The Hickory Fund returned -16.05% in the fourth calendar quarter compared to -18.49% for the Russell 2500 Index (the Fund’s primary benchmark.) For the 2018 calendar year, the Fund returned -13.55% compared to -10.00% for the Russell 2500.
The final months of the year were painful. The fact that our portfolio outperformed its benchmark through the quarter’s decline is only a modest relative consolation to an otherwise painful absolute experience. Warning signs of a cooling economy were compounded by investors’ perception that the Federal Reserve had mismanaged interest rate policy. Add fear of escalating trade tensions and a view that the new split-controlled Congress might undermine the so-called Trump Bump, and investors’ collective psyche switched from greed to fear in short order.
We have written (many times) of our belief that volatility breeds opportunity. Given the recent, rapid price dislocations, we anticipate the primary question of most shareholders is some version of, “Volatility’s back, so what did you do about it?” In short, we were buying. As market declines accelerated, we began to view stock prices as increasingly divorced from our estimation of their underlying business values. Although unsettling, we felt the conditions were improving for potential forward investment returns. Against this more constructive backdrop, we elected to deploy a significant amount of the Fund’s formerly elevated cash position (during the quarter, cash declined from roughly 17% of net assets to under 5%). More than half of the newly deployed capital was invested in four new investments, with the remainder added to six existing positions.
Roughly 60% of purchases were allocated to investments that we felt were increasingly mispriced. This includes existing holdings, such as Summit Materials and Colfax, as well as new positions in Gardner Denver (maker of highly engineered pumps, compressors, vacuums and blowers for applications across industrial, energy and medical end markets) and Marvell Technologies (maker of semiconductors used in data storage and networking applications). Although each has near-term headwinds to address, we believe the market has simply overreacted, creating significant potential upside once cooler heads prevail.
Next, just over one-third of purchases were geared toward building core positions in Guidewire Software and portfolio newcomer Black Knight. We have long admired Black Knight (BKI, Financial)’s dominant position in software used by financial institutions to process and service mortgages, and we believe the company has ample opportunity to replicate its strong position in the underpenetrated home equity loan market. We frequently refer to businesses like these as “compounders,” businesses that we believe can continue to compound their value per share for a long time. Although investments in these kinds of companies are typically not optically cheap by traditional metrics, such growth is particularly valuable, and we hope to be the beneficiaries for years to come.
Finally, the remainder of purchases were in new holding Myers Industries (MYE, Financial), run by CEO David Banyard (an alum of Roper and Danaher). We see an opportunity for Myers to potentially transform its profile through acquisition and improve its disparate collection of manufacturing businesses (ranging from agricultural seed boxes to fuel cans) through the implementation of lean continuous improvement principles. We built a small initial position and will closely monitor Myers’s progress against these grand ambitions. Although a portfolio of only transformational opportunities might not be prudent, in the context of a full portfolio, we think there is room for opportunistic investments like Myers that have the potential to become something greater than the sum of their parts.
Looking to performance for the quarter, the swift correction across the U.S. equity markets dominates the discussion. Positive absolute contributors to performance were few. Commercial property REIT Equity Commonwealth eked out a positive return, and the Fund also generated positive initial returns from Marvell. Colfax was the top detractor. Colfax surprised investors by announcing an acquisition of orthopedic device maker DJO Global. The use of currently depressed equity to partially fund the transaction is disappointing, but we believe the purchase of DJO combined with the planned sale of their air and gas handling business results in a higher-quality and more balanced portfolio of businesses. Liberty Broadband was also a top detractor while experiencing a market-like decline. Lastly, LabCorp shares fell following their announcement of slowing volumes in their core testing business.
For the calendar year, Colfax was joined by Lions Gate and Summit Materials as the top detractors. Lions Gate and Summit shared the common theme of disappointing results coupled with financial leverage. XO Group’s takeover earned it top marks for the year, while LICT and ACIW rounded out the 2018 Honor Roll.
Looking ahead to 2019, we claim no insight on the direction of the market’s next 10% move. That said, given a portfolio-level price-to -value (the ratio of stock’s price to our base case value estimate) in the low 70s, the environment feels more constructive to us than in recent memory. We appreciate the opportunity to invest alongside you and look forward to reporting our progress to you again next quarter.
Contributions to performance are based on actual daily holdings. Securities may have been bought or sold during the quarter. Return shown is the actual quarterly return of the security or combination of share classes. Source for return shown is FactSet Portfolio Analytics.
