September 30, 2019
The slowing global economy and declining interest rates set the table for more volatile and defensive stock markets in the third quarter of 2019. The best performing sectors – utilities, REITs and consumer staples – accounted for more than 100% of the Russell 1000 Value Index’s third quarter return. Further, these three “bond proxy” sectors gained an average of 7%, while the remaining eight averaged slight losses. After leading the benchmark through mid-year, Sound Shore’s short term results lagged for the period, largely due to our limited holdings of these relatively expensive bond proxy stocks.
Since the 2008 financial crisis, equity markets have grown increasingly averse to uncertainty, as the global buildup of $17 trillion of negative yielding debt, periodic industrial recessions, and trade and political friction have eroded the appetite for longer-term investment horizons. Indeed over the last 12 months, this condition has reached a crescendo with yield- and stability-hungry investors seeking shelter, regardless of value. In the process, they have bid up the price-earnings multiples for utility and consumer staples stocks to more than 20 times, and the REITs to more than 40 times.
As shown in Exhibit 1 below from JP Morgan research, the 2018-19 fervor for these low volatility securities has even surpassed that reached during the late 1990s dot-com period. Their analysis compares the valuation (price-to-earnings or P/E) of value stocks to both the overall market (green line) and to low-volatility stocks (blue line), both of which have reached 30-plus year extremes as shown in the circled area on right.
We have witnessed this type of crowding into a narrow part of the market before. While our patience is always tested in these environments, each time we have resisted the siren call to abandon our strategy and chase short-term performance. Over four decades, Sound Shore’s full cycle outperformance against the broader indices has been driven by disciplined adherence to our company-specific value investment process. An important element in this framework, our value check, confirms a stock’s valuation using a company’s own price history and financial results. At critical times, this step has steered us away from the most expensive parts of the market, including technology stocks in the late 1990s and banks in 2005-2006.
For the third quarter, a handful of our stocks declined due to the market’s lack of patience. For example, healthcare investments Alexion, Elanco and UnitedHealth Group accounted for almost half of Sound Shore’s underperformance in the period. All three are growing revenue and earnings, but the unknown path of US healthcare policy contributed to the stocks’ retreat. All are examples of how we aim to invest for the long-term in attractively valued companies with sustainable businesses and where management teams are building value. We are looking for change that will unlock the opportunity we have identified.
Alexion’s third quarter pullback followed strong year-to-date gains through June. A leading maker of drugs for extremely rare and life-threatening conditions, Alexion’s extensive research and development platform is driving innovation. We purchased the stock last year at a below normal 14 times P/E. The company prices consistently worldwide, has a strong balance sheet with little debt, generates steady cash flow from long-dated patents, and owns a promising pipeline. Still, the impatient third quarter market showed no appetite for uncertainty and the stock sold off.
Meanwhile, one of our strongest contributors was homebuilder Lennar, the industry’s largest. We added the name during the fourth quarter 2018 market selloff, another period of uncertainty. At the time, 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. Its strong 2019 performance has been driven by share gains in a steady US housing market, as well as lower mortgage rates. Led by a management team that has consistently created shareholder value, we continue to like the risk/reward profile of the stock.
A quick glance at some of our top holdings in the chart below provides a great window into the portfolio as a whole. Each of these companies is a contender in their industries and, given their reasonable valuations, have great potential to outperform the market.
While we have high conviction in our portfolio, we also remain disciplined and continually focused on the fundamental drivers of each holding. Since 1978, Sound Shore’s research process is keeping a close eye on balance sheet strength, historical market share wins, and business sustainability…all critical components in a company’s ability to build long-term value.
Although Wall Street’s pundits are anxious, the market has continued to climb a wall of worry. As of September 30, 2019, the S&P 500 Index was close to its last peak and valued at 16.8 times earnings, while the Russell 1000 Value Index was at 14.0 times earnings. By contrast, Sound Shore’s portfolio had a forward price-earnings multiple of 11.7 times, a meaningful discount to those broader indices.
The Standard & Poor’s 500 Index is an unmanaged index representing the average performance of 500 widely held, publicly traded, large capitalization stocks. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. It is not possible to invest directly in an Index. FCF (Free Cash Flow) yield represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Data presented reflects that of the underlying holdings of the Fund, not of the Fund itself. Forward P/E (estimated price-to-earnings) is a measure of the P/E using forecasted earnings for the P/E calculation.
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 9/30/19 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.