September 30, 2021
After a significant surge over the last twelve months through May, stocks were mixed in the third quarter of 2021. Buoyant first half 2021 GDP growth of more than 6% persuaded the Federal Reserve to indicate tapering could begin later this year, with rate increases to follow as soon as 2022. That guidance left the market uneasy. Compounded with uncertainty around COVID-19, supply chain disruptions, rising inflation and Congressional gridlock, a cyclical selloff unfolded throughout the summer. As a result, the industrial, material and energy sectors all finished lower for the quarter.
Volatility, often driven by short-term market participants, creates opportunity for long-term investors like Sound Shore. Regardless of market conditions, our process focuses on identifying attractively priced, out-of-favor stocks where value is building ahead of low expectations. We continue to find quality opportunities to invest in while maintaining discipline to sell names as they hit price targets.
Leading alternative asset manager Blackstone is a good example. Blackstone finished the quarter higher as it continues to diversify its investment products which are attracting substantial inflows, $69B in the first half of 2021 alone…a 22% annualized rate. We were able to purchase the stock last year at an attractive 11 times earnings with a 3% dividend yield. Management has maintained a very conservative balance sheet and the company boasts an A+ debt rating by Fitch and S&P. With the stock surging nearly 75% this year, investors are acknowledging the strength of Blackstone’s franchise.
Similarly, our investment in Eaton is another great Sound Shore case study. Eaton is an electrical equipment maker that we were able to purchase in 2018 when it was trading below normal at 13 times earnings. Over the last ten years, Eaton has methodically repositioned its business mix from a traditional auto and truck parts manufacturer with exposure to internal combustion engines, to a high value-add electrical parts and aerospace supplier that now represents greater than 80% of operating earnings. This transformation has positioned the company well for the anticipated surge in demand for electric energy efficiency and environmentally friendly solutions. In addition, Eaton’s experienced management is focused on capital efficiency and has executed on improving organic revenue growth and improved profitability. The company is generating substantial free cash flow (FCF) and returning 6% of capital to shareholders through dividends and buybacks. The stock gained 31% in 2020 and was up approximately 40% YTD through August 2021, substantially outperforming its peers. Its transformation is now well understood and the market is rewarding Eaton shareholders.
Another strong performer during the third quarter was software maker Oracle. A name we have owned successfully in the past, we were able to purchase the stock again in October of 2019 when it was trading at just 14 times earnings with a 7% free cash flow yield. This “legacy” technology franchise is successfully competing amidst significant industry disruption. Oracle surged after indicating gains in their cloud and database end markets. Looking ahead, our research indicates that the company’s cloud and AI efforts could drive increased growth and more than double earnings per share. With management’s commitment to returning cash to shareholders and Oracle’s unrivalled installed customer base, we believe the stock has significant upside from here.
As mentioned above, the unpredictable path of COVID infections and global supply chain issues plagued the outlook for the economy and impacted the performance of a few of our holdings. One of our companies challenged with supply chain disruption is automotive systems and component manufacturer Magna. The stock gave back some of its prior YTD gains as investor concern was reflected in Magna’s underperformance during the last three months. We were able to purchase the stock in 2020 when it was trading at just 7 times normalized earnings with a strong balance sheet and scale that provides opportunities for growth. The management team, led by CEO Swamy Kotagiri, is repositioning the company into an auto 2.0 leader in both electric/autonomous vehicle development and best practices for employee safety. We believe that a strong balance sheet and scale offer opportunities for both organic and inorganic growth. Magna is still attractively valued at 11 times 2021 earnings and remains a holding.
Meanwhile, health care holding Cigna was another of our detractors, as it had to absorb increased COVID costs in the last few months. We believe that Cigna’s business, which combines a best-in-class pharmacy benefit manager (PBM) with a strong health insurance underwriter is extremely cheap, 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. Cigna’s valuation should rerate higher as the market appreciates its growth potential and consistent free cash flow.
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.
With the end of 2021 now in sight, COVID-19, interest rates, fiscal stimulus and inflation will surely be headwinds on investors’ minds. However, we are encouraged that stock performance based upon company-specific fundamentals seems to be more characteristic of recent markets. Helping to provide balance should be the tailwinds of solid corporate earnings, strong industrial demand/orders, and a continued back-to-school/office boost. We note that at September 30, 2021, Sound Shore’s portfolio had a forward price-earnings multiple of 12.3 times consensus, a meaningful discount to the S&P 500 at 20.1 times and the Russell 1000 Value at 15.5 times, despite strong balance sheets and better free cash flow.
Many thanks as always for your investment alongside ours.
Important Information
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 9/30/21 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.