March 31, 2020
The Sound Shore Fund’s strong first quarter 2021 gain was just ahead of the Russell Value. Stocks continued their recovery to start the year as investors were encouraged by an accommodative Federal Reserve, passage of the American Rescue Plan Act and continued rollout of COVID-19 vaccines. Meanwhile, solid corporate earnings backed up these macro factors. Participation was broad with all 11 S&P 500 sectors solidly in positive territory, led by the energy and financials sectors.
The portfolio’s return was driven by 11 holdings from five different sectors that were each up 20% or more for the period: Applied Materials, Bank of America, Capital One, Citigroup, EOG Resources, Lennar, Magna, NXP Semiconductors, SVB Financial, Whirlpool and Dentsply Sirona. These stocks outperformed as they continued to execute and win in their respective end markets. Since Sound Shore’s founding in 1978, our contrarian investment process focuses not only on valuation, but also on the adaptability and sustainability of company business models.
Automotive systems and component manufacturer Magna is a great example. We were able to purchase the stock when it was trading at just 7 times normalized earnings with a strong balance sheet and scale that provides opportunities for growth. The management team, led by CEO Swamy Kotagiri, has repositioned the company as an auto 2.0 leader in both electric/autonomous vehicle development and best practices for employee safety. Magna has signed a joint-venture with LG Electronics that will strengthen its electric vehicle capability and it has agreed to manufacture and share its EV architecture and platform with the new Fisker Ocean electric SUV. Meanwhile the company’s almost 60-page, industry leading Smart Start Playbook was developed to help transition back to work after COVID-19 forced plant shutdowns. The plan outlined best practice details like disinfecting guidelines, the use of personal protective equipment such as masks and face shields, as well as treating and tracing infected employees. Even after Magna’s strong gains, the stock is attractively valued at 10 times earnings and remains a holding.
Another strong contributor was homebuilder Lennar, the industry’s largest. We added the name during the fourth quarter 2018 market selloff when Lennar was trading below normal at 7.5 times earnings and 1.1 times tangible book value. We believed the company had scale-driven advantages over small and mid-size builders, and also less exposure to sluggish premium housing trends versus its competitors. Lennar has been simplifying its portfolio to focus more as a pure-play builder, with less asset intensity, which should increase returns on capital and cash flow. During the quarter the company announced it would be spinning off parts of its business not directly related to homebuilding and financial services. According to management, the noncore asset spin will total $3 to $5 billion, with no debt. In spite of a recent uptick in interest rates, the US housing market remains very strong across the country and Lennar continues to gain share. Led by a management team that has consistently created shareholder value, we continue to like the risk/reward profile of the stock.
Laggards for the quarter included electricity generator and marketer Vistra Energy. Our research identified the company as a low cost provider with a healthy balance between generation and retail (transmission and distribution). Although it will take time, they are committed to transitioning the portfolio to a sustainable footprint by closing older plants and increasing 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. That’s the equivalent of 110 million LED light bulbs! The seven projects are expected to see a capital investment of approximately $850 million. Despite volatility around the recent Texas cold snap, we like the outlook for Vistra and believe it is attractively valued at a below normal 10 times earnings and 15% free cash flow yield.
Elanco Animal Health, which designs, develops, and manufactures products for both companion and food animals, was down slightly for the period as well. Uncertainty around a potential product recall gave investors pause, even as Elanco continues to gain market share in the US companion animal segment and from a lessened COVID-19 impact in farm animal end markets. The company’s purchase of Bayer Animal Health in the second half of 2020 created the second-largest global animal health company. We expect Elanco to execute well on the Bayer integration, generate significant cost savings and margin improvement, de-lever the balance sheet, and introduce important pipeline products. Trading below 15x normalized earnings we see further upside potential from here.
For the second quarter in a row, we were encouraged that value outperformed growth and that stock performance based upon company-specific fundamentals seems to be more characteristic of recent markets. Looking ahead, progress of COVID-19 vaccinations and reopening of the economy will certainly be in the front of investors’ minds. As well, the duration of central bank and fiscal stimulus and the pace of inflation are important factors to monitor. We note that at March 31, 2021, Sound Shore’s portfolio had a forward price-earnings multiple of 14.7 times consensus, a meaningful discount to the S&P 500 at 21.4 times and the Russell Value at 17.4 times, despite strong balance sheets and better free cash flow.
Thank you for your investment alongside ours in Sound Shore.
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.
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 3/31/21 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.
Distributed by Foreside Fund Services, LLC.