Performance
For the quarter ended March 31, 2021, the Small Cap Select Value Strategy appreciated 20.79% gross (20.52% net of fees) versus gains of 21.17% the Russell 2000 Value Index and 12.70% for the Russell 2000 Index.
Macroeconomic Review
Following more than a decade of growth stock leadership the rotation into value appears to be sustainable for an extended period. While equities have appreciated materially since the March 2020
Covid-19 pandemic driven market bottom, we believe the macro backdrop remains
favorable for future gains.
Never in recent history have we witnessed an exogenous shock to global economies comparable in magnitude to the pandemic and its impact on travel, leisure, hospitality, entertainment and overall business logistics. Following a steep, rather short, recession, the U.S. economy has rebounded in tandem with massive government fiscal stimulus along with unprecedented Federal Reserve monetary accommodation.
The Fed estimates U.S. Gross Domestic Product (GDP) will grow at an annualized rate of six percent in 2021 followed by further growth in 2022. Corporate earnings meanwhile, are expected to exceed pre-pandemic levels. President Biden’s $1.9 trillion stimulus bill takes to nearly $3 trillion the amount of pandemic related spending paid since December, and to about $6 trillion the total paid out since the crisis. And that’s not all. The Biden administration is considering as much as $3 trillion worth of additional measures addressing infrastructure and climate change.
The Fed, meanwhile, will provide some $2.5 trillion to the banking system this year through its bond purchases. Fed o cials left their benchmark lending rate unchanged in March and projected it would remain around zero for the next three years, even as inflation moves up and employment gathers momentum. Inflation fears have forced the yield on the U.S. Ten Year Treasury note to more than double to 1.7 percent in recent months. In January, U.S. retail sales were already 7.4% higher than a year earlier, as many Americans received checks from the government. Household savings could hit $2 trillion by year end, according to Morgan Stanley. The American economy is recovering quickly, as fiscal transfers have left households with lots of extra savings. Lockdowns have given rise to pent-up demand.
Financial markets, meanwhile, are not pricing in monetary tightening by the Fed until 2023. Corporate earnings should be strong in 2021, given that last year’s numbers were hit hard by lockdowns. This year’s earnings should be boosted by robust economic growth, thanks to the major rollout of Covid-19 vaccinations, pent up demand and trillions in fiscal stimulus. Earnings for the S&P 500 should hit $172 per share in 2021, up 25% from 2020, according to Factset data. At the same time, corporations, which cut capital spending in 2020, have started spending again and the rebound could extend into 2022. Company holdings in our portfolio stand to benefit from the ripple e ects of accelerated megacap tech capex spending.
Intel Corp, for example, just announced plans to spend billions to revive its manufacturing prowess. The company will spend an initial $20 billion on two new plants in Arizona to support Intel’s attempt to break into the foundry business. It plans to build additional manufacturing facilities in the U.S., Europe and elsewhere with the CEO pledging that the majority of the company’s chips will be produced in house. What’s more, Taiwan Semiconductor Manufacturing Co. plans to spend $100 billion over the next three years to expand its chip fabrication capacity, a staggering financial commitment to address booming demand for new technologies. Our overweight in industrial technology companies has positioned the portfolio to capture the tailwind of growing infrastructure spending on broad band 5G deployment, datacom connectivity and cloud computing, along with a revival in spending on personal computers. Miniaturization and greater semiconductor content in automotive and industrial applications, is also driving profit growth for many of our holdings. Companies such as: Onto Innovation (ONTO, Financial); FormFactor (FORM); Entegris (ENTG) and Applied Energy (AEIS).
The macro backdrop has also been favorable for our multiple regional bank holdings. The steepening yield curve has increased bank profitability by widening net interest margins. Unforeseen was the pandemic driven boom in housing, and its contribution to mortgage underwriting and refinancing. Covid has also forced banks to implement competing initiatives of both cost reduction and technology investment to improve operating e ciencies. Loan growth should also rebound in 2021 to low single digits and credit generally remains solid with many banks having taken aggressive loan loss provisions last year. Loan deferrals have also been declining in tandem with businesses reopening. We would expect an acceleration in merger and acquisition activity in 2021 and beyond as the benefits of consolidation and scale broaden the deposit footprint and better absorb the increased technology investments.
