For the six months ended December 31, 2015, the Meridian Contrarian Fund Legacy Class shares returned (7.37)%, outperforming the Russell 2500 Index, which returned (7.66)%.
Performance during the period was aided by relative outperformance of our investments in the technology and health care sectors. Outperformance was mainly driven by strong individual stock performances, some of which are detailed below. Additionally both these sectors were strong during the quarter, and we benefitted from an overweight position in technology. Performance was hurt by weakness in our consumer discretionary and industrial investments. Industrials was among the weakest sectors in the index and we had two investments that were notably disappointing, as detailed below.
Energy is currently one of the most contrarian sectors in the market. Investors who were eager to call the bottom in oil prices during early 2015 suffered losses as inventories and production levels remained stubbornly high, resulting in a decline in crude prices from $60/barrel to $38/barrel in the second half of 2015. Recently prices have dropped further to $30/barrel. Global demand and production for many countries is highly unpredictable, however US production is more analyzable and currently comprises nearly 10% of global crude production. US production is also more costly due to higher decline rates in US oil fields. Therefore sustainably lower oil prices should result in a decline in US production as the laws of physics and finance collide. The impact should be lower supply and higher market share for those companies with the financial wherewithal to manage the current low priced environmen
As oil prices declined most US producers have cut their capital expenditure budgets dramatically, as evidence by the declining rig count. The rig count drives the growth of new oil wells which is important given that (1) much of the world’s supply growth in recent years has come from US shale and (2) US shale oil wells experience production declines at a high rate so must be replenished with new wells.
This decline in the rig count has had little effect to date due to a natural lag effect and as companies focused the remaining rigs on their most productive properties. We believe that production cannot defy the rig count indefinitely, and with WTI at $30/barrel the risk / reward in energy has improved dramatically over the past year. As such we are modestly overweight energy, with a focus on high quality companies with strong balance sheets.
The three largest contributors to performance during the period were NVIDIA Corp. (NVDA, Financial), Microsoft Corp. (MSFT, Financial) and Old Republic International Corp. (ORI, Financial).
- NVIDIA Corp. (NVDA, Financial) is the dominant provider of visual computing technologies used for PC based video games and is expanding into new markets in enterprise computing and automotive. We originally invested in the company after management significantly increased R&D spending in order to enter the mobile, automotive, and enterprise markets. These investments depressed earnings, and investors were initially disappointed with failed product launches in cell phones and tablets. However, we view NVIDIA’s technology as highly differentiated, and feel that there are excellent opportunities outside of mobile devices. Stock performance this quarter was driven by another solid earnings report, supported by continued growth in the traditional PC gaming industry and sales of chips for automotive infotainment systems. Based on the market opportunities in auto, and enterprise computing, we continue to hold shares.
- Microsoft Corp. (MSFT, Financial) is a global leader in software for PC’s and enterprise computing. The company had struggled for a number of years to find growth outside of its traditional markets, missing out on large opportunities in the social and mobile markets. Last year, shares were hit hard due to weak end markets related to PC’s as well as foreign exchange headwinds. Based on our research, we felt new management was reinvigorating innovation and the company was well positioned to offer compelling cloud-based computing services. In 2015, we began to see the signs of progress in this transformation, with shares propelled by an 80% increase in cloud computing revenue during the September quarter. We continue to hold our shares as the cloud transformation is in its early innings and we think the company has the potential to generate $4 of free cash flow per share within the next 2-3 years.
- Old Republic International Corp. (ORI, Financial) is a 100+ year old insurance underwriter focused on commercial casualty lines and title insurance. We originally invested in the company after earnings suffered due to (1) higher losses in its workers’ compensation line of business due to medical cost inflation and poorly underwritten policies, and (2) the title insurance segment declined against difficult comparisons relative to the 2012-2013 refinancing boom. The stock performed well for us in 2015 as the company returned to more traditional workers’ comp loss ratios by shifting its book of business to more risk sharing with insureds and away from more competitive coastal geographies, and as the title business enjoyed close to double digit growth in premiums. We continue to hold shares in Old Republic due to its 4% dividend yield and steady results, but have reduced our position due to significant stock price appreciation.
The three largest detractors from performance during the period were Verint Systems, Inc. (VRNT, Financial), Dick’s Sporting Goods, Inc. (DKS, Financial) and Clean Harbors, Inc. (CLH, Financial).
- Verint Systems, Inc. (VRNT, Financial) technologies provide collection and analysis of unstructured data including voice, video, email, internet and other data transmissions. Solutions are used for security, interception, surveillance, defense, and customer service and enterprise intelligence. The company is a leader in its markets with competitive advantages derived from a core analytical technology platform that can be applied to different products and end markets. We invested when earnings declined due to significant investment by the company in new products to re-accelerate product development and sales. Verint has been a strong performer for the Contrarian Fund over the 3 years since our original investment. This year the stock has suffered from adverse foreign exchange and cautious guidance due to macro factors. We believe Verint’s end markets remain attractive, and that the company continues to have leading technology and a significant market opportunity for its new cyber-security products. As such we continue to own Verint shares while we confirm this thesis.
- Dick’s Sporting Goods, Inc. (DKS, Financial) is the largest full-line, omni-channel sporting goods store in the US with over 700 stores and an expanding online presence selling an extensive selection of equipment, apparel, footwear and accessories. We invested in Dick’s after the company’s earnings growth slowed due to weakness in its golf business combined with a slowdown in guns and ammunition sales. We believed the company had finally accepted that there is a secular decline in golf and had a solid plan to improve profitability by allocating square footage from golf to more popular product lines and closing many of its specialty golf locations as their leases come up. Gun and ammunition sales were weak against a tough comparable period that had seen strong demand due to worries about increased gun control. Industry data indicated to us that gun and ammunition sales were picking up as the tough comparable period passed. This thesis played out quickly and we initially had gains in our investment and held on to the stock as the company continued to post solid earnings results. During the quarter, however, the company announced that historically warm weather would hurt sales of outerwear and reduce earnings. We continue to hold shares of Dick’s Sporting Goods as we believe it is the best merchandiser in its category, has a compelling and improving online presence, and will benefit from strong market share gains in brick and mortar retail as weaker competitors succumb to the pressure of online competition.
- Clean Harbors, Inc. (CLH, Financial) provides a variety of environmental remediation and industrial waste management services. The business has high regulatory barriers to entry and roughly three fourths of revenues are recurring in nature. Clean Harbors came across our contrarian screens due to tough comparisons in its comparatively volatile event-driven business and a poorly timed oil recycling acquisition. While our investment thesis largely played out as these businesses have improved, the company has suffered due to significant declines in its oil and gas related businesses. We continue to hold Clean Harbors’ shares due to the defensive nature of its core business and an attractive valuation that ascribes little value to the most energy exposed areas. We expect earnings growth to resume late in 2016 and see this as a potential catalyst for the stock.
As we enter 2016, our focus remains on businesses with depressed but improving fundamentals, lower valuations, and high quality business models. Our experience shows that these out-of-favor companies, over a long time-horizon, have the potential to provide strong risk adjusted returns.
Thank you for your continued investment.
Jamie England and Larry Cordisco
Arrowpoint Asset Management LLC
