March 31, 2023

The Sound Shore Fund Investor Class (SSHFX) and Institutional Class (SSHVX) advanced 1.37% and 1.41%, respectively, in the first quarter of 2023, ahead of the Russell 1000 Value Index (Russell Value) which advanced 1.01%. The three year advances for SSHFX of 19.51% and for SSHVX of 19.73% were ahead of the Russell Value’s 17.93%. As long-term investors, we highlight that Sound Shore’s 35 year annualized returns of 10.08% and 10.38%, for SSHFX and SSHVX, respectively, as of March 31, 2023, were ahead of the Russell Value at 9.97%. For the Fund's most recent standardized performance information, click here.

The year began with hopes that interest rates and inflation were peaking and that the economy would be more resilient. Stocks responded positively in January before pausing in February as inflation data suggested the Fed’s more restrictive posture would continue. Meanwhile, the speed of the Fed’s rate rises led to problems in the banking sector, which manifested themselves in the crisis that unfolded in March. Although it is too early to draw conclusions, this episode may be yet another example of the market’s adjustment to the normalization of interest rates. As we have discussed in prior letters, this will likely take a number of years to play out and will be an important driver of valuation and performance within both the equity and fixed income markets. During the quarter, as rates began to stabilize, growth stocks had a sharp rebound. Leading the rally were a concentrated group of large companies within the technology, consumer discretionary and communications services sectors. Meanwhile, utilities, health care, energy and financials all finished lower. We’ve seen tremendous dispersion in performance as this cycle rolls through various geographies and industries at different times.

Our portfolio ended slightly ahead of the Russell Value but had similar divergence in performance. As the market adjusts to higher rates, earnings and cash flow will drive stock performance and the first quarter included that dynamic. Contributors included semiconductor capital equipment supplier Applied Materials (AMAT) which advanced after announcing higher than expected fourth quarter sales growth. With a strong balance sheet to withstand uncertain near term orders, the company continued to gain market share. A name that we have owned successfully in the past, we were able to purchase AMAT during the market selloff in June of 2022 when it was trading below normal at 10 times earnings. A technological winner in its industry, the company has 70%+ share in many of its submarkets and is diversified across customer segments. We believe management can continue building value through market share gains and operating discipline.

Another strong performer was apparel maker PVH Corp. Similar to AMAT, PVH fell during the downturn last summer bottoming at five times 2022 earnings and a staggering three times longer-term earnings power. At the time, consumer spending concerns made investors uneasy, despite the company’s core business continuing to grow. With leading brands such as Tommy Hilfiger and Calvin Klein, along with a strong balance sheet to withstand a sales slowdown, PVH was executing well and we added to our position. After a solid report in November and again this March, the stock has rebounded nicely. A more focused product development process and disciplined cost cutting has resulted in stable earnings per share, which the market has applauded. Although we are watching consumer spending closely, we believe PVH is still attractively valued at 8 times earnings and see further upside from here.

The biggest detractor for the period was our investment in SVB Financial Group. In December 2022, the stock was trading for a slight premium to book value (1.2 times) for a bank that historically generated above average growth and returns, with limited credit risk. Over the last few years, the company had grown its deposit base as a preferred provider of capital for the innovation economy. In the process, SVB built a portfolio of high quality securities, primarily U.S. Treasuries and Agency-backed mortgages, which declined in value as interest rates rose. By itself, this would impact profitability over time, but not be a significant regulatory issue as they could hold the securities to maturity. However, management’s unexpected announcement to raise capital created uncertainty for depositors and investors. What followed was a classic “bank run” where corporate clients began to withdraw deposits at an unprecedented rate, amplified by social media and the speed of digital banking.

After SVB’s announcements, we moved swiftly: Recognizing the deposit outflow risk, we sold approximately 1/3 of our shares before trading in the stock was halted. In addition, we reduced the portfolio’s financial services and bank exposure. While clearly a disappointing outcome, we were quick to monitor the broader impact on the economy and markets. Importantly, given the diversification of the portfolio, which includes 36 positions, Sound Shore’s return for the first quarter, as outlined above, was slightly ahead of our primary benchmark, the Russell Value.

Another first quarter detractor was drug maker Pfizer, a leader in vaccines and treatments. We started our investment during the fourth quarter of 2019 after management announced it would separate the company’s slower growth assets, providing us with the opportunity to invest at an attractive valuation. After almost a decade of flat earnings, we believe that Pfizer’s limited near-term patent expirations and strong expense control could yield sustainably higher earnings. In addition, the company’s new product pipeline, including advanced cancer treatments and vaccines, received little valuation credit. Of course no one could have foreseen the pandemic, but Pfizer’s ability to innovate proved vital. The company’s COVID-19 vaccine and antiviral treatment have been life-saving for millions of patients. The return to a more normal, post-COVID environment has some investors reconsidering Pfizer’s growth prospects. We believe that the years-long repositioning of Pfizer’s core business should improve earnings growth, without the help from COVID related products. The stock remains compelling at 11 times earnings.

The events of the first quarter remind us of one of our favorite quotes by legendary economist Peter Bernstein, “Humility is an enormously important quality. You can’t win without it. Survival in the end is where the winners are by definition, and survival begins with humility.” We remain active, as we always are, in volatile periods as opportunities present themselves. Our team is 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 critical to remain humble - know that you don’t know, and keep digging. We believe our portfolio, with an average twelve month forward P/E ratio of 11 times versus the Standard & Poor’s 500 Index of 18 times and the Russell Value of 14 times, is well positioned with strong balance sheets and better free cash flow.