Equity markets finished the quarter with positive returns, while the path to those gains was a rocky one. January was marked by robust performance, with shares of lower-quality, higher beta companies showing significant gains. Markets were dampened in February with news that inflation, while cooling, persists and employment remains strong. March followed with the big story of the quarter, the “don’t say bailout” banking crisis, and the ninth in a string of interest rate increases from the Federal Reserve. Each of the QSV strategies produced returns ahead of their respective Russell value and core indexes during the quarter supported by positive stock selection. More information including since-inception performance for each of the strategies may be found at www.qsvequity.com.
QSV Small Cap returned 3.40% and 3.31%, gross and net of fees, leading both the Russell 2000 Value Index return of (.66)% and the Russell 2000 Index return of 2.74%. The most significant positive impact was made in Financials, where QSV added value in security selection and was underweight compared to the index, and in Communication Services, where QSV was overweight and outperformed the index. Our underweight and underperformance compared to the Consumer Discretionary sector detracted from performance.
NAPCO Security Technologies (NSSC) was the leading contributor to performance during the quarter. Shares rose over 36% on better-than-expected revenues for the quarter and positive trends toward more recurring revenues. NAPCO manufactures security products for intrusion, fire, access control, and door locking systems. The company’s revenue primarily comes from commercial customers and products are sold through NAPCO’s ecosystem of 10,000 dealers and 2,000 integrators. Shares of media company World Wrestling Entertainment (WWE) were up more than 33% as expectations of a sale of the business rose. WWE has a strong brand within a niche audience, especially for its popular Raw and SmackDown content. Most revenues for WWE come from North America, but we believe there is an opportunity for growth outside the U.S. It was announced on April 3 that Endeavor Group (EDR) will form a new company, combining the UFC and WWE brands.
Seacoast Banking Corp of Florida (SBCF) was the leading detractor to performance for the quarter as shares dropped in tandem with the banking industry. SBCF offers commercial and consumer banking, wealth management, and mortgage and insurance services in the rapidly growing Florida market. While QSV Commentary Q1 2023 shares fell along with their regional bank peers, we see SBCF as a well-capitalized business with growing net interest margins, Returns on Tangible Equity of 10% and Returns on Equity of 7%. Also in the banking industry, Horizon Bancorp (HBNC), fell during the quarter, detracting from performance. HBNC offers commercial and consumer banking, wealth management, and mortgage and insurance services to customers in Central Indiana and Michigan. Its network of branches includes those acquired from TCF Financial in 2021. While negatively affected by the quarter’s banking crisis, we see HBNC as a strong enterprise, with Returns on Tangible Equity of 18% and Returns on Equity of 13%.
Aerojet Rocketdyne Holdings Inc. (AJRD) shares were sold early in Q1 as the company was acquired by L3Harris Technologies. QSV initiated new positions in investment banking and wealth management firm Evercore Equity (EVR), Kulicke & Soffa Industries (KLIC), a maker of capital equipment and tools for the semiconductor industry, and NexPoint Residential Trust (NXRT), an operator of multi-family properties
in the southeastern U.S. The QSV Mid Cap strategy returned 5.28% and 5.02%, gross and net of fees, for the quarter, leading both the Russell Mid Cap Value Index return of 1.32% and the Russell Mid Cap Index return of 4.06%. QSV’s security selection added value in the Energy and Consumer Staples sectors, while security selection in Financials detracted.
West Pharmaceutical Services (WST) rose by 47% during the quarter on further evidence of pricing power and margin increases across its portfolio of products. WST has competitive advantages as a key supplier to pharmaceutical, biotechnology, and generic drug businesses, with expertise in the development and manufacture of supplies for the containment and administration of injectable drugs. The company delivers Returns on Invested Capital of 22%.
Monolithic Power Systems Inc (MPWR) gained more than 40% during the quarter on optimism over the firm’s year-over-year results, diversification of its manufacturing capabilities, and long-term growth prospects. MPWR is a global provider of high-performance, semiconductor based power solutions. As a “fabless” company – one that does not manufacture the chips used in its products – MPWR has benefitted from devoting more resources to chip design rather than capital expenditures, resulting in greater free cash flows, higher margins, and Returns on Invested Capital of 24%.
