risk: Securities of medium sized companies may be more volatile and more difficult to liquidate during market downturns than securities of large, more widely traded companies. Foreign Securities Risk: The Fund may invest in foreign securities primarily in the form of American Depositary Receipts. Investing in the securities of foreign issuers also involves certain special risks, which are not typically associated with investing in U.S. dollar-denominated securities or quoted securities of U.S. issuers including increased risks of adverse issuer, political, regulatory, market or economic developments, changes in currency rates and in exchange control regulations. The Fund is also subject to other risks, including, but not limited to, risks associated with value investing.
The views in this letter were those of the Fund managers as of the date first published and may not necessarily reflect their views on the date this letter is first published or anytime thereafter.
You should consider the Fund’s investment objective, risks, charges and expenses carefully before investing. The summary prospectus and/or the prospectus contain this and other information about the Fund and are available from your financial intermediary or www.soundshorefund.com. The summary prospectus and/or prospectus should be read carefully before investing.