QSV Equity Investors
Q3 2021 Commentary
More information including a since-inception performance for each of the strategies may be found at www.qsvequityinvestors.com.
As we noted in our outlook last quarter, U.S. equity markets delivered between one and two years of expected returns in just the first six months of 2021. Equity markets pushed higher through August, but fell in September, as uncertainty regarding fiscal and monetary policy, inflation concerns, and slowing growth impacted investor sentiment. Factors driving performance shifted multiple times during the quarter. 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 outperformed low-quality businesses, as measured by the Russell Dynamic indexes, across the market cap spectrum.
QSV Strategy Quarterly Performance
The QSV Quality Value Smallcap Strategy returned -1.68% and -1.77%, gross and net of fees, beating both the Russell 2000 Value and Russell 2000 Indexes’ returns of -2.98% and -4.36%, respectively. Quality “QSV-like” businesses, those with less sensitivity to economic and credit cycles and with more sustainable business models, outperformed. Information Technology and Communication Services holdings helped performance, while Energy and Consumer Staples holdings hurt performance. Security selection was a strong contributor to performance, adding more than 100% of the strategy’s relative outperformance.
Quality Value Smallcap Top Contributors
Shares of Hollysys Automation Technologies (HOLI) rose significantly during the quarter as multiple offers were presented to acquire the business. HOLI is a China-based leader in integrated solutions for industrial automation and rail transportation and has been a long-term QSV holding. With the tailwinds presented by the buyout offers, QSV exited its position in HOLI during the quarter for valuation reasons.
Specialty pharmaceutical company Eagle Pharmaceuticals, Inc. (EGRX) rose over 30% during the quarter, supported by a court ruling that determined the company’s marketing application for Vasopressin did not infringe on patents held by the makers of the generic Vasostrict. We believe the outlook for EGRX is bright, with numerous late-stage pipeline assets, new collaborations with certain biotech companies, and additional indications in development for its existing products.
Quality Value Smallcap Top Detractors
In spite of a quarterly earnings beat and management raising guidance, Leslie’s Inc. (LESL) was the largest detractor to returns during the quarter. LESL is the largest consumer-facing omni-channel brand in the U.S. pool and spa care industry, operating more than 900 locations across 38 states. Quarterly earnings comparisons have gotten more difficult, and “reopening” has likely resulted in some shift in consumer spending from the home and pool to travel, restaurants, and other discretionary spending. That considered, QSV believes the competitive advantages of LESL remain intact, which includes the company’s installed base of customers driving strong recurring maintenance revenues.
Simulations Plus Inc. (SLP) shares were down during the quarter as its revenues disappointed as a result of a drop in its services business. We believe this dip to be temporary. SLP is a software and services provider to the pharmaceutical industry, aiding those businesses with software and services that support their drug discovery, product quality and innovation. The company is approaching a 20% market share of the companies that would be potential users of its software and consulting services. We see the outlook as strong for SLP, both due to organic growth and through acquisitions supported by its strong balance sheet.
Quality Value Smallcap Portfolio Activity
Rising markets and volatility presented abundant opportunities to sell positions for price reasons and to buy where better opportunities arose. Positions added during the quarter were on-line auto marketplace Car Gurus (CARG), on-line retailer 1-800 Flowers (FLWS), and Hawkins (HWKN), a provider of chemicals and ingredients for water treatment and nutrition. Also added were Johnson Outdoors (JOUT), a manufacturer of outdoor recreation products, insurer Primerica (PRI), and media company World Wrestling Entertainment (WWE). In addition to the previously mentioned sale of HOLI, QSV exited positions in US Ecology Inc. (ECOL), J&J Snack Foods (JJSF), Sensient Technologies (SXT), and airport operator Grupo Aeroportuario del Centro Norte (OMAB).
The QSV Quality Value Midcap Strategy returned 1.49% and 1.25%, gross and net of fees, for the quarter, leading both the Russell Mid Cap Value Index return of -1.01% and the Russell Mid Cap Index return of -0.93%. QSV added value in the Healthcare and Real Estate sectors, while Energy and Consumer Staples holdings detracted from strategy performance. Overall, security selection delivered more than 100% of the outperformance relative to the index during the quarter.
Quality Value Midcap Top Contributors
Microchip manufacturer Monolithic Power Systems Inc. (MPWR) was the top contributor to performance during the quarter. In the midst of a chip shortage, MPWR continues to progress in its transformation from a semiconductor device company to a technology solutions company, which we believe will drive meaningful revenue growth in the coming years. The mission of MPWR to reduce total energy consumption in end systems is well suited to the demands of its clients in the automotive, industrial, communications, and consumer end markets.
