First Quarter 2018 Commentary

First Quarter Results

Volatility is back. After a subdued market environment in 2017, we are seeing the return of market swings that are adding a level of complexity for portfolio managers across all asset class spectrums. As a frame of reference, we have had a total of twelve trading days in the first quarter where the S&P 500 was up over 1% on the day compared to just four in all of 2017. We have seen eleven days in the first quarter of 2018 where the S&P 500 was lower by 1% or greater compared to just four in all of 2017. The standard deviation of daily returns for the S&P 500 in 1Q18 is a whopping 1.3% versus only 0.4% in all of 2017.

We have achieved a total return in the Ruterra equity portfolio of 0.6% in the first quarter of 2018 compared to a return of -1.6% for the S&P 500. Our core value portfolio is responsible for the gains achieved, up 1.3% for 1Q18 offsetting losses in our merger arbitrage portfolio (-2.5%) and our opportunistic portfolio (-2.3%).

Merge-Arb Portfolio

The Trump administration has certainly turned the merge-arb world on its head, with the attempted block of the AT&T – Time Warner vertical merger and its insertion to block the Broadcom – Qualcomm deal.

In light of these events we have absolutely seen spreads in merge-arb opportunities widen as political questions surface regarding President Trumps populist platform along with weaker equity prices on threats of a brewing trade war.

In our merge-arb portfolio, we have had our fair share of setbacks in the past quarter. Ultra-Electronics Holdings terminated its acquisition of Sparton Corp. (SPA) following an unfavorable antitrust review from the DOJ. We attempted to capture the buyout spread premium by going long Sparton Corp. but the company’s stock dropped on the news and we ended up losing 12.5% on the trade.

SandRidge Energy (SD) also terminated their acquisition of Bonanza Creek Energy (BCEI) after pressure from Carl Icahn to cancel the deal. Our long position in BCEI lost 10.0% on the announcement.

As a result of the negative events affecting our merge-arb positions, the merge-arb portfolio lost 2.5% in the first quarter of the year. Currently our merge-arb positions represent only 5.0% of our total portfolio.

Core Value Portfolio

We have attempted to use this increased volatility to construct a portfolio with favorable metrics relative to the S&P 500. Our core value portfolio is weighted towards cyclicals (52%), financials (20%) and industrials (12%). This has sheltered us somewhat from the dramatic technology sell-off that we are seeing late in the first quarter as FAANG stocks have their day of reckoning.

Our core value portfolio, which consists of a basket of S&P 500 companies that offer the best growth prospects at a reasonable price has a weighted average twelve month-forward P/E of 13.8 compared to 16.1 for the S&P 500. Our weighted average twelve month-forward earnings growth expectations is 34.8% for the portfolio against forecasts for 29.9% for the S&P 500. In aggregate, our expected five-year annual compounded earnings growth rate for the core value portfolio is 13.5%. When we discount that back to the present value, we have a weighted average IRR of 18.9% for the portfolio. This compares to a five-year compounded annual earnings growth rate of 10.6% for the S&P 500 thus providing an IRR of only 8.7%.

We are pleased with the construction of the portfolio relative to our benchmark because it offers greater EPS growth prospects at a cheaper multiple relative to the S&P 500 and we have managed to hone in on a 0.98 weighted average beta with the goal of keeping our portfolio volatility reasonable.

Animal Spirits

A recent story on Bloomberg had caught our eye. The article was titled, “Stock Bulls in Trump Country are Freaking Out Their Brokers”. In the midst of the market sell-off in February, there seemed to be an apparent lack of panic during the heightened volatility. It would appear that confidence in the Trump administration has provided a phycological “put” in the market. In a similar article from Investment News entitled, “Investors stood pat during February correction”, they cited a Bankrate.com survey taken in February. They noted, “Just 6% of individual investors were net sellers during the February correction, according to a survey of 1,063 adults with investment accounts conducted by Bankrate.com. Another 15% added to their investments, while 60% intentionally did nothing. (Sixteen percent were unaware of the sell-off altogether.)” As students of behavioral finance, we fully appreciate the power of animal spirits and the driving power of market sentiment and decided to take a closer look to see if we were picking up similar readings in the various sentiment indicators that we track. We were curious to see if the act of fiscal policy was the new mantra of a positive market bias, after many years of monetary policy holding that title. What we found indeed confirmed a lack of panic during the February sell-off and the late March (early April) retest of the lows.

