During the one-year period ending June 30, 2015, the Meridian Contrarian Fund Legacy Class shares returned 6.84%, which compares to a return of 5.92% for its primary benchmark, the Russell 2500 Index.
Performance in the period was aided by the strength of our investments in the financial and energy sectors, as well as by avoiding the utility sector, which was among the weaker sectors in the benchmark.
Our financial holdings are mainly high-quality companies that will benefit from higher interest rates. Interest rates have been near historic lows for an extended period of time, a condition that has hurt the earnings of many banks and certain financial markets, and the idea that interest rates will eventually rise is largely a consensus view. We are “bottom-up” investors and believe that our competitive advantage lies in fundamental analysis of out-of-favor companies. As such, we do not make large investments based on macroeconomic factors unless we believe that our bottom-up research has given us insight into macro trends that run counter to the prevailing market view. In this case, we have no such contrarian viewpoint about rates, per se, but our fundamental analysis of how rates may improve the earnings power of financial services companies suggests to us that the market is not accurately discounting this possibility. This situation has created an asymmetric investment opportunity in financials that we find compelling. Consistent with our overall investment strategy, within the financial sector, we focus on companies that we believe may not only benefit from a higher interest rate environment, but also are out of favor due to company-specific challenges that may be better suited to our fundamental investment process.
One such recent investment is MetLife. The company underperformed the broad market, as low rates have pressured earnings. Shareholder returns also have suffered due to the company’s designation as a Structurally Important Financial Institution (SIFI), which limits management’s ability to return excess capital to shareholders. Resolution of either of these headwinds could unlock improved earnings-per-share growth and return on invested capital and support a valuation re-rating for the company. If neither of these headwinds are resolved, we see very little risk to the status quo, as shares are currently valued at less than 10 times next year’s earnings.
Our performance in the period was hurt by our investments in the energy and industrial sectors. Energy markets continue to be volatile, and we do not have a view on the timing of a rebound. Our strategy in this sector is to take advantage of the volatility by continuing to invest in what we believe are high-quality energy companies that have attractive long-term growth opportunities.
The top three contributors to our performance for the fiscal year were Neurocrine Biosciences, ServiceMaster and Denny’s.
- Neurocrine Biosciences (NBIX, Financial) is a pharmaceutical company with two development-stage programs focused on neurological and endocrine-based health problems. The company came to our attention after poor clinical trial results for one of its programs resulted in a 40% reduction in the share price. We invested because the issues with the trial were related to trial design, not drug efficacy. Management presented a credible plan for addressing the design issues, and the company’s valuation was capturing only a fraction of the potential cash flows that could be generated by both drug programs. Over the past year, both of Neurocrine’s drug programs have delivered strong clinical trial results and are on track for commercialization, which may drive significant earnings and cash flow growth. We have reduced our position somewhat over the past year due to the strong appreciation in share price but continue to hold shares in Neurocrine Biosciences.
ServiceMaster Global Holdings (SERV, Financial) is a leading provider of termite and pest control services, home warranties and other residential services. The company had problems with marketing and service missteps at its lawn care division, which is no longer part of the company. We invested in ServiceMaster because of its dominant positions in fragmented markets, including 40% market share in home warranties, and consistent sales growth, driven by 80% customer retention and share gains from smaller competitors. The stock outperformed over the past year, as earnings results showed continued revenue growth and much better than expected profit margins driven by cost-saving initiatives, lower fuel costs and product mix. We remain ServiceMaster shareholders as its business continues to improve and the sectors in which it operates remain attractive. We maintain a significant position in ServiceMaster though we have reduced our position, as the valuation multiple has increased significantly since our initial investment.
- Denny’s (DENN, Financial) is an iconic casual dining chain with approximately 1,500 franchises and 160 company-owned restaurants. The company came across our contrarian screens repeatedly during years of decline under a series of previous management teams. We invested in 2011 when strong new management took over with a coherent turnaround plan. Denny’s made solid progress, stabilizing the business with menu and marketing improvements and using solid free-cash flow to pay down debt, repurchase shares and fund a successful restaurant remodel program, though sales growth remained subdued. An inflection point came in 2014 as sales improved significantly, aided by lower gas prices that alleviated pressure on Denny’s core customer. This is a trend that accelerated through the remainder of the year and has held up in 2015. We remain shareholders though we reduced our position significantly due to the rise in the stock.
The top three detractors to performance for the year ending June 30, 2015, were – unsurprisingly, given the historic drop in oil prices – energy companies: Halcon Resources, EOG Resources Corp and National Oilwell Varco. Energy remains volatile, and as such, we are proceeding with caution. Our current energy exposure lies in leading companies that we believe have strong balance sheets and growth prospects, such as EOG (EOG, Financial), Helmrich & Payne, Corelabs and Occidental Petroleum (OXY, Financial). With the energy sector deeply out of favor, we will opportunistically look to increase our exposure to the sector. We are monitoring several companies that we believe could be attractive holdings in a rebound scenario.
OUTLOOK
Equity markets are coming off several strong years, U.S. unemployment has decreased and the strength of the dollar has improved. Prices of oil and other commodities have plummeted, which is hurting some areas of the industrial economy, and the financial markets are increasingly concerned about the timing of an inevitable increase in interest rates. Our strategy is to monitor the macro picture without attempting to predict it, to be conscious of how macro may affect the performance of the businesses in which we invest, and to take advantage of macro-induced market volatility to find opportunities in individual companies that have attractive business economics and improving fundamentals.
We thank you for your continued investment.
Jamie England, Larry Cordisco, & Jim O'Connor
Arrowpoint Asset Management LLC
