The majority of the major indices posted negative results for the first quarter of 2022 as investors reacted to the winds of war, heightened levels of inflation and rising interest rates. The SMID Cap Value Strategy slightly trailed its benchmark during the period due to sector emphasis, while stock selection was positive. The relative return was negatively impacted by an overweight to Consumer Discretionary and an overweight to Technology. Health Care and Materials accounted for a large portion of the positive stock selection.
|Period||Composite Gross||Composite Net||Russell 2500 Value Index|
Source: SEI Global Services
Equity Prices Driven By Inflation and Monetary Policy Action
The prices of commodities from wheat to corn to aluminum have hit multi-year highs, while oil surged to over $100 a barrel. Meanwhile, the labor market recovery has been particularly notable with the unemployment rate declining to 3.6% (Figure 1), the lowest level since February 2020. With dynamics swinging in favor of workers over their employers and a tight labor market, wages are likely to continue to move higher.
U.S. Unemployment Rate
The unemployment rate represents the number of unemployed as a percentage of the labor force. Labor force data is restricted to people 16 years of age and older, who currently reside in one of the 50 states or the District of Columbia, who do not reside in institutions (e.g., penal and mental facilities, homes for the aged), and who are not on active duty in the Armed Forces.
Source: Federal Reserve Bank of St. Louis
Concerning higher prices, the economy continues to experience supply-side inflation, which we expect to persist. The commodity price shock exacerbated by the Russian invasion of Ukraine should continue to stoke real asset prices higher and could suppress private consumption, ultimately contributing to lower aggregate demand.
Given the aforementioned forces, it was not surprising that the Federal Reserve lifted its policy interest rate during the most recent meeting, marking the first increase since 2018. Forecasting six more rate increases this year, the Fed has demonstrated that it is solely focused on inflation and has very little sensitivity to slowing growth in the U.S. With the increase in policy rates and investors expecting aggressive tightening in the near-term, the shape of the yield curve flattened substantially during the first quarter, especially between the two and ten-year notes (Figure 2).
Treasury Yield Curve
Termed Quantitative Tightening (QT), the central bank will also end its large-scale securities purchases and reduce its massive holdings of Treasury and mortgage-backed securities. These changes in monetary policy mean that the curve may lose some of its predictive power in the future. Since central banks have bought long-dated bonds in quantitative-easing schemes, they now affect both sides of the yield curve directly, making long-term interest rates a less reliable proxy for market expectations.
How Have Corporate Profit Margins Peaked?
As the pace of globalization increased after 1990, corporate earnings (Figure 3) and profit margins grew at accelerated rates. Much of this was due to technology facilitating the integration of the global economy, which led to pools of capital and labor coming together efficiently. As international borders opened, corporations increasingly shifted their operations abroad using cheap labor and low-priced goods.
Companies benefited from the broad-based decline in labor’s bargaining power, lower anti-trust enforcement and gains in technology, which allowed for greater scale and lower marginal costs. At the same time, lower corporate taxes, interest rates, and tariffs further buoyed margins by directly reducing the cost of goods sold. Lower corporate costs in turn exerted downward pressure on wages and resulted in quiescent levels of inflation (Figure 4) for several decades in the United States. Taken together, these factors have produced the most pro-corporate environment in history.
U.S. Corporate Profits
Source: St. Louis Fed
Year over Year Inflation
Source: Bloomberg – Year over year annual inflation
In our view, many of the forces that have driven profit and margin increases will erode going forward. Primary factors include global labor costs moving closer to equilibrium and the end of the effectiveness of international corporate tax rate arbitrate. Meanwhile, Russia’s invasion of Ukraine has led to sanctions reaping havoc on the global economy and as a result, many governments are likely to attempt to be more self-reliant. Similarly, several politicians have commented about onshoring manufacturing and relocating the supply chain to the U.S., which could foreshadow the end of globalization. It is unknown how these factors will weigh on profit margins, and how much can be offset by further advances in technology, but in our opinion, it will be hard for companies to maintain the current level of profitability, let alone increase margins further from here.