The chart below looks at the ten-week moving average of the Wall Street Weekly Sentiment Survey Bulls/Bears ratio. We use the moving average to attempt to smooth what is a fairly volatile survey. This survey can be viewed as a contrarian indicator that tends to be overly bearish (lower) at market bottoms. In the past few market sell-offs, the ten-week moving average bull-to-bear ratio tends to decline to the 0.50 range. During the latest bout of volatility, the ratio dropped to a low of 0.79, well above levels seen in previous market turbulence.

Similar readings can be seen from the survey conducted by the National Association of Active Investment Managers (NAAIM). This survey can be viewed as another contrarian indicator and we tend to use the ten-week moving average to smooth the results. In previous market bottoms the survey average tends to fall to the 20 – 40 range. During the last sell-off the average only dipped to the 65 range.

Another sentiment indicator that we track is the year-over-year rate of change of the Sabrient Insider Sentiment Index. For those that are unfamiliar with this index, Bloomberg defines it as, “The Sabrient Insider Sentiment Index is an equal- dollar weighted index comprising publicly-traded companies that reflect positive sentiment among those 'insiders' closest to a company's financials & business prospects (top management, directors, analysts)”. Typically, when the year-over-year growth rate falls to -20%, it usually corresponds with a major demise in sentiment and a near-term market bottom. During the latest bout of volatility the index dropped to just under +20%, no where near the distressed levels in past corrections and just another example of the positive views regarding the economy and the market.

Commodity Readings

One of the many commodities that we track to gauge the health of the economy is lumber prices. Since late 2016, lumber prices have been in a clear bullish trend, doubling in price as the “Trump Trade” pulled asset prices upward. We value the information provided in the pricing of “hard” assets that can at times be more reflective of economic supply and demand dynamics than other types of sentiment indicators.

Lumber prices have been rising recently for a number of reasons. A trade dispute between the U.S. and Canada and subsequent 20% tariff or more on Canadian sawmills impacted prices given Canada supplies about one-third of our timber needs. Canadian wildfires along the Pacific Coast and hurricanes in the U.S. temporary shuttered mills, causing price fluctuations due to supply and demand factors. A shortage of trucks and railcars further escalated the issue due to transportation complications. That said, these market obstacles are largely transitory and we would expect pricing anomalies to revert back to normalcy rather quickly.

We believe the true driving factor behind the price of lumber is the expectation of a busy building season this year, a strong economy and a tight supply of homes on the market. According to the Commerce Department, the number of new units under construction in the U.S. rose almost 10% in January and building permits are indicating a busy year in 2018.

Using the commodities market as a leading economic indicator we compare relative pricing differentials between different instruments. We find the relative pricing differential between lumber prices and gold prices offer a telling view of how the markets view economic strength. The following chart shows the correlation between the lumber/gold pricing differential and quarterly GDP growth. As can be seen, there is a positive correlation between these metrics. The thought process behind this model is that lumber prices should accelerate ahead of strong economic growth as construction picks up and gold will rally in the face of slowing economic growth or a pickup in inflation as a safe-haven hard asset. The strength in the lumber/gold pricing differential over the past few years is evident and is now trading roughly three standard deviations from its five year mean. It is our opinion that the strength and trajectory of this indicator paints a favorable outlook for the U.S. economy in the coming year and thus provides added comfortability to increase our equity exposure given the current market sell-off that we suffered in February.

The housing market in the U.S. continues to exhibit strong demand with insufficient inventory, thus it’s our view that the industry can continue to grow as long as pricing remains under control and mortgage rates don’t start exponentially increasing. Monthly single-family housing starts were 877,000 in January, an increase of 3.7% month to month and up 8.0% year over year. This is impressive given industry concerns regarding labor and materials shortages. New home sales climbed 10.0% last year to an annualized 615,000 units and we anticipate this trend continuing through 2018. According to the National Association of Realtors, sales of existing homes dropped 3.2% month to month in January and 4.8% year to year. The drop in sales may partially be a function of higher mortgage rates but industry experts place blame on temporary factors such as weather in specific regions and supply disruptions.

With unemployment near its historic lows, wages increasing, consumer sentiment soaring and household debt service decreasing the housing market looks to have the potential to offer investment opportunities. Demographics are also working in the sectors favor as millennials start to enter the market and Morgan Stanley analysts are projecting annual household formation of over 1.35 million units over the next half decade.

The home building industry dynamics are compelling. The S&P 500 home builders index is expected to earn $92.63 per share in the coming twelve months and is currently trading 10.3x twelve-month forward EPS. Over the past five years the industry has traded 12.8x on average and the industry is expected to grow earnings by approximately 45.6% in the coming year. The five-year expected compounded annual earnings growth rate is approximately 20% giving the industry a PEG ratio of 0.50. Calculating the net present value of future earnings, the industry offers an IRR of greater than 20% over the coming five years.

