Quarter Ended June 30, 2020
While pandemic driven lockdowns across the globe sent markets into bear territory in March, massive fiscal and monetary stimulus propelled a monumental recovery. The S&P 500 logged its best quarter in percentage terms in more than 22 years, however the market’s rally has since slowed. A resurgence in coronavirus cases has paused or reversed reopening plans across twenty-one states. High unemployment, income losses and weaker consumption due to the lockdown, as well as U.S. election uncertainty have blurred the path ahead. Yet, it’s important to be mindful that equities continue to receive meaningful support from record levels of stimulus, sustained ultra-low interest rates and ongoing non-inflationary growth. While we expect volatility in the second half, we believe the U.S. economy will continue its recovery as restrictions ease. Ariel Fund advanced +23.32% during the quarter, significantly ahead of the similarly positioned Russell 2500 Value Index’s gain of +20.60% but behind the Russell 2500 Index, which returned +26.56%.
Several stocks in the portfolio delivered strong returns in the quarter. Leading entertainment company, ViacomCBS Inc. (VIAC, Financial) was a top contributor in the quarter, with shares benefitting from solid earnings results driven by revenue growth across advertising, content licensing and its subscription categories. VIAC also reported a deal with YouTube TV and continued growth in streaming. Other bright spots included the return of live golf on television and green shoots in advertising. Subsequently, VIAC announced it hired Naveen Chopra as Chief Financial Officer, a licensing deal with NBCU’s Peacock streaming service and affiliate agreement renewals with DISH Network and local broadcaster, Sinclair. In our view, premium video content is the most valuable part of the media ecosystem. Based on our sum of the parts analysis, VIAC is currently trading 43% below our estimate of private market value. At today’s valuation, we continue to believe VIAC’s risk/reward is extremely skewed to the upside.
Additionally, shares of specialty cutting tool insert maker Kennametal, Inc. (KMT, Financial) jumped following the announcement that the company would be accelerating its structural cost reduction plans to mitigate headwinds from COVID- 19. KMT continues to adjust production levels and is focused on managing costs while executing on its simplification/modernization and restructuring initiatives. We believe the scale, scope, quality, low- cost production and the value proposition of the cutting tools themselves also mitigate pricing pressure. Additionally, KMT continues to execute on its strategic plan to improve economies of scale and generate margin improvement, while gaining share in the marketplace.
Bar code manufacturer Zebra Technologies, Inc. (ZBRA, Financial) was another strong performer in the period. Although global supply chain disruptions and weaker demand in China resulted in ZBRA modestly missing its sales and profitability outlook, the company entered the second quarter with healthy order backlog. While ZBRA is beginning to see a disruption in global demand, we continue to believe their diversified end-markets and strong financial position will enable the company to ride out weakness in the enterprise spending environment. Although ZBRA pulled full year 2020 guidance, management articulated the expected impact of COVID-19 on second quarter results, which was better than consensus expectations.
Alternatively, after being a top contributor to results last quarter, leading manufacturer of consumer food products, J.M. Smucker Co. (SJM, Financial) reversed course and became a top detractor from performance in the period. Although SJM delivered a fiscal fourth quarter and full year 2020 earnings beat from high consumer demand for the company’s staple products driven by shelter-in-place orders, management issued Fiscal 2021 guidance below consensus expectations. We believe management’s underlying sales growth for the year ahead are reasonable and expect SJM will maintain financial discipline and will continue to strengthen its bottom line. At today’s valuation, we continue to see the risk/reward skewed sharply to the upside.
Jones Lang LaSalle (JLL, Financial) also underperformed in the quarter, as the pandemic has been a significant headwind for commercial real estate transaction activity. While management withdrew the 2020 outlook for its brokerage segment, we believe the company’s diverse business model and annuity like non-transaction revenue mix, such as corporate outsourcing will help offset weakness in the cyclical leasing business. For instance, customers are engaged with JLL to discuss bringing employees back to their office spaces, including potential space re-configurations, increased cleaning and security and more advisory and technology -led solutions. In addition, we believe JLL has sufficient liquidity to weather the storm. At current levels, the company is trading at a 25% discount to our estimate of private market value.
Shares of owner and operator of regional sports and entertainment networks, MSG Networks Inc. (MSGN, Financial) have been pressured by uncertainty surrounding the financial and operating implications related to the NBA and NHL halting their seasons. Investors are also concerned with continued subscriber losses across Cable, Telco and Satellite video distributors, which has negative implications for affiliate revenue. On a positive note, the company bought back a little more than 6% of shares outstanding in the quarter, further supporting our view that shares are currently undervalued. We believe MSGN’s long term rights agreement to broadcast Knicks and Rangers games through 2035 in the largest Designated Market Area in the country makes these rights more valuable than other regional sports rights, all things equal. We also highlight that despite ratings pressure across all professional sports leagues, sports content remains the most valuable type of content to advertisers because of its live consumption.
Also in the quarter, we initiated a position in Core Laboratories NV (CLB, Financial), which is a provider of reservoir description and production enhancement services in the oil and gas industry. In response to recent headwinds within the operating environment, management recently announced prudent enhancements to an existing cost reduction plan, which we believe will help CLB achieve its free cash flow targets and reduce debt levels. Longer- term we expect current challenges will continue to soften and believe this asset light business will deliver modest growth in reservoir description. We also think CLB will see increased activity in fracturing rock, which should increase output in well completions and fuel longer term growth of the production enhancement sector.
We also added Madison Square Garden Entertainment Corporation (MSGE, Financial), which owns scarce and well positioned venue assets in New York City and Las Vegas. MSGE was spun out from Madison Square Garden Company on April 17. Given current restrictions on large gatherings, we entered the name at a meaningful discount to our estimate of private market value. With $1.4 billion in cash and investments, we believe the company has enough liquidity to withstand the current cash burn until event attendance normalizes – at which point, we think MSGE is positioned to see a more rapid return to higher usage than peers.
Meanwhile, we exited our position in Molson Coors Beverage Company (TAP, Financial) to pursue more compelling opportunities.
Looking ahead, we believe U.S. stocks will overcome the obstacles created by COVID-19. The Federal Reserve has pledged to do whatever it takes to support markets and the economy. Actions thus far have included cutting rates to zero, quantitative easing, committing to purchase investment grade and high yield corporate bonds, forgivable loans to small businesses, as well as extended unemployment benefits equal to wage income for the median worker. A Phase Four Stimulus package also appears to be on the way. Amidst this backdrop, we expect a solid recovery for equities and earnings as early as the fourth quarter of 2020 or first quarter of 2021. Meanwhile, we stand ready to take advantage of any pull backs in the market on negative news. We strongly believe the dedicated, contrarian, patient investor that stays the course and consistently owns differentiated business models with solid competitive positioning and robust balance sheets will deliver superior returns over the long-run.
This commentary candidly discusses a number of individual companies. These opinions are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