Leading Contributors
Boston Private Financial Holdings, Inc. (BPFH, Financial) is a bi-coastal private bank and wealth manager forhigh-net-worth individuals. We became involved with the stock given the risk/reward opportunity at the time: trading at tangible book but with an audacious goal to expand wealth assets threefold under a new management team sporting a background of performing similar moves for significantly larger institutions. The low valuation was on account of limited public company experience exhibited by that management team, as targets were conveyed absent a clear timetable, which only led to investor disappointment. As investors grew impatient with the rate of traction against those stated goals, the company sold itself this past quarter. The all-stock deal was to a former holding of ours, SVB Financial (SIVB), and has taken the stock to our upside target. The fit is an appropriate one for both the business and leadership remaining with the organization.
Teradata Corporation (TDC, Financial) is a long-standing provider of data warehouse and analytics software.While the stock was a detractor in the prior quarter, our thesis held that the stock reflected a discarded turnaround story. This past quarter, the company demonstrated it had, indeed, passed through the intermediate negative financial e ects of the subscription model transition as revenue has now stabilized. When the company guided for a return to growth, the significant valuation discount closed, aided by short covering. While the stock recovery was an impressive one, it remains modestly valued.
Onto Innovation Inc (ONTO, Financial) is a semicap equipment provider, formed from the merger of NanometricsInc and Rudolph Technologies Inc. After doubling in size, the company led a product refresh cycle which culminated in share gains and strong earnings this past quarter. Though tech stocks faltered midway through the quarter, the Onto continued its upwards trajectory as key customers Taiwan Semiconductor (TSM) and Intel (INTC) both announced plans to expand production capacity with new fab builds. These actions form a strongly supportive backdrop for an extended period to come.
Leading Detractors
KAR Auction Services, Inc (KAR, Financial) is a provider of vehicle auction services in an e ective duopolymarket structure. Last year’s pandemic forced the shutdown of physical auction sites but hastened adoption of the company’s long-term move towards digital auction tools, an inherently more profitable business. Recovery hopes were dashed following fourth quarter earnings as it became apparent how important sourcing channels are for the company. Currently, vehicle supply remains constrained, mainly due to limitations on new vehicle production, which would free up o -lease vehicles destined for auction. While the stock reflects investor frustration by sporting a valuation implying no recovery, we see significant opportunity given the history of high free cash flow conversion (still maintained, even at these cyclical lows). Similarly, we see no reason to doubt the resolution of new car production issues, easing supply issues for the auction business.
Bottomline Technologies, Inc (EPAY, Financial) is software vendor o ering subscription-based products forbusinesses, from managing legal spend to receivables settlements to digital banking. Caught up in the year-end euphoria, the stock started the year a little ahead of itself as it reported solid, but not spectacular, results. The company often has a di cult time in managing investor expectations given inclusion within the hypergrowth “fintech” subsector. After posting record profit margins in the prior year, the company chose to reinvest a portion within the business, which has served to dampen profit growth in the interim. Though cumbersome to perform by investors, an analysis of the key new business verticals show promising adoption trends and we believe the market potential is significantly greater than what is addressed today by the company.
Infinera Corporation (INFN, Financial) designs and builds network equipment for optical transport, which is thehigh-speed transmission of data in the form of light waves. After exiting the year near the high mark of three years ago, the stock traded o modestly in an up market as investor preferences shifted away from names deemed to be early beneficiaries of the pandemic. While remote-working trends certainly boosted demand for networking equipment, the company has gained ground against ambitious gross margin leverage targets set at the time of the Coriant acquisition. We still believe the stock has further upside as end market trends remain in place, credible competitive threats have narrowed, and the company continues to have operating leverage potential.
Outlook
As we enter 2021, our portfolio remains well positioned to deliver attractive risk adjusted returns over the next market cycle. In conclusion, thank you for your investing alongside us in the Small Cap Select Value Strategy. We appreciate your confidence and trust.
Past performance is no guarantee of future results. As with all investments, there is a risk of loss. Any performance and/or attribution information contained herein are based on a representative account of the specific strategy discussed. The periods prior to March 20, 2009 represent the performance record established by the Portfolio Manager while a liated with a prior firm. Returns are presented gross and net of management fees and include the reinvestment of dividend and other earnings.
The opinions expressed in this document are those of Teton Advisors, Inc. as of the date indicated and are subject to change without notice and are not intended as recommendations of individual securities.The net performance numbers shown are for informational purposes only. Management fees are negotiable and standard fees is contained in the Firm’s Form ADV Part 2A, which is available at no cost at www.keeleyteton.com.
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