Shares of exploration and production company APA Corp (APA) fell as recessionary concerns and waning oil and natural gas prices weighed on investor sentiment. We see APA as a strong operator with geographically diversified sources of production and the ability to emphasize oil or gas production as each presents itself as more advantageous. APA is committed to returning 60% of its strong free cash flow to shareholders in the form of dividends and share repurchases. Shares of management consulting firm Booz Allen Hamilton (BAH) pulled back during the quarter due to a potential Federal government shutdown and feared budget cuts. While these actions would impact QSV Commentary Q1 2023 revenues to BAH, the current backlog of projects should produce growth for the business in 2023 and beyond. Additionally, BAH has been more resilient as it focuses on large government-wide acquisition contracts (GWACs) that can be less susceptible to reductions across government agencies.
With the early quarter rally and later decline, QSV took opportunities to upgrade its portfolio. QSV exited Casey’s General Stores (CASY), Skyworks Solutions (SWKS), and Snap-on Inc (SNA). New positions were started in multi-family real estate investment trust Mid-America Apartment Communities (MAA) and Paycom Software (PAYC), a provider of payroll and human capital software. The QSV Select strategy returned 6.68% and 6.45%, gross and net of fees, leading the returns of 1.40% for the Russell 2500 Value Index and the return of 3.39% for the Russell 2500 Index. Select is a high conviction strategy that takes QSV’s best ideas from our Small Cap and Mid Cap strategies. An underweight and outperformance in Financials helped performance, as did an overweight and outperformance in Healthcare holdings. The leading detractor from performance was our overweight and underperformance in Industrials.
West Pharmaceutical Services (WST) was the leading contributor to performance during the quarter and is discussed above.
MarketAxess Holdings (MKTX), the leading platform for the electronic trading of corporate bonds, contributed to performance during the quarter as investors continued to move from voice-negotiated trading to electronic trading of bonds. MKTX’s dominance in corporate bonds also stands as a risk, as revenues are tied to the level of corporate bond issuance and credit spread volatility. Trends toward increasing turnover in these bonds and capabilities in trading U.S. Treasuries and municipal bonds should help boost revenues. MKTX produces Returns on Invested Capital of 28% and its shares are at a discount to QSV’s measure of intrinsic value.
Following a solid quarterly earnings report, shares of Synovus Financial Corp (SNV) fell along with the banking industry during the March banking crisis. SNV offers shareholders an opportunity to take part in the rapidly growing southeastern U.S. market. The company produces Returns on Tangible Equity of 20% and Returns on Equity of 16%. Shares sell at a significant discount to QSV’s measure of intrinsic value.
Booz Allen Hamilton (BAH) shares also detracted from performance. BAH is discussed above.
Turnover was limited during the quarter. As in the QSV Mid Cap strategy, we exited shares of premium tool provider Snap-on Inc (SNA) for valuation reasons.
The banking crisis puts the Federal Reserve in a tenuous spot as it considers added rate increases in the battle against inflation. Pressure on banks’ balance sheets caused by both the stresses on existing borrowers and the need to raise rates credited on deposits will lead to tightened lending standards and diminished lending. This, in turn, will put the brakes on growth and contribute to the risks of a recession. QSV cannot predict with any greater accuracy than the next person whether a recession occurs, but we do know that challenging times such as these generally favor quality businesses that can self-fund growth through free cash flows and less reliance on debt markets. Investors sought quality in a compact list of mega-cap tech companies in early 2023; we believe more compelling opportunities exist in small and midcap companies for investors able to dig out those with durable competitive advantages and reasonable valuations.
Returns are for the respective composites of QSV Equity Investors. Gross returns are calculated net of trading fees. Net returns are calculated net of trading fees and net of the firm’s management fee. All dividends are assumed to be reinvested. The returns of the QSV Small Cap strategy are compared to the historical performance of the Russell 2000 Indices as they are a widely used benchmarks for small capitalization securities. The returns of the QSV Mid Cap strategy are compared to the historical performance of the Russell Midcap Indices as they are a widely used benchmarks for mid capitalization securities. The returns of the QSV Select strategy are compared to the historical performance of the Russell 2500 Indices as they are a widely used benchmarks for SMID capitalization securities. An investment with QSV Equity Investors should not be construed as an investment in a program that seeks to replicate, or correlate with, these indices. Market conditions vary between the QSV products and these indices. Furthermore, these indices do not include any transaction costs, management fees and other expenses, as do the QSV products. Lastly, QSV may invest in securities and positions that are not included in these indices.
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