QSV Equity Investors
Q1 2021 Commentary
More information including since-inception performance for each of the strategies may be found at www.qsvequityinvestors.com.
Vaccines and stimulus provided a double-barreled boost to equity markets in the quarter, with particularly sharp gains in lower quality, more economically sensitive stocks. These sharp gains produced significant headwinds for the quality-biased strategies managed by QSV and were most pronounced in small caps where low-quality D and E ranked companies outpaced high-quality ranked companies in the QSV universe by 780 basis points. Companies with no net income in 2020 outperformed those with earnings by substantial margin and this, again, was most extreme in small caps where those with no net income outperformed by 10% during the quarter.
A steepening yield curve prompted worries about inflation and turned investors’ attention to financial stocks that offer a possible hedge against rising rates. GameStop made headlines for both its volatility and short term returns along with other “back from the dead” stocks in industries such as airlines, construction, retailers, hotels and restaurants. And while the “meme” stock trading in GameStop and other companies prompted media criticism of newly minted retail investors, those Robinhood account holders were not alone; a survey from State Street of institutional investors noted “evidence of a sustained rotation from cash and fixed income into equities since July 2020.”
QSV Strategy Quarterly Performance
Against this backdrop, the QSV Quality Value Smallcap Strategy returned 11.81% and 11.53%, gross and net of fees, lagging both the Russell 2000 Value and Russell 2000 Indexes’ returns of 21.17% and 12.70%, respectively. At a sector level, significant under weights to Consumer Discretionary stocks hurt performance; within the Index, GameStop and retailer Express produced returns of 907% and 341%, respectively. QSV’s holdings in Financials and Real Estate helped returns.
Quality Value Smallcap Top Contributors
Ligand Pharmaceuticals (LGND) shares rose sharply during the quarter in response to short covering, moving the price well above QSV’s estimate of fair value and prompting its sale from the strategy. The biopharmaceutical company is involved in drug discovery, early-stage drug discovery and reformulation and partners with leading pharmaceutical and biotech businesses. LGND operates as a quasi-royalty fund and benefits from a broad pipeline of drugs to fuel future revenue and earnings growth.
Economic tailwinds to the performance of bank financials and the strong business performance of Premier Financial Corporation (PFC) supported strong returns for our holding in PFC during the quarter. PFC focuses on traditional banking, property and casualty, life and group health insurance in northwest and central Ohio, southeast Michigan and northeast Indiana. We see PFC as a quality franchise producing 16% return on tangible equity and 3.5% net interest margins. The company focuses on organic growth but has also proven adept at integrating bolt-on acquisitions.
Quality Value Smallcap Top Detractors
Simulations Plus (SLP) was the leading detractor to returns after rising significantly in 2020 on optimism over its role in resolving the COVID-19 pandemic. SLP produces software and provides consulting analytics for use in drug discovery. SLP is approaching a 20% market share of the pharmaceutical, biotechnology, and generic companies that would be potential users of its software and consulting services. Its StrategiesPlus COVID-19 ACT Program, launched in early 2020, is designed to help speed pharmaceutical research and accelerate the process of regulatory approval, contributing to resolving the COVID-19 pandemic. During the quarter, one significant contract was signed with a large pharma client for this program. Governance of the business is strong and founders of SLP own 23% of the outstanding voting stock.
US Physical Therapy Inc. (USPH) shares were down on profit taking during the quarter. Revenues have been impacted by the pandemic and UPH lowered guidance due to anticipated declines in Medicare reimbursement. Despite these challenges, we are optimistic about the company’s near and long-term prospects; USPH has lowered expenses and our outlook is for both improved revenues and margins. USPH generates consistently strong free cash flows and is skilled at using that cash to acquire physical therapy practices within the fragmented rehabilitation industry. USPH completed the acquisition of five additional clinical practices in late March.
Quality Value Smallcap Portfolio Activity
With the continued rise in small cap stocks, QSV sold holdings for valuation reasons. In addition to Ligand Pharmaceutical, EBIX, Inc. (EBIX), Armanino Foods of Distinction, Inc. (AMNF), Balchem Corp.
(BCPC) and Badger Meter (BMI) were sold as they rose above our estimates of fair value. NIC Inc. (EGOV) was sold as it agreed to be acquired by another of our holdings, Tyler Technologies (TYL), creating a powerful combination of two quality businesses. With the proceeds from these sales, QSV purchased NAPCO Security Technologies (NSSC) and CSG Systems International (CSGS). NSSC provides security products, including door locking products, intrusion and fire alarm systems and video surveillance products. The company benefits from high recurring revenues and gross margins of over 80% in its services business. CSGS is a provider of revenue management and digital payment solutions. The company benefits from high switching costs and recurring revenues and produces returns on invested capital of 10%.
The QSV Quality Value Midcap Strategy returned 7.27% and 7.01%, gross and net of fees, for the quarter, lagging both Russell Mid Cap Value Index return of 13.05% and the Russell Mid Cap Index return of 8.14%. Security selection helped performance in the Energy and Financials sectors and detracted from performance in the Technology and Industrials sectors.
Quality Value Midcap Top Contributors
As in the previous quarter, Synovus Financial (SNV) shares were higher based on strong financial results and optimism over a reopening economy. Synovus is a significant banking force in higher growth markets in the Southeastern U.S. and is recognized as one of the country’s “Most Reputable Banks” by American Banker and the Reputation Institute. The bank reported higher loan growth and improving net interest margins. Management is keenly focused on managing expenses and is turning its attention to revenue generation with the improving economy.
