QSV Equity Investors
Q2 2022 Commentary
More information including since-inception performance for each of the strategies may be found at www.qsvequityinvestors.com.
Stocks were sharply lower during the second quarter of 2022, as persistently high inflation and the response from the Federal Reserve sparked worries over the severity of a resulting economic slowdown and risks of a recession. Consumers, the growth engine of the economy, showed fatigue as both their spending and savings rates waned in reaction to rising food and energy costs. Inflation hurt investor confidence and the visibility into future corporate earnings. While not immune to the selloff, stocks of higher quality companies weathered the downturn better than those of lower quality companies. Using the Russell Stability indexes as proxies for high and low quality, the Russell Defensive indexes containing businesses with higher Returns on Assets, lower leverage, and lower volatility significantly outperformed low quality businesses, as measured by the Russell Dynamic indexes, across the market cap spectrum.
Each of the QSV strategies outperformed its respective Russell indexes and each added value through stock selection during the quarter. Of note is the QSV Quality Value Smallcap strategy reaching its fifth anniversary, outperforming both the Russell 2000 Value and 2000 Indexes with less risk and positive stock selection over the five-year period.
The QSV Quality Value Smallcap Strategy returned -7.88% and -7.96%, gross and net of fees, leading the Russell 2000 Value Index return of -15.28% and the Russell 2000 Index return of -17.20%. Security selection in Healthcare, Industrials and Information Technology helped performance, while an underweight and negative security selection in Energy and an absence of Utilities companies detracted. QSV generally finds few businesses with high returns on invested capital in the Energy and Utilities sectors and these exposures are typical for our portfolios.
UFP Technologies, Inc. (UFPT) was the leading contributor to performance during the quarter, as shares rose 20%. UFPT designs and manufactures products and packaging for customers in seven target industries including medical, automotive, aerospace, consumer, and industrial markets, using foams, plastics, composites, and natural fiber materials. The company produces returns on capital of 9% supported by its “medical centric” revenue mix that has high barriers to entry and is recurring in nature.
MGP Ingredients, Inc. (MGPI) shares rose on a strong earnings report during the quarter. MGPI manufactures distilled spirits and specialty wheat protein and food ingredients, operating through its Distillery Products and Ingredient Solutions segments. The Distillery Products business is more than fifty years old and produces whiskey, rye, bourbon, and vodka for the premium beverage market. In addition to its premium brands, MGPI gained over 100 spirits brands and national distribution capabilities in 2021 through its acquisition of Luxco. The company produces returns on invested capital of 17%.
Shares of CarGurus (CARG) fell during the quarter, along with other online auto retailers, due to price volatility and softer retail sales. CARG offers a leading marketplace for both individuals and dealerships to buy, market and sell vehicles in the U.S. as well as Canada and the U.K. Asset light CARG has the competitive advantage of a strong network effect with over thirty-nine million unique visitors each month and over 30,000 paying dealerships globally. The company produces returns on invested capital of 16% and shares trade significantly below QSV’s view of intrinsic value.
Shares of energy services company Core Laboratories (CLB) fell during Q2 following robust returns in the first quarter. CLB is the singular energy holding in the QSV strategy and has competitive advantages that include its intangible assets (patents, proprietary technology, and human capital) and network effects (multi-client reservoir studies). Business performance has been negatively impacted as both COVID and the war in Ukraine have slowed exploration and production initiatives. Despite the headwinds to business performance, CLB produces returns on invested capital of 10% and we expect improvement to performance supported by strong commodity prices and consumer demand.
Based on our conviction in certain holdings in the Quality Value Smallcap portfolio and on the valuations of certain stocks, some trims and additions were made during the quarter. There were no outright sales or additions of holdings.
The QSV Quality Value Midcap Strategy returned -12.94% and -13.16%, gross and net of fees, for the quarter, leading both the Russell Mid Cap Value Index return of -14.68% and the Russell Mid Cap Index return of -16.85%. QSV’s security selection added value in the Industrial and Financials sectors, while an underweight and negative security selection in Energy and an absence of Utilities companies detracted. QSV generally finds few businesses with high returns on invested capital in the Energy and Utilities sectors and these exposures are typical for our portfolios.
W.R. Berkley Corporation (WRB) rose during the quarter adding to strong business and stock performance in the first quarter of 2022. WRB provides specialty coverages within the property and casualty insurance and reinsurance markets. Rate increase tailwinds and robust premium growth have supported strong business performance that is reflected in returns on average tangible equity of 18%. While we have conviction in WRB as a business, QSV exited its position during the quarter to capture gains and pursue companies with more compelling valuations.
Shares of Campbell Soup Company (CPB) aided performance during the quarter on strong business performance and an increase in guidance for 2022. Inflation and increasing input costs stand as a risk and management has acknowledged the headwinds that costs for steel cans and other inputs will create in the second half of 2022. Pricing actions in both the first and second half of the year and supply chain productivity gains are expected to offset much of these pressures. CPB produces returns on invested capital of 12% and shares currently trade at a discount to QSV’s estimate of intrinsic value.