Icon PLC (ICLR) contributed to performance as shares were propelled by strong business results and optimism over expected synergies in its acquisition of PRA Health. ICLR is a late-stage contract research organization that provides drug development and clinical trial services to pharmaceutical, biotechnology, and medical device firms. While the business has operated globally, its purchase of PRA Health is expected to enhance these capabilities and deepen its relationships with clients including Pfizer.
Quality Value Midcap Top Detractors
Core Laboratories (CLB) dropped nearly 30% during the quarter, detracting from performance. CLB helps oil and gas companies better understand how to improve production levels and economics with core and reservoir analysis. Competitive advantages include its intangible assets (patents, proprietary technology, and human capital) and network effects (multi-client reservoir studies). Quarterly results were disappointing as COVID-19 related disruptions weighed on margin performance.
Shares of Scotts Miracle-Gro Company (SMG) declined sharply in September, in part due to investors’ concerns over the oversupply of cannabis in California. SMG’s Hawthorne division is a leading supplier of hydroponics products to the cannabis industry. While this news makes for click-worthy headlines, SMG remains the largest player in the U.S. gardening industry with a market share greater than 50% with its Scotts Miracle-Gro, Ortho, Tomcat, and Roundup brands. As a result, Scotts can charge materially higher prices than its competition. QSV added to its position on the weakness in share price.
Quality Value Midcap Portfolio Activity
As in the Quality Value Smallcap Strategy, portfolio activity was higher than typical as rising markets and volatility presented opportunities for taking gains and allocating to better opportunities. Positions added were management consulting firm Booz Allen Hamilton Holding Corp. (BAH), government health and human service provider Maximus Inc. (MMS), and Trinet Group Inc. (TNET), a provider of human resource solutions to small businesses. QSV exited its positions in US Ecology Inc. (ECOL), J&J Snack Foods (JJSF), SEI Investments (SEIC), and Waters Corp. (WAT).
The QSV Select Value Strategy returned 2.04% and 1.82%, gross and net of fees, leading the returns of -2.07% and -2.68% for the Russell 2500 Value and Russell 2500 Indexes, respectively. Select Value is a high conviction strategy that takes QSV’s “best ideas” from its Quality Value Smallcap and Quality Value Midcap strategies. Holdings in the Healthcare and Financials sectors aided returns, while the Consumer Staples and Energy sectors detracted. As with QSV’s Quality Value Smallcap and Midcap strategies, more than 100% of excess returns were a result of security selection in the Select Value strategy.
Select Value Top Contributors
Icon PLC (ICLR) was the leading contributor to performance. Our comments on ICLR are noted above. Shares of real estate management and investment firm Jones Lang LaSalle (JLL) rose over 25% as earnings results exceeded expectations. While some drivers behind this outperformance are temporary, the key drivers were the strong recovery in transactional leasing activity and the benefit of more permanent cost-saving measures. Competitive advantages of JLL include its retention rate of 90% when it takes over real estate management services from its clients.
Select Value Top Detractors
Core Laboratories (CLB) was the leading detractor to performance. Our comments on CLB are noted above.
Fair Isaac Corp. (FICO) detracted from performance as shares fell on disappointing aspects of its quarterly results. The company is a leading data and analytics company focused on predicting consumer behavior through its scores and software. FICO Scores serve as a benchmark “currency” in the U.S. consumer credit industry that are embedded in both industry processes and regulation, and in financial institutions’ systems and workflows. The scale advantage enjoyed by FICO supports high margins and free cash flows and the company produces Returns in Invested Capital of 12%.
Select Value Portfolio Activity
New positions in Booz Allen Hamilton Holding Corp. (BAH), CSG Systems International (CSGS), a leading provider of billing services to the cable, broadband and satellite industry, Maximus (MMS), and workforce solutions provider Insperity (NSP) were initiated in the Select Value strategy during the quarter. QSV exited its holdings in CBOE Global Markets (CBOE), J&J Snack Foods (JJSF), MGP Ingredients (MGPI), and Waters Corp. (WAT).
Our Focus on the Long Term
There is no shortage of risks in equity markets, including the above-mentioned uncertainty over fiscal and monetary policy, inflation concerns, and slowing economic growth. Tax policy looms as a potential impact to corporate margins and supply chain issues persist. While the potential impact of each of these is important for investors to consider, the macro future isn’t knowable. What we do know is the importance of maintaining a focus on fundamentals and quality businesses that have pricing power and persistent performance.
With 42% of the Russell 2000 companies lacking positive earnings in the trailing twelve months, we know that cheap money and government stimulus have propped up the market returns of low-quality companies. Selectivity will be critical in the coming months, and we will serve our clients through careful diligence and a continued attention to the sustainability of business performance and the price paid for each holding in our strategies.
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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