September 30, 2020
Stocks rose in the third quarter of 2020 as investors overall were encouraged by signs of recovery in much of the economy and improved corporate earnings reports. While COVID-19 vaccine optimism and business reopenings helped to fuel strong market gains through August, a turbulent September followed as virus cases began spiking again and fiscal stimulus negotiations stalled.
Sound Shore’s return was driven by stocks in a variety of industries, some which we describe below. Regardless of market conditions or volatility, Sound Shore focuses on identifying attractively priced, out-of-favor stocks where value is building ahead of low expectations. Financial headlines in recent years have been filled with highly-valued technology names, while the major cap-weighted indices, like the S&P 500 (Chart 1) and Russell Value, are driven by only a handful of these stocks. It bears repeating what we wrote in our 2nd quarter letter - there have been many companies left behind in the last few years. A momentum driven, late cycle market is often led by fewer and fewer stocks. The chart below illustrates how this has played out in the last few years. Never ones to predict, we understand that timing when this might change is a topic of much debate, but we remain focused, but we remain focused on finding value that has been overlooked.
While it may be tempting to invest via these passive indices after such a run, it is important to know what risk exposures lie beneath. At Sound Shore, our active, contrarian approach continually challenges us to know what we own and why we own it. It’s one way our process helps to manage portfolio risk. Our clients don’t invest with Sound Shore to chase momentum or to track the major indices. Our mission is to find opportunities elsewhere and we are encouraged by the recent market environment. For example, since the March lows the equal weight indices have outperformed their cap-weighted peers and we are witnessing our stocks increasingly responding to earnings rather than just macro drivers.
Our best third quarter contributor was Whirlpool which surged 43% and provides an excellent example of an undiscovered opportunity that has responded to improving fundamentals. Whirlpool is the global #1 appliance maker with greater than 30% market shares in both North America and Europe. We invested in the company during the second quarter of 2020 when it was trading at 8 times our estimate of earning power, and after the stock had dropped by more than 40%. The capable management team is focused on inventory control and margin improvement, and is using its scaled manufacturing footprint in 14 countries as a low-cost competitive advantage. The disciplined pursuit of profitable growth and more consistent returns had gone largely unnoticed by Wall Street, while the pandemic has provided another challenge to prove the strategy is working. The stock has since rebounded, reflecting better than expected sales and margins due to the housing recovery and an accelerated, corona-virus driven replacement cycle. Even after these gains, Whirlpool is attractively valued at 11 times earnings and remains a holding.
Media giant Comcast gained 19% in the third quarter and is another underappreciated, change beneficiary that our contrarian investment process identified. Having successfully invested in the company in the past, we restarted our Comcast position 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. Our due diligence concluded that many “over the top” rivals need Comcast’s broadband service to supply content to their own customers. Additionally, given the current era of work from home and online learning, internet access, speed and reliability are paramount. Comcast is well positioned to capitalize on these trends. Management continued to deliver results in broadband and cable subscriber growth, generating significant free cash, dividends and buybacks. The stock was one of our top performers in the quarter and we see further upside from here.
Meanwhile, healthcare holding Cigna was one of our larger detractors. We believe that Cigna’s business, which combines a leading pharmacy benefit manager (PBM) with a strong health insurance underwriter is extremely undervalued, trading at below normal 9 times earnings. We were able to build our position in March 2020 as the stock sold off while investors weighed what impact the election may have on the healthcare sector. Our research identified a company with a sturdy balance sheet, stable businesses and resilient cash flows over time. Though the stock has lagged, Cigna continues to execute and post results above consensus estimates. We believe that Cigna’s valuation should rerate higher as the market appreciates its growth potential and consistent free cash flow.
Every crisis has its unique characteristics and this one certainly redefined how fast and deep the demand environment can change. We have found a number of investments over the last few months in industries that suffered extreme short-term impact but, in our opinion, will remain resilient over the long term. Importantly, we are looking for companies that have a business model that is gaining market share and the crisis has only accelerated that opportunity. As long-term investors, our investment horizon affords taking the risk. Our investment in Booking Holdings (formerly Priceline) is an example of a contrarian opportunity that will require patience to develop. The leading provider of online travel and restaurant reservation services, we were able to purchase the stock for less than 12 times recovered earnings after it sold off on COVID-19 related travel concerns. While the duration of travel recovery remains uncertain, management is focused on cost containment and head count reduction to weather the storm. We believe Booking can leverage its brand and business model to continue to gain market share in North America, Asia and Latin America. With double-digit earnings growth upon COVID-19 recovery and a normalized free cash flow yield of 8%, the stock has a very attractive risk/reward profile.
A quick glance at some of our holdings in the chart below provides a further window into the portfolio as a whole. We believe we own industry-winning companies at reasonable valuations that will drive value for our portfolio.
Looking ahead, U.S. elections, the path of COVID-19 and central bank and fiscal stimulus will likely top the list of macro factors on pundits’ minds. However, we are encouraged that stock performance based upon company-specific fundamentals seems to be more characteristic of recent markets. We note that at September 30, 2020, Sound Shore’s portfolio had a forward price-earnings multiple of 14.5 times consensus, a meaningful discount to the S&P 500 at 21.0 times and the Russell Value at 16.3 times, despite strong balance sheets and better free cash flow.
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 9/30/20 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.
Distributed by Foreside Fund Services, LLC.