With the start of fall we find ourselves returning to some familiar ground as the market embarks on the final quarter of the year. For starters, the Cubs have returned to the post season (still sounds weird). Secondly, the market is once again consumed with regulatory reform unleashing animal spirits and sparking the reflation trade, much like last year on the heels of the election. And last, but not least, we welcomed the return of Curb Your Enthusiasm, a staple of the Sunday night routine on par with checking Bloomberg headers and prepping weekday lunches.
After failed attempts at implementing infrastructure and healthcare legislation, the administration has turned its attention to tax reform. Subsequently the market has shifted its focus to the implications, hopes, and possibilities of such actions. It should come as no surprise that many of the factors and forces at work in the fall of 2016 appear to be front and center again. Allow us to quickly tick off a few for reference:
»» A resurgence of small cap equity outperformance (Exhibit 1)
»» An increase in correlations among rate sensitive assets concurrent while sector dispersion rises (Exhibit 2-3)
»» Financials returning to the spotlight after unwinding much of their late 2016 outperformance
»» Capital investment considerations in light of possible expensing of Capex
»» Corporate buyback program announcements in anticipation of future cash levels
EXHIBIT 1: While small caps have given back most of their initial post-election outperformance, they have exhibited recent relative strength
As we have discussed in recent letters, the fund has con-centrated on a select few themes into the second half of the year. In light of the renewed emphasis on regulatory reform and the summer’s unfortunate influx of storms, we thought we would highlight two such investment themes:
Basket of Regional Bank Equities:
The fund has a select basket of names at the intersection of tax and regulatory reform that should materially benefit from passing legislation, even in part. We have identified companies with strong balance sheets that are currently in the process of completing a transaction or are likely targets. These companies already have the infrastructure in place to be substantially larger, standing to benefit from significant cost savings opportunities. All the while, these institutions remain committed to returning capital to shareholders (past and future). Each of these fund holdings has a unique angle to the anticipated reform, however, in the event that the regulatory process stalls (again) they each stand on their own merits. The securities trade at below to in-line valua-tion, achieve top quartile credit metrics, carry respectable dividend yields, and have sizeable runway to improve their standalone efficiency ratios.
Basket of Storm Recovery Equities:
On the heels of this unprecedented storm season, the fund sourced a group of equities that are set to benefit directly from rebuilding efforts, and cyclical tailwinds as broad economic activity continues to show signs of gaining steam. In the past month, economic indicators such as Institute for Supply Management (ISM) and average hourly earnings (AHE) have registered multi-year highs. Given the magni-tude of the necessary rebuilding efforts the fund has focused on a group of securities appropriately positioned to respond to the demand after this summer’s string of storms. The securities are a mixture of manufacturers and suppliers of construction products and building materials, specialty infrastructure services related to electric power, and automo-tive repair and sales providers with geographic exposure to the impacted regions. Reports suggest that the GDP region impacted by hurricane Harvey alone is seven times the size of Katrina and 40 times that of super storm Sandy. Depend-ing on the metrics used, hurricane costs will run well into the hundreds of billions of dollars. Compared to the imme-diate post-storm estimates that were sub $100 billion, the potential impact to companies levered to the recovery efforts is meaningful.
In each of the recent baskets the fund has initiated, we’ve focused our efforts on pockets of opportunity in the market where strong fundamentals are coupled with tailwinds and momentum set to unlock further value. Often times, the mar- ket is slow to price the full impact of change, which was the case in the immediate aftermath of the 2016 election. While knee jerk moves can appear large, when a thorough analysis of the true potential of structural reform are contemplated amid the backdrop of strong fundamentals, the numbers tell a different story.
Until next month, all the best,
K.C., Michael, Yoav & Tom
K.C. Nelson Michael Caldwell Yoav Sharon Tom McCauley
Portfolio Manager Assistant Portfolio Manager Assistant Portfolio Manager Assistant Portfolio Manager
Disclosures This material is not intended to be relied upon as a forecast or research. The opinions expressed are those of Driehaus Capital Management LLC (“Driehaus”) as of October 16, 2017 and are subject to change at any time due to changes in market or economic conditions. The commentary has not been updated since October 16, 2017 and may not reflect recent market activity. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Driehaus to be reliable and are not necessarily all inclusive. Driehaus does not guarantee the accuracy or completeness of this information. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
