Market Summary
Inflation and risk of a recession weighed on market participants with most indexes posting negative results for the quarter. Consumers continued to grapple with high gasoline prices as oil surged to over $100 per barrel. Russia’s invasion of Ukraine, stretched refining capability, and strong consumer demand led to a 38% increase in oil since the start of the year.
Recovery in the labor market has been particularly strong. The unemployment rate remains low and has been steady at 3.6%, the lowest level since February 2020. The demand for labor, coupled with rising prices, continues to lead to wage pressure. From May 2021 to May 2022, the Consumer Price Index (CPI) spiked to 8.6%, the largest increase since December 1981.
During the quarter, the Federal Reserve intensified the magnitude of its interest rate increases. The most recent increase of three-quarters of a percentage point is its most aggressive hike since 1994. Chairman Powell announced that he expects the July meeting to result in another increase of 50 or 75 basis points. He also indicated a much stronger path of rate increases ahead, to arrest inflation moving at its fastest pace in over 40 years.
Performance Highlights
The Snow SMID Cap Value strategy outperformed its benchmark by 249 basis points, returning -12.90% gross of fees (-13.01% net of fees) during the quarter, while the Russell 2500 Value Index declined -15.39%. The strategy is outperforming the index by 208 basis points (197 net) through the first half of 2022.
The portfolio benefited from security selection in Information Technology, Energy, and Health Care. The portfolio was also aided by an underweight allocation in both Real Estate and Materials. Security selection in Financials and Consumer Discretionary, along with an underweight allocation in Utilities, were the largest detractors from relative performance during the quarter.
Portfolio Attribution
Top 5 Performance Contributors
| Stock | Avg Weight % | Contribution % |
|---|---|---|
| Delek US Holdings | 4.53 | 1.04 |
| Photronics | 2.66 | 0.37 |
| Super Micro Computer | 3.87 | 0.35 |
| Silicon Motion Technology | 1.98 | 0.35 |
| AMN Healthcare Services | 1.03 | 0.31 |
Delek US Holdings (DK)
DK appreciated as the rise in margins for refined products led to strong cash flow generation. With enriched refining margins, DK’s cash flow has improved significantly, and the management team expects to announce a new shareholder return program this year.
Photronics (PLAB)
PLAB is the world’s leading manufacturer of high precision photographic quartz or glass plates containing microscopic images of electronic circuits, known as photomasks. During the period, PLAB’s share price appreciated largely due to the company reporting strong earnings, which was driven by increased operating leverage. The firm is benefitting from pricing power in a tight semiconductor supply market and we believe this dynamic will be sustainable, driving further margin expansion as well as generating substantial free-cash-flow.
Super Micro Computer (SMCI)
SMCI appreciated during the quarter as the company issued an upbeat earnings report and forecast. The company continues to execute on growth initiatives and is taking share in the server market. We believe the stock remains significantly undervalued, trading at approximately seven times forward earnings estimates.
Performance Detractors
| Stock | Avg Weight % | Contribution % |
|---|---|---|
| Lions Gate Entertainment | 3.02 | -1.38 |
| American Eagle Outfitters | 2.89 | -1.05 |
| Brinker International | 2.1 | -1.02 |
| PacWest Bancorp | 1.75 | -0.9 |
| JetBlue Airways | 1.57 | -0.89 |
Lions Gate Entertainment (LGF/A)
LGF detracted from performance during the quarter as larger streaming peers NFLX and DIS pulled back, and operating income compressed due to outsized spending on growing the international streaming and studio businesses. The company is currently exploring potential alternatives for their STARZ business, which could include a spin or sale, with management citing recent transaction multiples in the media space as evidence that the stock price is not reflective of the value of their underlying assets. We continue to view the company’s best asset as its title library, which has produced more than $770m in trailing twelve-month revenue at a 50%+ cash margin. On a sum-of-the-parts basis, we see significant value to be unlocked.
American Eagle Outfitters (AEO)
AEO underperformed, along with several Consumer Discretionary stocks, as inflationary pressures, most notably rising gasoline prices, weighed on consumer demand. AEO and peers issued lower outlooks for the remainder of the year. The company expects high inventory levels to pressure gross margins throughout the year. We continue to hold AEO; efforts to rebalance inventory are well underway, the company has a clean balance sheet, and shares trade for just under nine times forward earnings.
Brinker International (EAT)
EAT declined during the quarter, largely on fears of a potential US spending slowdown and recession. Company specific, EAT reported commodity inflation of 11%, well ahead of expectations with management saying they don’t see a moderation until calendar 2023. Labor pressure was said to be moderating, but the combination of elevated commodity and labor costs eroded the margin profile. We maintain a position under the premise that short-term pressures will mitigate, and changes made to the business during the pandemic will drive operating leverage improvements in a normalized environment.