As we have alluded to, rising mortgage rates can negatively impact the industry, but mortgage rates are still low by historical standards and need to rise aggressively from the current levels before making an impact on the housing market, in our view.

Another interesting dynamic in the sector stems from accelerating home prices. Home prices have been on the rise nearing levels just prior to the housing crisis and Great Recession but individuals have dramatically cleaned up their personal balance sheets so that their mortgage service debt as a percent of disposable income is the lowest it’s been in decades, according to data from the Federal Reserve.

New home sales have greatly improved from the depths of the financial crisis but haven’t come anywhere near the over-supply witnessed prior to the crash. In fact, US existing home sales months’ supply is only around 3. Fewer months’ supply means few homes available for sale which translates into strong demand. Given the favorable aspects of the US economy (albeit a late stage cycle) and the tight supply of homes with strong demand, we believe it makes sense to review a few of the larger S&P 500 homebuilding companies as a potential way to profit from the housing data.

One interesting company in the S&P 500 is D.R. Horton, Inc. (DHI). The company is run by best of breed management whom have exhibited the ability to produce above average margins and rates of returns relative to their peers. While focusing on single-family homes in the US, they have also branched out to providing financing and insurance services that contributes to their overall value add, in our view. They are fairly diverse in the markets they serve with approximately 30% of their revenue derived from the Southeast US, 24% of revenues from South Central US, 24% of revenues from the Western US and 12% of revenues from the Eastern US. The remainder of revenues are divided among the Mid and South Western part of the US. They also offer a broad range of price points for the homes they sell with approximately 20% at the $200k price point, 27% near the $250k range, 20% approaching $300k and 26% near $500k. We believe this works in their favor as it’s best suited for the millennial market and high-end (expensive) home sales have been the laggards in the recent past.

Their recent acquisition of residential developer Forestar has added, not only properties to build on, but the option to build on lots in the future. We view this as a positive in that, should the economy soften somewhat, they have decreased their cost of carry through the options as opposed to outright purchases of land.

The company trades 10.8x forward EPS of $3.98, undervalued relative to their five-year average P/E of 12.5x. They are expected to grow earnings by 44% in the coming twelve months and have a long term expected compounded annual growth rate of 20%. With a PEG of .53 and an IRR of 20.3% over the next five years, we view this as a favorable investment opportunity. It pays approximately 1.2% annually in dividends that is well covered by cash flows and earnings.

In keeping with the housing theme, Lowe's Companies, Inc. (LOW) looks interesting as well. When the company reported 4Q17 earnings, same store comp sales was very favorable and average ticket transaction size showed signs of a promising trend. That said the stock sold off aggressively as margin pressures became evident. Gross margins declined by 68bps with higher shrink and transitory mix and pricing strategies. Management addressed the concerns on the call and announced steps to improve these metrics. Operating margins were under pressure from higher SG&A pushing operating margins down to nearly 7%. They detailed their strategy for margin expansion in the future and guided for 4% growth in revenue for 2018 on comps of 3.5%. They expect margins to continue to be under pressure for 2018 but did offer that they would be buying $2.5B in stock to offset the margin deterioration. When taken with improved earnings power from the recent corporate tax cuts, we believe there is a cushion in place to let management continue its margin turnaround story.

Lowe’s is trading 15.5x twelve-month forward earnings expectations of $5.61 versus a five-year average of 18.0x. Earnings are expected to grow almost 33% in the coming year and the five-year compounded annual growth rate is approximately 16.5%. This gives us an IRR of 18.0% with a PEG ratio of 0.93. Lowe’s has a 1.9% annual dividend yield that is safely covered by cash flows and a long-term ROIC of 23.0%. The S&P 500 Consumer Discretionary sector trades 18.0x forward earnings with earnings growth expectations of 24.8% over the coming year, as a means for comparison.

Outlook

We continue to believe that the economy is on strong footing and place a low probability that we are heading for a near-term economic recession in the United States. As mentioned in our last quarterly review, we feel there is a risk that monetary policy could surprise the market with an overly aggressive tightening cycle, especially in the face of increased fiscal stimulus and the possibility of inflationary pressures but believe the U.S. equity market can withstand the current trajectory of Fed action. Barring an economic recession, we view the current market weakness as an opportunity for enhanced profits for the remainder of the year and are seeking additions to the portfolio that enhance our investment metrics and comply with our stated criteria and objectives.

Joseph S. Kalinowski, CFA