Macroeconomic Backdrop Favors Value Stocks
During the first quarter, the Russell 2500 Value Index outperformed the Russell 2500 Growth by more than 10%. Value has become defensive again, just as it was in the aftermath of the late 1990s Technology Bubble. As we detailed in our previous newsletter, heightened levels of inflation and rising interest rates are macroeconomic tailwinds to value stocks. In our view, value should continue to outpace growth in the period ahead.
While we expect inflation to pull back from its recent high, we think it will settle above its long- term average. Higher average accelerations in underlying prices often coincide with investors rewarding value stocks. Low price-to-earnings companies produce cash flows that track inflation and the revenue streams of these assets are typically tied to higher prices as well. In our portfolio, many of the businesses have continued to report higher input and labor costs. We expect companies to raise prices as they have demonstrated in the past, though margins could be compressed in the short run. Looking forward, we expect these stocks to perform well as price increases hold and supply constraints abate with the backdrop of strong demand.
Moreover, the value style of investing has historically outperformed during rising interest rate environments. With the recent decision by the Fed to raise short-term interest rates and additional increases anticipated, the rotation from growth to value is likely in its early stages. There is also the strong possibility of increased regulations for high growth technology companies which may curtail their revenue and earnings power. At the same time, the differential in valuation multiples between the two styles continues to remain wide by historical standards.
In our opinion, the greatest opportunity is in the Financials sector. As a group, financial stocks have a more attractive balance of risk and reward than any other sector. Within the sector, banks generally benefit from higher rates, as they are able to increase profit margins from the spread between deposits and loans. At the same time, many banks have the ability to drive significant shareholder value in the form of dividends and share repurchases. Our focus within Financials is on those firms that are well capitalized with strong credit quality and the ability to grow net interest margins, as well as market share.
Market expectations are extremely elevated in the high price-to-earnings (P/E) sectors and are more prone to upcoming earnings disappointments. This further leads us to believe that low P/E stocks will remain in favor as investors look for opportunities in a late-stage bull market. Conversely, higher interest rates may lead to a contraction in elevated P/E growth stocks. Therefore, our outlook is for near-term volatility, with future gains being driven primarily by valuation and fundamental earnings growth. All things considered, we believe the current environment is particularly well suited to our value investment approach.
Delek Holdings Inc. (DK)
Shares in DK appreciated after the company reported its strongest operational quarter since the pandemic upended refining fundamentals. Crack spreads have soared; rising demand and limited supply led to a tight market for refined products, which was further exacerbated following Russia’s invasion of Ukraine. We believe with its growing midstream and retail businesses, DK’s earnings power remains underappreciated in a normalized refining environment.
Southwestern Energy Co. (SWN)
SWN shares appreciated alongside the rise in natural gas prices. While SWN hedged away most of the near-term upside from higher prices, the company expects to reduce its leverage throughout the year.
Biodelivery Sciences International (BDSI)
Shares in BDSI rose during the quarter after Collegium (COLL) announced their intent to acquire BDSI at a significant premium. After the announcement, we liquidated the position in order to deploy cash elsewhere.
Coterra Energy (CTRA)
Shares of CTRA appreciated alongside the surge in crude and natural gas prices. The company’s relatively unhedged production profile generated significant free-cash flows, of which 60% were returned to shareholders through dividends. CTRA also announced a buyback authorization for ~5% of the market cap.
Commercial Metals Corporation (CMC)
CMC reported two exceptional quarters, driven by higher steel prices and strong cost control. While steel prices may fluctuate, we believe the company’s long-term earnings power remains under-appreciated from additional capacity coming online in the next few years.
American Eagle Outfitters Inc. (AEO)
Shares of AEO underperformed during the quarter following disappointing guidance and rising uncertainty around consumer demand. This is a well-run company with an attractive market position, multi-year revenue growth opportunities and cost initiatives that allow the company to generate strong shareholder returns including a share repurchase and an attractive dividend. 90% of revenues are generated in the United States.
PROG Holdings Inc. (PRG)
Shares of PRG fell during the quarter as inflationary pressures sparked concerns about potential future weakness in consumer spending as a larger percent of consumer budgets is set aside for gas, electricity and food. PRG has significant exposure to furniture and appliance end markets from lower income consumers. In addition to potential credit concerns, weakness in consumer spending would lead to a decline in discretionary spending, slowing lease growth. We liquidated the position in order to invest the proceeds in opportunities with more attractive risk/reward profiles.
