March 31, 2022

We entered 2022 anticipating that the Federal Reserve would raise interest rates and with consumers feeling the bite of rising prices at the pump and the grocery store.  Over more than four decades of managing portfolios we’ve observed that the Fed’s transition to increasing rates requires investor patience, while keeping a keen eye on the impact it has on the economy.  This time is likely no different.  As inflation began tracking higher than Fed expectations, the market priced in more aggressive central bank tightening and investors braced for a slowing economy.  Meanwhile, continued supply chain disruption and climbing oil prices were exacerbated by the tragic war in Ukraine and resulting sanctions from the international community, leading to a more volatile environment.  The Sound Shore Fund’s portfolio finished slightly behind the Russell Value for the three month period.

Energy was the best performing sector which was reflected in our top contributors, including low cost oil and gas producer Coterra Energy which benefitted from disciplined capital spending and rising prices.  Likewise, energy technology provider Baker Hughes finished higher, driven by stronger than expected order growth in its liquid natural gas (LNG) turbo-machinery segment and increasing global rig count.  Both companies have strong balance sheets with little debt and are returning capital via dividends and stock repurchases.  Soaring energy prices and Europe’s unfortunate reliance on Russian supply reinforced our belief that low cost natural gas is both a strategic and economic advantage for the United States.  Over the last several years, the pandemic, supply disruptions and lack of investment, along with extreme weather conditions had already driven prices higher.  Still, natural gas is expected to play a critical role in the transition to renewable energy sources and these two investments benefit from the increased demand.

Baker is the dominant player in LNG projects and its growing backlog is a positive indicator of how this business may drive future earnings.  They are also a leader in carbon capture technology and the development of hydrogen as a clean, alternative fuel source.  Carbon capture technology is considered critical to delivering CO₂ reductions needed to meet global climate and net-zero emissions targets.  Applicable to both the energy and industrial sectors, carbon capture is among the most promising de-carbonization solutions for both existing facilities and new greenfield projects.  We were able to purchase the stock at a below normal valuation and an attractive 8% free cash flow yield and we remain positive on its future prospects.

Another strong performer for the quarter was property and casualty insurer Alleghany Corp.  Often referred to as a mini-Berkshire Hathaway, we initiated the Alleghany position during the COVID-19 selloff of March 2020 when the stock was trading at a below normal 12 times earnings and at a discount to tangible book value.  Under the leadership of CEO Joseph Brandon, (former CEO of General Re, a Berkshire insurance company), Alleghany’s core property and casualty insurance businesses are capitalizing on industry pricing gains.  Meanwhile, the company’s noninsurance business, Alleghany Capital, has accumulated a diverse group of increasingly profitable divisions in industrial parts, machine tools, hotels, toys and funeral services.  Apparently Warren Buffett agreed with us and at the end of March, Berkshire Hathaway (also a portfolio holding) struck an agreement to buy Alleghany for $11.6 billion, a 25% premium.

Detractors for the period included two of our technology names which sold off along with the sector.  Mobility technology supplier Vontier was lower despite earnings that beat estimates as investor debate focused on the longer term earnings power for Vontier’s division that sells equipment to convenience stores.  The company offers environmental sensors, fueling equipment, field payment hardware, remote management and workflow software, vehicle tracking, and fleet management software solutions.  Led by a strong management team with a track record of continuous improvement, we believe Vontier will steadily expand margins and grow market share.  Attractively valued at 8 times earnings, we added to our position and Vontier remains a holding.

Similarly, analog chip supplier NXP Semiconductors declined even though the company reported above consensus revenue growth.  A leading chip maker for infrastructure and automotive applications, we view NXP as a “new industrial,” uniquely positioned to benefit from increased chip content per application/vehicle.  This includes electric and autonomous vehicles and more broadly, connectivity and the internet of things.  We added the stock to the portfolio during the volatile fourth quarter of 2018 at just 10 times earnings.  Today, NXP is still valued at a very reasonable 14 times earnings.

Short-term changes that have resulted from the tragic war in Ukraine led us to trim exposure to holdings we felt had uncertain outcomes in a stalled European economy.  Additionally, we took profits in names that hit our target valuation in financial services, health care and energy.  Meanwhile, indiscriminate selling provided the opportunity to add to existing holdings and initiate new positions with less exposure to European end markets.  While never easy to go through, periods of market correction have often presented opportunities for Sound Shore to achieve attractive returns in the years to follow.  In fact, the current environment is providing a remarkably robust set of opportunities that we have not seen in some time.

We are continuously researching stocks that are cheap versus their historic norms and the market, where value is building ahead of expectations.  Today, our emphasis on stock-specific sources of outperformance should prove as relevant as ever.  While the duration of central bank and fiscal stimulus and the pace of inflation will be important factors to monitor, it’s very important to know what you own and maintain discipline when volatility rises.  We believe our portfolio, with an average twelve month forward P/E ratio of 10.7 times versus the Standard & Poor’s 500 Index of 19.4 times and the Russell Value of 15.1 times, is well positioned with strong balance sheets and better free cash flow.

Thank you for your investment alongside ours in Sound Shore.