September 30, 2022

The Sound Shore Fund Investor Class (SSHFX) and Institutional Class (SSHVX) declined 7.81% and 7.78%, (for the Fund's most recent standardized performance information, click here) respectively, in the third quarter of 2022, trailing the Russell 1000 Value Index (Russell Value) which declined 5.62%.  Year-to-date returns for SSHFX of -20.98% and for SSHVX of -20.88% were behind the Russell Value’s return of -17.75%.  As long-term investors, we note that Sound Shore’s 35-year annualized returns of 9.17% and 9.47%, for SSHFX and SSHVX, respectively, as of September 30, 2022, were ahead of the Russell Value at 9.13%.

In what was an extremely volatile quarter, September lived up to its historical reputation as the cruelest month of the year for equity markets.  The S&P 500 Index year-to-date return of -23.9% was the worst first nine-month return in twenty years.  Bond investors fared no better.  With inflation at 40 year highs, the US Federal Reserve accelerated its plan to raise interest rates and yields rose across the curve.  Longer-dated Treasury bonds had their worst start to a year this century.

The broad sell-off drove a number of our holdings to levels that are extremely attractive relative to our assessment of long-term value.  That’s the bad news.  The good news is that we had the opportunity to increase our investments in many high quality companies that we believe offer double-digit free cash flow yields and excellent risk/reward prospects.

While the recession debate has dragged on all year, it appeared to us that many stocks were already discounting one, or at least a much slower economy.  As always, we maintain a keen eye on identifying sustainable businesses that we believe can manage through a slowdown in order to derive value on the other side.  Specialty drug manufacturer Organon is an example.  This mid-cap stock sold off harder than the overall market, likely due to its inclusion in baskets of companies with high yielding debt.  However, we are careful to offset any perceived balance sheet risk with stable cash flow and this is no exception.  The company is generating free cash flow and has very little debt due in the next five years.  Organon, a spinoff from Merck, has a very steady pharmaceutical business focused on women’s health.  Trading at less than 5 times earnings, the company is growing steadily, investing in its research & development pipeline and generating ample cash flow to repay its debt.

Another resilient business with growing bookings and backlog is contract manufacturer Flex. Originally an electronics-focused outsource manufacturer with highly cyclical cash flows and short product lifecycles, the company has evolved its customer base toward the capital goods, automotive and healthcare industries.  For example, Flex’s exposure to consumer devices has dropped from 60% of revenues to 10% since the Global Financial Crisis.  Having successfully recast itself as a longer-cycle, “new industrial,” Flex’s stock has benefitted from more stable and diversified cash flows and more consistent revenue growth.  CEO Revathi Advaithi joined in early 2019 and she has refocused the company by accelerating the transition to these longer-cycle businesses.  Moreover, the company has been shareholder oriented, using its ample free cash to reduce shares outstanding by 35% in the last decade.  Meanwhile, the upcoming spin or sale of Flex’s Nextracker division should provide nice upside as private equity firm TPG invested at a valuation equivalent to over $6.00 per share.  This solar tracking company manufactures motors, software and systems for utility-scale power generation projects and business is growing quickly as the shift toward sustainable energy sources hastens.  Excluding Nextracker, Flex’s core business is trading at 6 times earnings and we expect it will grow earnings at a double digit rate over the medium-term.

Finally, electricity generator and marketer Vistra Energy is a low cost provider with a healthy balance between generation and retail (transmission and distribution).  Demand for electricity is going up, particularly in Texas where they have a lot of exposure.  Vistra has multiple fuel sources including solar, nuclear and battery power storage facilities.  CEO Jim Burke, leads a veteran utility management team that is committed to transitioning Vistra’s portfolio to a sustainable footprint by closing older fossil fuel plants and increasing the renewables portfolio.  They have also been an important voice to advocate for changes that will accelerate the global transition to a clean, renewable energy future, while maintaining adequate near-term supply.  Vistra has a strong balance sheet that allows the company to invest in innovation and operational improvements. Additionally, management is using excess cash flow to buy 40% of the outstanding shares over a four year period and they are more than half way through that process.  Currently valued at 7 times earnings with a 16% free cash flow yield and a 3.5% dividend, the stock remains a full position.

Looking into the final quarter of 2022, US mid-term elections will join the list of macro factors on investors’ minds, with central bank moves and the Ukrainian conflict following close behind.  We have our eyes wide open given the uncertain path for the economy.  As we have mentioned in previous letters, the process of normalizing interest rates, although ultimately necessary, will continue to create volatility coming from such a low level.  Nevertheless, Sound Shore carefully focuses its investments on attractively valued, high quality companies with manageable risks that we can research and understand.  As outlined above, we believe the current backdrop is ripe for these types of opportunities.

Indeed, at September 30, 2022, Sound Shore’s portfolio had a forward price-earnings multiple of 8.6 times consensus estimates, a meaningful discount to the S&P 500 Index at 15.2 times and the Russell Value at 11.9 times.  Exact timing is elusive, as always, but we think the current environment is well suited to our bottom up, value driven investment process.  All of us at Sound Shore continue to invest our personal assets in the Sound Shore Fund.