For the six months ended December 31, 2015, the Meridian Growth Fund Legacy Class shares declined (8.90)% underperforming its benchmark, the Russell 2500 Growth Index, which declined (7.66)%.
After a strong start in 2015, small cap stocks reversed course in the second half of the year, ending the period in negative territory. Market volatility was fueled by a sharp decline in oil prices, continued weakness in China, deteriorating commodity prices, and anxiety over a potential increase in U.S. interest rates, which finally transpired in December.
With an investment process that prioritizes the management of risk over the opportunity of return, our strategy should have served us well in this environment, and in some respects it did: We successfully met our downside protection goal of 80% when the market declined. However, we were not successful in achieving our secondary goal of 100% participation when the market gained.
We attribute this shortfall to a number of unexpected—and atypical—market developments. Key among these was the continued outperformance of high-momentum stocks, which do not meet our risk-first investment parameters and therefore are not owned in the portfolio. Other dynamics included the market’s bias toward larger-capitalization stocks and investors’ enthusiasm for companies in sectors that we believe offer fewer quality names and, as a result, are underweight positions in the portfolio.
Despite these challenges, we continued to find compelling long-term opportunities within the small and mid cap universe. Several of these opportunities were in the information technology and materials sectors, which made positive contributions to portfolio performance during the period. Meanwhile, industrials and consumer discretionary names were areas of weakness in the portfolio.
The three largest contributors to performance during the period were SolarWinds, Inc. (SWI, Financial), Solera Holdings, Inc. (SLH, Financial), and Dyax Corp. (DYAX, Financial).
- SolarWinds, Inc. (SWI, Financial) accepted a $4.5 billion offer to be acquired by two private equity firms, turning it into a home run for investors. In October, the developer of IT infrastructure management software agreed to be purchased at nearly a 20% premium by Silver Lake Partners and Thoma Bravo. We initiated a position in SolarWinds in 2013 based on our belief that the company would benefit from an increasingly large market opportunity created by a pervasiveness of performance-driven IT infrastructures. We opportunistically added to the position when the stock pulled back and were rewarded by the takeout.
- Solera Holdings, Inc. (SLH, Financial) is a company we’ve owned for several years. As a provider of risk and asset management software and services to the global automotive industry, Solera is a stable business that is both predictable and defensive in nature. The majority of the company’s revenues are recurring, and it has a strong competitive position, particularly outside of the U.S. where it generates over half of its revenue. In August, Solera’s management announced the sale of the company to private equity firm Vista Equity Partners for $6.5 billion, causing the stock to appreciate. We viewed the increase in Solera’s share price as an opportunity to take profits and trimmed our position.
- Dyax Corp. (DYAX, Financial) is a biopharmaceutical company focused on novel therapeutics for patients with rare diseases. One of the things that initially attracted us to this company was its development of a promising new drug for hereditary angioedema, a rare and potentially life-threatening disease that causes swelling. Ireland-based biopharmaceutical company Shire also recognized the potential of this experimental drug and, in November, offered to purchase Dyax in an all-cash deal valued at approximately $5.9 billion—a premium of about 35%. We were pleased to be among the investors who benefited from this lucrative deal.
The three largest detractors from performance during the period were Roadrunner Transportation Systems, Inc. (RRTS, Financial), Wolverine World Wide, Inc. (WWW, Financial), and Clean Harbors, Inc. (CLH, Financial).
- Roadrunner Transportation Systems, Inc. (RRTS, Financial), a leading transportation and logistics service provider, declined along with other transportation service providers. Weak freight markets, a more competitive pricing environment, and an increase in accidents worked against Roadrunner, causing it to miss third-quarter earnings expectations. The company also took a one-time charge after discontinuing a lease-guarantee program designed to attract owner-operators. We believe Roadrunner’s position as the low-cost provider in this space will enable it to successfully weather the competitive pricing environment, which we expect will be short-lived. In addition, the company is gaining market share and enjoying double-digit returns on acquisitions. We opted to hold onto this stock while closely monitoring fundamentals.
to attract owner-operators. We believe Roadrunner’s position as the low-cost provider in this space will enable it to successfully weather the competitive pricing environment, which we expect will be short-lived. In addition, the company is gaining market share and enjoying double-digit returns on acquisitions. We opted to hold onto this stock while closely monitoring fundamentals.
- Wolverine Worldwide, Inc. (WWW, Financial) is the leading manufacturer of non-athletic footwear in the U.S. Like many other retail companies during the period, Wolverine struggled against a bleak consumer backdrop. The company announced an 18% decline in third-quarter earnings due to inconsistent retail traffic and disappointing re-order patterns from its retail partners. Wolverine owns a broad portfolio of footwear brands including Sperry, Merrell, Keds, and Saucony and manufactures work boots for the military and construction workers. We believe an unusually warm winter and exposure to the oil and gas industry will create headwinds for Wolverine’s winter and work boots. Although we maintain a position in the stock, we are continuing to closely monitor fundamentals.
- Clean Harbors, Inc. (CLH, Financial) is a provider of environmental, energy, and industrial services, including hazardous waste disposal for companies. The rapid deterioration of oil prices during the period caused Clean Harbors’ re-refining business to suffer. However, we believe the company’s hazardous waste disposal business is its greatest asset. It is extremely difficult for companies to meet Environmental Protection Agency (EPA) requirements and to obtain permitting for new hazardous waste incinerators, giving Clean Harbors a competitive advantage. This business has benefitted from a steady increase in the types of waste classified by the EPA as hazardous. Given the industry’s limited capacity and Clean Harbors’ dominant position in this space, the company has been able to consistently raise prices. We believe investors are too focused on the short-term movement of crude oil prices and not focused enough on the long-term growth potential of this company. We consequently increased our position in the stock.
OUTLOOK
Looking ahead, we believe it will take some time for current global economic issues to resolve themselves and that market dynamics will remain challenging in 2016. However, we are confident that our rigorous fundamental research and disciplined, risk-first investment approach will allow us to successfully navigate choppy waters and stay on course toward the portfolio’s long-term performance objectives. By focusing on businesses with predictable and recurring revenue streams, improving margins, strong competitive advantages, increasingly large market opportunities, and whose destinies are not closely tied to the economy, we believe we can deliver the consistent returns our investors deserve and expect.
Thank you for your continued investment.
Chad Meade and Brian Schaub
Arrowpoint Asset Management LLC
