December 31, 2021
Equity markets advanced briskly during the year as investors were encouraged by a recovering global economy and solid corporate earnings growth. All eleven Standard & Poor’s 500 Index sectors posted double-digit gains. Growth stocks finished the year with a surge in the fourth quarter, outpacing value stocks and the broader market. While disappointed that we gave back some of our performance advantage over the broader indices in the last three months of the year, we remain undeterred. Since 1978, Sound Shore Management’s contrarian investment philosophy has focused on finding inexpensive, out-of-favor stocks with internally driven earnings and free cash flow improvement.
One of our strongest contributors was drug maker Pfizer, a clear leader in COVID-19 vaccines and treatments. We started our investment during the fourth quarter of 2019 after management announced the separation of the company’s slower growth assets, providing us with the opportunity to invest at 13 times forward earnings. Pfizer has had almost a decade of flat earnings. We believe that Pfizer’s limited near-term patent expirations and strong expense control could yield sustainably higher earnings. In addition, the company’s new product pipeline, including advanced cancer treatments and vaccines, received little valuation credit. Of course no one could have foreseen the pandemic, but Pfizer’s ability to innovate proved vital. The first dose of the company’s COVID-19 vaccine was administered on December 14, 2020. In August of 2021 the FDA officially approved the vaccine and by November, Pfizer had secured a government contract for its oral COVID-19 antiviral treatment.
Looking ahead, we believe that the increasing prospect for recurring booster-shot and antiviral demand should translate into 30% incremental earnings growth for Pfizer. Importantly, the years-long repositioning of Pfizer’s core business is designed to drive improved earnings growth without the help from COVID-related products. The stock remains a full position in the portfolio.
Interestingly, another of our health care holdings was negatively impacted by the pandemic. Although only down approximately 12%, over the counter health product supplier Perrigo was the year’s biggest detractor. Perrigo is the leading private label and branded drug manufacturer with a market share of approximately 70%. Consumers may not realize it, but the store brand Tylenol, Allegra, Prilosec etc., that they purchase is likely produced by Perrigo. With typical cold and flu infections on the decline due to COVID restrictions, demand for over the counter remedies slowed, which had an outsized negative impact on earnings. We originally purchased the stock in July 2019 when it was trading below normal at 12 times forward earnings. At the time, the company was in the midst of a transformation that our research indicated would increase shareholder value over time. In prior years, Perrigo had expanded beyond its core business into generics, which weighed on the stock. The new management team was committed to returning the business to a pure-play consumer self-care supplier. Additionally, Perrigo was working through an international tax dispute which we believed would be negotiated lower than the Street was estimating. Throughout the year, our thesis began to play out. In July, the company completed the sale of its generics business and in September the stock surged after management announced a favorable settlement to the tax dispute. However, in the fourth quarter, the stock pulled back after noting that packaging cost inflation and supply chain constraints would reduce near term earnings and we added to our position on the weakness. With the company re-focused, management is aimed at growth and margin improvement and we see significant upside potential from here.
We had a number of our financial services names up significantly during the year… SVB Financial (+75%), Capital One (+49%), Bank of America (+47%) and Morgan Stanley (+47%). We believe the market continues to underestimate the strength of these franchises. While none are overly levered to interest rates, each has a slightly different business model that is growing market share. Another strong contributor was homebuilder Lennar (+54%), the industry’s largest. In spite of an uptick in interest rates, the US housing market remains very strong across the country and Lennar continues to gain share while management has restructured the business to drive even higher returns. Meanwhile, oil and gas producer EOG Resources (+89%) benefitted from disciplined capital programs and rising prices.
Our experience, for over four decades, has been that there is no substitute for the judgment of a strong management team focused on the right variables to grow value and control risk. We engage with management teams frequently on a variety of issues, encouraging them to balance short-term forecasts and quarterly guidance with a focus, as well, on enduring goals that aim to sustainably improve their competitive advantage over time. Many of the issues we have always discussed with companies are now considered to be components of environmental, social and governance (ESG) best practices. Conducting ESG-focused company meetings/calls, emphasizing material matters are an integral part of Sound Shore’s active engagement with management. We are looking for change, and company-specific improvement has always been at the core of Sound Shore’s value investing strategy.