First Financial Bankshares (FFIN) contributed to performance and the company announced its 34th year of consecutive annual earnings growth. Like Synovus, FFIN operates within a high growth footprint in the South, in the case of FFIN, through 78 locations in Texas where markets reopened quickly and are operating at near normal conditions. Positive migration trends to certain markets in Texas have spurred FFIN to consider additional acquisitions that could further its growth. We believe FFIN to be a leading franchise with strong net interest margins, a solid balance sheet and high capital levels.
Quality Value Midcap Top Detractors
Copart Inc. (CRPT) detracted from performance due to profit taking and concerns over the impact of COVID-19. As the largest player in the automotive salvage market, concerns over fewer miles driven during the pandemic led to expectations of fewer accidents and dampened revenues. Sales volumes were down only slightly, however. With fewer cars on the road, drivers were willing to engage in riskier behavior, leading to higher accident frequency and greater loss rates. Auction results for salvaged vehicles reached record levels, partially offsetting volume declines. We see CRPT as a core holding due to the wide moats created by its strong network. The company has a long history of generating real economic returns, supported by its competitive moats, and delivers a robust 26% return on invested capital.
Rollins Inc. (ROL) dropped 11% during the quarter, detracting from performance. Much of the pest control company’s residential business has been fueled by the work from home trend and concerns persist over the impact of the reopening economy. ROL believes this impact can be offset by an anticipated recovery in commercial sales. The pest control business is quite fragmented and ROL benefits from operating leverage and strong free cash flow generation as it acquires and integrates smaller firms.
Quality Value Midcap Portfolio Activity
As with Quality Value Smallcap, a number of long-term holdings in the Quality Value Midcap strategy were exited during the quarter. ACI Worldwide (ACIW), AptarGroup Inc. (ATR), Cracker Barrell (CBRL) and Vail Resorts (MTN) are all quality businesses but exceeded our estimates of fair value. TCF Financial Corporation (TCF) was sold as it was acquired by Huntington Bancshares (HBAN), Varian (VAR) was sold as it was acquired by Siemens, and Xilinx (XLNX) was sold due to its acquisition by AMD. Proceeds from these sales were committed to positions in Equity LifeStyle Properties (ELS), Pool Corporation (POOL), and Gentex Corporation (GNTX). ELS is a manufactured housing and RV REIT that operates 413 properties in 33 states and British Columbia. Favorable demographics and a rising demand for camping support growth in ELS’ business and its size provides a competitive advantage. POOL has scale advantages within the highly fragmented pool supplies industry and has returns on invested capital of 33%. GNTX produces automatic-dimming mirrors, aircraft windows and commercial smoke alarms and signaling devices for the fire protection industry. Its competitive strength delivers returns on equity of 21% and supports a free cash flow yield of 5%.
The QSV Select Value Strategy returned 10.27% and 10.04%, gross and net of fees, lagging the returns of 16.83% and 10.93% for the Russell 2500 Value and Russell 2500 Indexes, respectively. Stock selection in the Real Estate and Consumer Staples sectors aided returns, while selection in the Information Technology and Industrial sectors detracted. Select Value is a high conviction strategy that takes QSV’s “best ideas” from its Quality Value Smallcap and Quality Value Midcap strategies.
Select Value Top Contributors
Synovus Financial (SNV) was the leading contributor to the performance of the Select Value Strategy during the quarter. Our comments can be found above.
ABM Industries (ABM) contributed to performance of the Select Value strategy during the quarter boosted by enthusiasm over the reopening of the economy. ABM is the largest and only truly national janitorial company in the U.S., with 350 U.S. & international locations, 20,000 clients and 140,000 employees. The company benefits from economies of scale relative to its peers in a very fragmented business. COVID-19 led to a clear and indisputable need for evolving cleaning and disinfecting capabilities that ABM is uniquely situated to provide.
Select Value Top Detractors
Copart Inc. (CRPT) was the leading detractor to the performance of the Select Value strategy and commentary is noted above.
Masimo Corp. (MASI) detracted from performance of the Select Value strategy as profit taking and a “reverse COVID” trade occurred in the quarter. MASI is a medical technology company, which develops, manufactures and markets non-invasive patient monitoring technologies, medical devices and sensors. The company’s patents, global footprint and seasoned team stand as competitive advantages and enable the business to produce returns on invested capital of 20%.
Select Value Portfolio Activity
AptarGroup Inc. (ATR), Badger Meter (BMI), and Balchem Corp. (BCPC) were each sold from the portfolio as the share prices of each rose above QSV’s view of fair value. NIC Inc. (EGOV), Varian (VAR), and Xilinx (XLNX) were each sold on the news of acquisitions, as described above. Proceeds from the sale of these businesses was committed to NAPCO Security Technologies (NSSC), Pool Corporation (POOL), and Gentex Corporation (GNTX), each of which are discussed above.
Our Focus on the Long Term
QSV calls Chicago its home and our professionals grew up as fans of its sports teams. The drought that value investors endured in recent years felt like the dry spell we have faced since the Bears’ Super Bowl Championship in 1985. The question now is whether value will persist in its dominance of growth or falter going down the stretch. With the fuel provided by stimulus programs, the reopening of the economy and strong economic performance, it is likely that value stocks’ out performance will persist for some time. The long-term disparity of returns – small cap growth companies have delivered nearly 3% per year greater performance than small cap value over the trailing ten years – also stands in favor of the value style, as mean reversion continues. We believe that the strong rally by lower quality stocks has largely played out. Strong balance sheets, cash flows and earnings persistence will come back into the picture and businesses with durable competitive advantages will continue to reward investors. Selectivity is important in seeking out these wealth creating businesses and this is where we continue to work to serve our clients.
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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