June 30, 2020
Global equities rebounded strongly in the second quarter of 2020 after a swift decline in the first quarter due to the COVID-19 pandemic. Investors were encouraged that unprecedented stimulus from major central banks — nearing $5 trillion in aggregate — combined with economic “re-openings” would lead to a recovery from the current recession. It was notable that, despite all the monetary and fiscal stimulus, government treasury rates stabilized in the US, Europe, and Japan after the brief March fall.
Sound Shore’s contrarian investment philosophy has always focused on finding attractively valued companies with internally driven earnings that can drive value for years to come. Our long-term investment process looks forward to assess where a company’s normal earning power will be. Developing a view on what normalized earnings power will be is highly uncertain under the current circumstances. However it is not unusual for Sound Shore to operate in this environment. In fact, it is often periods of uncertainty which create the best opportunities for our strategy. This leads us to stocks with management teams employing strategies that are durable and have sustainable businesses we want to partner with in our portfolio. The ability to have a long-term view is increasingly rare, but will likely determine our success.
It is important to note the market dynamics leading up to the volatility of the first six months of 2020. In previous letters we have communicated how narrow the market has been in the last few years. To provide perspective, in the three years ended June 30, 2020, the top ten performing stocks in the Russell Value contributed more than 100% of the 3-year benchmark return. Ten stocks…over three years. Though the market’s recovery this quarter appeared broad at the sector level, there were many companies that were left behind, as is often the case. A late cycle market led by a few stocks, which then suffers a broad decline as a recession begins, is not a new phenomenon. But, this cycle has been a big one. Market volatility is likely to continue as the path of the pandemic will drive sentiment. Meanwhile, we will be searching to buy great companies at attractive prices.
Aptiv, one of our strongest second quarter contributors, provides a great case study. Formerly Delphi Automotive, Aptiv is a global technology supplier to the automotive sector. The company makes electrical and active safety solutions for legacy vehicles as well as for the electric and automated cars of the future. We initiated our position in Aptiv during the market sell-off in March 2020 when the stock pulled back more than 60%. Our investment team has been following the company for a number of years and, given the opportunity to add the name at less than ten times normalized earnings, we acted quickly. Aptiv is a technology-driven business with excellent growth prospects. As global auto demand recovers, Aptiv’s content per vehicle will likely continue to increase. The investment is off to a good start and in spite of the stock’s rapid recovery, we see the potential for further significant upside.
Several of our financial holdings also performed well in the quarter. For example, SVB Financial, a specialty bank in Silicon Valley, gained over 40%. We believe the company should continue to generate outsized growth and returns, focusing on the innovation economy globally. Similarly, newer addition Blackstone, a leading alternative asset manager, was higher as it continued to grow net new assets. We were able to purchase the stock an attractive eleven times earnings with a 3% dividend.
Meanwhile, property and casualty insurer Alleghany was among our detractors. Alleghany is a conservatively run insurer that should benefit from stronger property and casualty pricing. We initiated a position in the first half of 2020 at an attractive one times book value. The company has grown book value per share at 8% per year over the past decade. The ultimate claims liability due to COVID-19 will not be known for a few quarters and has held back some of the industry from participating in the recent rally. Given its strong franchise and balance sheet, we believe the prospect for the company to create value and realize multiple appreciation makes Alleghany an attractive risk/reward opportunity.
Mark Twain is credited with having proclaimed, “History doesn’t repeat itself, but it does rhyme.” While every market cycle is different, looking back to the post-financial crisis period, we see similar opportunities to buy great businesses at attractive prices. It is notable that during that period we were able to purchase Microsoft at ten times earnings. At the time, Street consensus felt management was ineffective. They had missed the consumer market, social media, mobile and their core, on-premise software franchise was at risk as cloud adoption was ramping up. Sound Shore’s contrarian view was that Microsoft’s enterprise software unit was being extremely well run, by current CEO Satya Nadella, and was beginning to take market share. Microsoft turned out to be an incredible long-term investment for our investors. With a tear in our eye we recently sold our position as we believe Microsoft’s valuation reflects most of its ample future growth prospects.
Against this backdrop of a highly concentrated, fairly valued market, we believe our portfolio, with an average twelve month forward P/E ratio of 15 times, has ample room to run. Even more important is what the P/E for our portfolio will be, based on earnings after the recession. It is likely to be significantly cheaper on earnings power out a year or two more. The table below highlights a sample of holdings at reasonable valuations that are driving change in their industry to create value.
After a strong recovery in the most recent quarter, the broad indices could mark time for a bit. Wall Street pundits will have much to debate through year end, including COVID-19 developments and US elections. Never ones to predict, we remain focused on our bottom up investment process, which continues to find compelling opportunities at attractive prices.
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.
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 6/30/20 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.
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