Electricity generator and marketer Vistra Energy is a good example of sustainable, company-specific improvement. Our research identified the company as a low cost provider with a healthy balance between generation and retail (transmission and distribution). During our focused engagement with the company, management reiterated Vistra’s commitment to transitioning the portfolio to a sustainable footprint. They closed older plants and increased the renewables portfolio. In fact, management has introduced Vistra Zero, a portfolio of zero-carbon power generation facilities, including seven new projects in its primary market of Texas that total nearly 1 gigawatt, the equivalent of 110 million LED light bulbs! The seven projects are expected to see a capital investment of approximately $850 million. These initiatives along with its announced coal plant retirements, gives Vistra a clear line of sight to achieving its 2030 emissions reduction goal. They continue to invest in innovation and operational improvements, as well as advocate for policy changes that will accelerate the global transition to a clean energy future, while maintaining adequate near-term supply. We like the outlook for Vistra and believe it is attractively valued at a below normal 10 times forward earnings with a free cash yield exceeding 12% consensus estimates.
During the most recent rally from 2017-2020, the market's earnings multiple expanded from around 18 to 22 as investors responded to prolonged lower rates and anticipated corporate earnings growth would be revised higher. This scenario has largely played out and for the last year or so, the market multiple has fluctuated. As 2021 moved on, investors were faced with a simple question…How much do they want to pay for earnings growth that may be peaking, particularly if rates may no longer be falling?
Historically low interest rates have been a key factor helping to drive valuations (multiple expansion).
The chart below illustrates how the bond proxy parts of the equity market have benefited and this may change. Meanwhile, the U.S. is coping with a surge in inflation, continued supply chain issues and fear of higher taxes. In response, the Federal Reserve announced in December it would end its pandemic-era bond purchases in March 2022 and pave the way for three quarter-percentage-point interest rate hikes by the end of 2022. Rising interest rates increase borrowing costs for businesses and consumers alike, while higher long-term rates can depress stock multiples (multiple compression), especially for bond-like equities and high-multiple growth stocks. Of course, the push and pull of higher short-term rates can ultimately lead to a slower economy and many pundits have already begun to predict when/if that may happen.
We have never been ones to predict, but if interest rates have bottomed, valuations are likely to be flat or down in the coming months. Historically, when bull markets transition from early-cycle recovery phases to slower growth mid-cycle periods valuations typically decline, which may make for a more volatile market. It doesn’t mean we can’t find opportunities, but it is likely that earnings and cash flow become more important drivers versus PE ratios or multiples. Just as we have been in a low interest rate environment for the last few years, the transition to higher rates could also be lengthy. It is not unexpected to see some back and forth between value and growth stocks like we did in 2021. With that backdrop in mind, we are encouraged by the attractive valuation and earnings power of our portfolio holdings, as highlighted in the graph below.
Given the market movements we described, our focus on valuing out-of-favor stocks and identifying company-specific sources of revenue, earnings and cash flow growth, should continue to surface potentially profitable investment opportunities. Our conviction is high and we remain steadfast in our approach. Sound Shore’s portfolio is attractively valued at 11.8 times forward earnings versus 21.4 times for the S&P 500 and 16.0 times for the Russell 1000 Value. As markets return to rewarding company-specific drivers, we believe our holdings should benefit.
Many thanks as always for your investment alongside ours.
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 Adviser analyzes risk on a company-by-company basis. The Adviser considers governance as well as environmental and social factors (ESG) as appropriate. While valuation, governance, environmental and social factors are analyzed, the evaluation of all key investment considerations is industry- and company-specific. Consequently, no one issue necessarily disqualifies a company from investment and no individual characteristic must be present prior to investment.
Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.
The views in this letter were those of the Fund managers as of 12/31/21 and may not necessarily reflect their views on the date this letter is first published or anytime thereafter.
This commentary may contain discussions about certain investments both held and not held in the portfolio. Current and future portfolio holdings are subject to risk. For the Fund’s Top 10 Holdings click here.
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.
Distributed by Foreside Fund Services, LLC.