December 31, 2019

Stocks finished higher in 2019 bolstered by steady, if not spectacular, economic growth. Ten plus years into the current bull run, the S&P 500 posted record high closings in December. Accommodative central banks, US unemployment at a 50-year low, few signs of inflation and solid corporate earnings all contributed to positive investor sentiment. It wasn’t smooth sailing from start to finish, however. Uncertainty around politics, trade and tariffs ebbed and flowed throughout the year.

Since 1978, Sound Shore’s contrarian investment philosophy has focused on finding inexpensive, out-of-favor stocks with internally driven earnings and free cash flow improvement. The first three quarters of 2019 looked much like 2018 with investors continuing to crowd into defensive, higher yielding sectors. But there was a marked change in sentiment during the fourth quarter as a backdrop of greater divergence and declining correlations drove Sound Shore’s results. Specifically, we had twelve stocks from six different sectors that rose more than 40% in 2019 including Applied Materials, AON, Bank of America, Citigroup, Eaton, First Data, Lennar, Marsh & McLennan, Microsoft, Mondelez, NXP Semi and Thermo Fisher.

Though card issuer Capital One just missed the list above, it is worth mentioning, as we discussed it last year after the short, sharp selloff in the fourth quarter of 2018. This long-term holding was another strong 2019 performer, gaining 38%. Capital One’s seasoned management team is keeping the company on its front foot through strong credit management and advanced technology platforms. We are keenly aware of the risks and opportunities as the banking industry evolves. Now is the time where scale, technology and brand will drive meaningful market share gains. A leader in digital banking and cloud adoption, Capital One has one of the highest rated mobile banking apps in the industry and we believe is clearly on the right side of disruption. Currently valued below 9 times 2020 consensus earnings and at a 20% discount to book value it remains a core holding.

Similarly, our investment in Eaton, which gained 43% in 2019 and outperformed its industrial peers, is another great Sound Shore case study. Eaton is an electrical equipment maker that we were able to purchase in 2018 when it was trading below normal at 13 times earnings. Over the last ten years, Eaton has methodically repositioned its business mix to a high value-add, electrical parts and aerospace business that now represents greater than 75% of operating earnings. In addition, Eaton’s experienced management is focused on capital efficiency and has executed on improving organic revenue growth and improved profitability. The company is generating substantial free cash flow and returning 6% of capital to shareholders through dividends and buybacks. Even with the stock up 43% in 2019, we believe it is still reasonably valued at 15 times earnings and remains a holding.

Sound Shore’s research process continually forces us to re-evaluate portfolio holdings in order to confirm that our investment theses remain on track. One of our detractors during the year was broadcaster ViacomCBS Inc. (nee CBS Corp.), a legacy media company successfully competing amidst significant industry changes. The company continues to grow its traditional advertising and affiliate fee revenues while significantly expanding its “over the top” streaming subscriber base. Although well known by the Street, the drawn out CBS-Viacom merger created uncertainty for investors and the stock underperformed. With the merger completed in December 2019, we believe targeted synergies and accelerating revenue growth will drive significant incremental value. Attractively valued at 7 times earnings, the company is well positioned as it heads into what should be a very strong year for TV advertising (Olympics & US Presidential election) and content subscriber growth.

Let’s take a step back to review the recent market environment. Over the last 2 years, markets have been averse to uncertainty, as the global buildup of $17 trillion of negative yielding debt, periodic industrial recessions, and trade and political friction have eroded the appetite for longer-term investment horizons. At the same time, slowing global economic expansion has fueled investors’ craving for growth of any variety. This bifurcated market has led to yield- and stability-hungry investors seeking shelter, while growth investors have pursued growth - regardless of valuations. In the process, they have bid up the price-earnings multiples for utility, consumer staples and technology stocks to more than 23 times, and the REITs to more than 36 times, as illustrated in the graph below.

Interestingly, in December Sweden, which was the first major country to implement negative rates (in February 2015), raised its rate to 0.00% from -0.25%, becoming the first country to end its negative interest rates. The Bank of England and Bank of Japan each voted to keep their interest rates unchanged and tethered near zero percent. Is this a sign that central banks have begun to consider the unintended consequences of negative rates? Time will tell.

From Sound Shore’s perspective, we don’t need rates to go up. As discussed before, it seems the market has discounted low rates forever, so the important question is…what’s next? We suspect fundamentals driving equity performance and a dose of patience are what matter. We had a taste of that again in the fourth quarter as more traditional value stocks started to see signs of life relative to growth stocks and bond proxies as investors appeared to refocus on company specific fundamentals. Patience was rewarded and Sound Shore outperformed the Russell 1000 Value. Clearly, one quarter does not make a trend, but we are encouraged.

As in prior cycles, when part of the market is driven to unprecedented valuation levels, Sound Shore has lagged the indices, as we remain disciplined in the pursuit of our strategy. It is important to note, each time in the past our performance improves as the cycle plays out. If history is any guide, now is a good time to invest with Sound Shore. For the past 20 years, we have outperformed the value and broad market indices as shown in the Exhibit below. These results include shorter term periods, like the current one, where our process is out of step and we lag. We believe this track record confirms the merits of our consistent process, though timing is always uncertain.

Storied investor Gary Brinson summed it up well when he said “I’ve learned that extreme dislocations in markets inevitably occur, and they also inevitably correct themselves. One needs to learn from that the discipline of being patient and having the conviction of one’s own analysis.”

As value investors, we start with price. There are a myriad of expensive stocks in today’s market, so you have to be careful what price you pay, know what you own and why you own it. A quick glance at some of our holdings in the chart below provides a window into the portfolio as a whole. We believe we own sector-winning companies at reasonable valuations that will perform well and create value for our investors.

Each of these companies is growing market share, yet trade at a discount to the market as measured by the multiple to free cash flow. To add some further perspective, please note that the stocks in the chart above have an average free cash flow yield greater than 8%. That is half the price of the overall market.

With an eye towards 2020, there is a lot to think about as a new decade begins. Sound Shore remains diligent in applying our time-tested contrarian investment process. No doubt, the recent relative performance of value investing has led to questions regarding its utility. Focusing on valuing out-of-favor stocks and identifying company-specific sources of revenue, earnings and cash flow growth, particularly given the market movements we described, should continue to surface profitable investment opportunities.

Our conviction is high and we remain steadfast in our approach. Sound Shore’s portfolio is attractively valued at 12.8 times forward earnings versus 18.2 times for the S&P 500 and 15.0 times for the Russell 1000 Value. As markets return to rewarding company-specific drivers, our holdings should benefit.