"We believe the current market offers us a rare, significant investment opportunity to buy several good businesses at a deep discount."- Sapience Investments, LLC
Market in Review
Our investment process is truly bottom up and, as a result, we do not employ macroeconomic forecasting in our investment. Any macroeconomic insight we develop would be generated from our individual company research.
Much of modern finance theory depends upon the simple proposition that there is no such thing as a free lunch. However, in practice, when central banks lower the cost of capital to near or below zero to stimulate the real economy, there are unintended consequences in the financial economy that give rise to significant investment opportunities. The unprecedented pace at which global yields are turning negative has been a bold experiment in central bank manipulation of the cost of capital. Remarkably, fixed income analysts estimate that roughly 25% of global debt is trading at a negative yield, including 75% to 85% of outstanding Bonds and Japanese Government Bonds. Money is not just “free;” the lender actually pays the borrower! Adopted to combat stagnant growth and heightened deflation expectations, we believe negative interest rates have instead become self-fulfilling, by reinforcing structurally low growth prospects through an impaired banking system and depressing long-term inflation expectations. In our view, the U.S. Federal Reserve (Fed) policy makers shifted their stance during the third quarter of 2019, taking out “insurance” against a nascent economic slowdown by prophylactically enacting two, 25-basis-point rate cuts that brought short-term interest rates down to 1.75% to 2.0%. A third move is widely anticipated in the fourth quarter of 2019, with the possibility of more to follow in 2020.
In our view, as the U.S. edges back to the zero-policy rate boundary, as it did during the great financial crisis, capital becomes misallocated. Amid mounting macroeconomic uncertainty and ample, low-cost capital, risk-adverse equity investors have flocked into a handful of popular stocks, driving their valuations to extreme levels. This market inefficiency can be seen in many ways, including the extraordinary behavior of momentum stocks with investors chasing recent performance, the growing cost of high-priced stocks, and the over-valuation of so-called ”safe” stable stocks.
In the third quarter of 2019, the Harbor Small Cap Value Opportunities Fund (Institutional Class) returned -0.11%, outperforming its benchmark, the Russell 2000® Value Index, which returned -0.57%.
From a relative perspective, stock selection was the primary contributor to relative performance. More specifically, compared with the benchmark, security selection in the Information Technology, Health Care, and Industrials sectors added value. Meanwhile, stock selection in the Financials sector detracted from relative return.
Contributors and Detractors
The three largest individual contributors during the quarter were Diebold Nixdorf, the Michaels Companies, and e.l.f. Beauty. Diebold Nixdorf reported better than expected revenues, profitability, and improved cash flow. In addition, Diebold successfully refinanced a key term loan, which was set to mature in December 2020. In our view, its management team continues to deliver steady progress on its “DN Now” cost initiatives. The Michaels Companies posted positive comps and better than expected profitability. Furthermore, initiatives that have mitigated a majority of the 2019 China tariffs were positively received by investors. These combined factors led to a significant recovery in the company’s stock price from what we believe was an oversold level. e.l.f. Beauty posted better than expected revenues and earnings. During its earnings call, management moderately increased annual guidance, which investors perceived as a conservative raise. We believe the company continues to make progress in its digital marketing initiatives.
The three largest individual detractors during the quarter were Forum Energy Technologies, Ascena Retail Group, and Whiting Petroleum. In our view, there was no fundamental reason for weakness in Forum Energy Technologies’ stock. We believe the underperformance is attributed to weakness in oil markets and investor apathy towards the industry. In our view, Forum is a self-help story, as the company is generating free cash flow by reducing their inventory and cutting costs to reduce its debt burden. While Forum has been impacted by near-term headwinds in their North American completions business, we believe there are green shoots emerging in their international land and offshore segments. Ascena Retail Group continued to underperform in the third quarter after the company reported weak quarterly results in June. Underperformance persisted for two reasons. First, there was a vacuum of information, as the results for the most recent quarter were not reported until the first week of October. Second, tariff-related uncertainties created an overhang in the company’s stock price as the potential upcoming list would directly impact the apparel category. In early October, Ascena posted in line to slightly better quarterly results. More importantly, the company provided clarity on the closure of its Dressbarn chain (to be completed by December) and discussed its ample liquidity, including more than $300 million of cash. During the quarter, Whiting Petroleum posted a poor quarter with weak results. The company missed their oil production targets for the third quarter in a row, and capital expenditures came in higher than expectations. Whiting’s management team articulated a myriad of reasons for the miss and also communicated a reduced guidance for the rest of the year. We ultimately exited our position in Whiting as we lost faith in management’s ability to execute.
Buys and Sells
We added a position in Melville, N.Y.-based MSC Industrial, which distributes metalworking and maintenance, repair, and operations products, with annual sales of approximately $3.4 billion. We identified several sustainable business model characteristics for MSC, including a long track record of generating attractive free cash flows, a conservative and strong balance sheet and what we view as competitive advantages over small independent distributors that account for the majority of the industry. We also identified numerous value drivers for the company, including the fact that it consistently returns cash to shareholders—the stock is currently paying a healthy and secure dividend yield of 4.4%. We believe in the company’s efforts to refocus its sales force, lower expenses and tighten new hiring.
We exited our position in Whiting Petroleum.
It is tempting to speculate on how today’s equity valuation anomalies will eventually resolve themselves. With a patient, long-term investment focus, we are reminded of economist Herb Stein’s Law: “If something cannot go on forever, it will stop.” We remain acutely aware that starting points are crucial to compounding positive long-term returns, so chasing today’s investment fads is a fool’s game. As value investors, we choose stocks whose long-term earnings potential is not widely recognized and seek to buy them when investor pessimism is fully reflected in valuations. We believe the current market offers us a rare, significant investment opportunity to buy several good businesses at a deep discount.
We recognize the economic slowdown but do not believe that we are at the cusp of a deep recession. We believe the Fund to be well-positioned for either a partial or a full shift towards value stocks. Though we have exposure to a few deeply discounted businesses today, relative to the perceived “safe” and momentum companies, we have been conscious to own businesses that are fundamentally sound and have drivers in place to close the valuation gap with their intrinsic value.
We recognize the two-fold challenges today for value investors: the economy has evolved such that there are more value traps than at any time in our careers. We have to resist being seduced by significant discounts appearing in businesses that do not have the ability to sustain the current returns. In addition, the technical and quantitative aspects of this market will cause a few compelling investment opportunities to underperform over the short-term, enough to discourage even experienced value investors like us. This is the test of discipline—to maintain conviction when we believe our investment thesis and valuations are correct.
Performance data shown represents past performance, which is no guarantee of future results. Current performance may be higher or lower than the past performance data shown. Investment returns and the value of an investment will fluctuate, and an investor's shares, when sold, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end (available within seven business days after the most recent month-end) by calling 800-422-1050 or visiting harborfunds.com.
Performance figures discussed reflect that of the institutional class shares.
The views expressed herein are those of the portfolio manager at the time of the interview and may not be reflective of their current opinions or future actions. These views are not necessarily those of the fund company and should not be construed as such.
This information should not be considered as a recommendation to purchase or sell a particular security and the holdings or sectors mentioned may change at any time and may not represent current or future investments.