Trailing Performance
as of June 30, 2022*
| QTD | 1 Yr | 3 Yr | 5 Yr | 7 Yr | Since Inception* * | |
|---|---|---|---|---|---|---|
| Composite (Gross) | -12.90% | -14.52% | 11.49% | 8.50% | 6.02% | 6.74% |
| Composite (Net) | -13.01% | -14.95% | 10.66% | 7.59% | 5.09% | 5.78% |
| Russell 2500 Value | -15.39% | -13.19% | 6.18% | 5.53% | 6.48% | 7.20% |
Calendar Year Performance
| 2022 | 2021 | 2020 | 2019 | 2018 | 2017 | 2016 | 2015 | 2014 | 2013 | |
|---|---|---|---|---|---|---|---|---|---|---|
| Composite (Gross) | -14.58% | 27.30% | 20.91% | 24.22% | -18.53% | 11.54% | 21.41% | -16.47% | 6.13% | 10.88% |
| Composite (Net) | -14.79% | 26.67% | 19.73% | 22.99% | -19.35% | 10.47% | 20.22% | -17.31% | 5.07% | 10.61% |
| Russell 2500 Value | -16.66% | 27.78% | 4.88% | 23.56% | -12.36% | 10.36% | 25.20% | -5.49% | 7.11% | 8.83% |
Source: SEI Global Services
* Returns for periods greater than a year are annualized. Past performance is not indicative of future results.
* * Inception: 10/31/06
Top 10 Holdings
| American Equity Investments | 4.00% |
| Centene Corp | 3.89% |
| Delek US Holdings Inc. | 3.84% |
| Lions Gate Entertainment | 3.83% |
| Photronics Inc. | 3.55% |
| Super Micro Computer Inc. | 3.47% |
| Acco Brands Corp. | 3.31% |
| Cinemark Holdings Inc. | 3.30% |
| ABM Industries Inc. | 3.03% |
| FNB Corp. | 2.82% |
| Total | 35.05% |
|---|
Portfolio Attribution vs. Russell 2500 Value
Outlook
We continue to be optimistic about the long-term outlook for the portfolio. While low P/E stocks performed relatively well for the first six-months of 2022, large valuation disparities remain. In turn, we expect value to continue to outpace growth over the coming quarters.
Given the market backdrop, we continue to hold a large allocation to the Financials sector. This sector has historically been among the most sensitive to changes in interest rates. Within Financials, banking stocks have been hit, as concerns about the economy have grown and they continue to trade at steep valuation discounts relative to the broader market. Even if the economy is recession bound, banks are better equipped to handle economic shocks than they were in the past. As a group, banking stocks have a more attractive balance of risk and reward than any other sector. Banks also generally benefit from higher rates, as they can increase profit margins from the spread between deposits and loans. At the same time, many of these companies could drive significant shareholder value in the form of dividends and share repurchases. Our focus within the sector 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.
Energy has been the only positive returning sector within the Russell 2500 Value Index this year. With the U.S economy slowing, many investors expect a cyclical pullback in commodity markets. Consumers are becoming more cautious of a slowing economy and higher inflation. Many believe that these factors will inhibit the Energy sector to continue its strong run. In contrast, we expect further equity appreciation in the Energy sector. There is a secular upward trend in demand for petroleum-based products and supply shortages created by global refining products, tightening that will likely persist through 2023.
Further contributing to the Energy sector is a decrease in the number of refineries within the U.S. America has lost in excess of one million barrels of daily refining capacity over the course of the last two years, and at least seven facilities have closed. This decreased refining production has led to an imbalance between supply of crude oil and U.S. refining capacity. Crude oil has no utilitarian value until a refiner processes it into fuels such as gasoline, diesel and jet fuel. The overall pricing difference between a barrel of crude oil and the products refined from it, is called a “crack spread.” Currently, widening crack spreads within the U.S are increasing the price of petroleum-based fuels. Despite higher prices for gasoline and diesel, demand will likely remain strong, supporting stocks within the Energy sector. Although U.S. crack spreads are mainly impacted by national refineries, global affairs continue to put pressures on supply and demand of crude oil. Crack spreads expanded further as the impact of Russian sanctions translated into even lower refined product supply. All things considered, we believe several of our positions within the Energy sector will benefit from this dynamic.
We believe the road ahead remains favorable for our investment approach. 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. 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.
Disclosures
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.