Silicon Motion Technology Corporation (SIMO)
Shares of SIMO detracted during the quarter, pulling back from an all-time-high reached late in the fourth quarter of 2021. A NAND controller vendor, SIMO retreated alongside memory peers over concerns surrounding both the supply side and demand side. Investors are paying attention to stretched supply chains and inventory tightness coupled with a demand environment that may decline following a strong two-year period. The strategy maintains a position in the name, as we believe end-market demand will remain strong and that the company’s pricing power isn’t fully reflected in current sell-side earnings estimates.
Bread Financial Holdings Inc. (BFH)
Shares of BFH fell during the quarter. Inflationary pressures sparked concerns about potential future weakness in consumer spending as a larger percent of consumer budgets is set aside for gas, electricity, and food. Some consumer weakness could drive elevated receivables growth for BFH, but further weakness could drive weaker consumer spending and credit concerns.
Super Micro Computer Inc. (SMCI)
SMCI lost value during the quarter on geopolitical uncertainty and overall market volatility. SMCI’s offerings are expected to benefit from continued adoption of 5G rollouts and datacenter expansions.
Looking ahead, the key variables for investors in 2022 will be the conflict in eastern Europe, the path of inflation, and central banks’ response to acute increases in prices. We believe the road ahead remains positive for our SMID Cap Value strategy. The stocks in our portfolio have compelling business fundamentals, strong balance sheets, skilled management teams, reoccurring cash flows and the flexibility to adapt to an inflationary environment. We believe these stocks will compound earnings over an extended period through both rising and declining markets. At the same time, our portfolio is significantly cheaper based on relative multiple valuations compared to the Russell 2500 Value (Table 1). All told, we remain dedicated to delivering strong long-term performance and transparent communications to our shareholders. As always, thank you for your commitment to Easterly Investment Partners.
|Multiples||SMID||Russell 2500 Value Index|
|Forward Price-To-Earnings Ratio||9.96||12.68|
|Free Cash Flow Yield||11.93%||4.38%|
Source: Easterly Investment Partners
Easterly Investment Partners (EIP) is a registered investment adviser. Registration of an Investment Advisor does not imply any level of skill or training. This composite has been assigned to Easterly Investment Partners (EIP) effective July 1, 2021. Performance presented prior to July 1, 2021, occurred while the Portfolio Manager(s) and the research team were affiliated with a prior firm (Snow Capital Management, L.P.). EIP claims compliance with the Global Investment Performance Standards (GIPS®). A fully compliant GIPS presentation along with a complete list and description of all composites is available upon request. The SMID Cap Value composite contains fully discretionary commission accounts where approximately 85% (+/10%) of the assets are invested in the Small Cap Value strategy and 15% (+/-10) of the assets are invested in the companies within the range of market caps defined by the Russell 2500 Value Index. The U.S. Dollar is the currency used to express performance. Leverage is not used in this composite. Investing involves risk; clients may experience a profit or a loss. In addition to the normal risks associated with investing, investments in smaller companies typically exhibit higher volatility. Past performance is not indicative of future results. Performance is preliminary. Composite returns are shown gross of fees and do not reflect the deduction of advisory fees. The performance of any individual portfolio may vary from the Composite’s performance.
The views expressed herein are solely the opinions of EIP. We make no representations as to their accuracy. This communication is intended for informational purposes only and does not constitute a solicitation to invest money nor a recommendation to buy or sell certain securities.
The performance figures are based on a composite of many accounts and not all accounts owned the securities mentioned in this commentary. Holdings and sector allocations are subject to change. The latest copy of our Form ADV Part 2A (Brochure) and a complete list and description of EIP’s composites and/or a presentation that adheres to the Global Investment Performance Standards (GIPS®) is available upon request.
Russell 2500® Value Index
The Russell 2500 Value Index measures the performance of those Russell 2500 companies with lower price-to-book ratios and lower forecasted growth values. Indexes are unmanaged. It is not possible to invest directly in an index.