Energy services company Core Laboratories (CLB) was the leading detractor from performance and is discussed above.
As with other bank financials during the quarter, Synovus Financial Corporation (SNV) shares fell sharply. QSV has conviction in SNV and likes the growth potential in its southeastern U.S. footprint. Mortgage loan growth may be depressed by higher interest rates and wealth management revenues will likely be reduced by the depressed market, but higher interest rates and operating efficiencies, that include a reduction in the branch network and greater digital delivery, should more than offset those challenges. SNV produces returns on average tangible equity of 18% and shares are discounted relative to QSV estimate of intrinsic value.
QSV exited CBOE Global Markets (CBOE), Fair Isaac Corporation (FICO), Steve Madden Ltd. (SHOO) and W.R. Berkley (WRB) during the quarter. QSV took advantage of the weakness in consumer stocks with new positions in on-line retailer Etsy Inc. (ETSY) and off-price retailer Ross Stores Inc. (ROST). New positions were also initiated in landscaping equipment provider The Toro Company (TTC) and specialty chemical company Celanese Corporation (CE).
The QSV Select Value Strategy returned -9.72% and -9.91%, gross and net of fees, leading the returns of -15.39% and -16.98% for the Russell 2500 Value and Russell 2500 Indexes, respectively. Select Value is a high conviction strategy that takes QSV’s “best ideas” from our Quality Value Smallcap and Quality Value Midcap strategies. Security selection delivered nearly all the outperformance during the quarter, with the greatest benefit in Industrials and Consumer Discretionary companies. As with QSV’s small and mid-cap portfolios, an underweight and negative security selection in Energy and an absence of Utilities companies detracted.
Record high sales lifted the shares of automotive parts provider Dorman Products, Inc. (DORM) during the quarter. Products from DORM are offered through aftermarket retailers such as Advance Auto Parts, AutoZone, and O’Reilly Automotive and distributors such as NAPA. The aging of cars is a tailwind to growth for DORM and the company produces returns on invested capital of 13% while shares remain discounted relative to QSV’S view of intrinsic value.
WD-40 Company (WDFC) shares aided performance during the quarter. The company reported a quarterly upside earnings surprise, while cutting its fiscal year 2022 earnings outlook due to higher oil- based input costs. WDFC benefits from one of the strongest consumer brands with 95% recognition. Growth opportunities are seen in international markets which the company estimates could reach $1 billion. WDFC produces returns on invested capital of 25%.
As in the Quality Value Midcap strategy, energy services company Core Laboratories (CLB) was the leading detractor from performance and is discussed above.
Tyler Technologies (TYL) detracted from performance during the quarter but remain a high conviction holding. TYL is the largest provider of enterprise software products focused solely on the public sector, with a focus on local governments where high switching costs stand as Tyler’s competitive advantage. The company has a 98% customer retention rate and incremental margins in its subscription business of over 70%. We believe TYL will benefit from increased government spending on infrastructure, the move of those clients to cloud-based solutions and a shift from the sale of licenses to a software as a service model with its customer base. The company produces returns on invested capital of 11%.
Keeping with its approach to invest in the best ideas of QSV’s Quality Value Smallcap and Midcap strategies, QSV exited positions in Copart (CPRT), Fair Isaac Corporation (FICO), and Icon PLC (ICLR). QSV initiated positions in Medpace Holdings, Inc. (MEDP), a leading clinical contract research organization, insurance and investment products provider Primerica, Inc. (PRI), and The Toro Company (TTC) during the quarter.
At the risk of restating our comments from the prior quarters, inflation, the Fed’s tightening cycle, slowing economic growth and geopolitical concerns all persist as risks for the remainder of 2022. We add to those risks the possibility of a recession as the Federal Reserve seems committed to its war on inflation while armed with the blunt tool of raising rates. Earnings estimates remain high, but inflationary pressures from input costs and wage increases will present challenges, as may weaker spending by consumers and businesses.
Positives sometimes come in unattractive packaging: While economic contraction is painful, a slow or no growth economy could prompt the Fed to slow the increases in interest rates, offering a boost to stock multiples. The pain felt by investors in the first half of 2022 has cut the valuations of many quality businesses to more attractive levels, offering investors the opportunity to upgrade their holdings. These quality businesses generally have less debt, consistent revenue growth, greater free cash flows, and histories of profitability, all supported by durable competitive advantages. QSV seeks out these qualities in its portfolio companies and we are optimistic that we can deliver compelling long-term results for our clients and ourselves as we invest alongside them.
Returns are for the respective composites of QSV Equity Investors (BEM). 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 BQV Midcap 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 BQV Smallcap 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 Select Value 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 BEM products and these indices. Furthermore, these indices do not include any transaction costs, management fees and other expenses, as do the BEM Products. Lastly, BEM may invest in securities and positions that are not included in these indices.
No client or potential client should assume that any information presented should be construed as personalized investment advice. Personalized investment advice can only be rendered after engagement of the firm for services, execution of the required documentation, and receipt of required disclosures. Investing carries risk of loss.
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