QSV Equity Investors Q3 2020 Commentary
Additional information and since-inception performance for each of the QSV strategies may be found at www.qsvequityinvestors.com.
QSV Strategy Performance
The QSV Quality Value Smallcap Strategy returned 1.41% and 1.16%, gross and net of fees, lagging the 2.56% and 4.93% returns, respectively, of the Russell 2000 Value and Russell 2000 Indexes. An overweight and strong selection in Healthcare companies aided performance, while an underweight and underperformance in Consumer Cyclical companies detracted. Year-to-date, the QSV strategy returned (13.27%) and (13.91%) gross and net of fees, in comparison to returns of (21.54%) and (8.69%), respectively, for the Russell 2000 Value and Russell 2000 Indexes.
Quality Value Smallcap Top Contributors
Omega Flex Inc. (OFLX) and Simulations Plus, Inc. (SLP) were the top contributors to performance for the quarter, each with tailwinds related to the COVID economy.
As COVID-19 restrictions eased in the U.S., investor optimism returned to Omega Flex and other industrial stocks related to construction. OFLX is a manufacturer of flexible metal hose with products used in residential and commercial construction. Residential housing has been a positive during 2020 and OFLX profits as more homes use gas for heating. Leadership extends to other markets, including road transportation, semi-conductor, medical, pharmaceutical, and petrochemical products. OFLX benefits from high switching costs once its solutions are designed into these products. Returns on Invested Capital are 33% and OFLX has net margins of 16%.
Simulations Plus 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. Positive results are also expected as employees of pharma and biotech customers return to work following the COVID-19 pandemic and commit to new engagements with SLP. High switching costs, intellectual property and high contract renewal rates support operating margins of 28%.
Quality Value Smallcap Top Detractors
Top detractors to performance during the quarter were PaySign, Inc. (PAYS) and Oil Services International, Inc. (OIS).
PaySign, Inc. provides prepaid card programs specializing in corporate incentive products, payroll cards, general purpose re-loadable cards, and travel cards. Areas of growth for the business include its pharmaceutical payment assistance programs and plasma donor network services. PAYS offers promotional campaigns to limit a patient’s out-of-pocket prescription drug costs through a prepaid debit card in the former and donor payment programs in the latter. PaySign benefits from a high level of contractually recurring revenue, but still suffered from impacts related to the pandemic that lowered revenues in its Pharma and Plasma businesses during the second quarter. While challenges exist, Returns on Invested Capital are 32% and shares are selling at a significant discount to QSV’s view of intrinsic value.
Oil Services International was a leading detractor during Q3 2020. OIS is a provider of specialty products and services to the drilling, production and infrastructure sectors of the oil and gas industry. Barriers to entry are high in each of its markets which supports high margin products. QSV has been mindful of risks to the business including being levered to the number of new wells completed in the U.S. We believe OIS to be well managed but have concerns over its balance sheet because of challenges to its end markets. QSV exited its position in early September, avoiding the subsequent slide in OIS’ stock price.
Quality Value Smallcap Portfolio Activity
Activity during Q3 2020 focused on lowering cyclicality and upgrading quality. In addition to the previously mentioned sale of Oil Services International, QSV sold positions including retailer Kohl’s and bank financials Summit Financial Group (SMMF) and Southern First Bancshares (SFST). Proceeds funded purchases of NIC Inc. (EGOV), a provider of technology services to state and local governments, and Sensient Technologies Corporation (SXT), a manufacturer of colors, fragrances, and flavors. Both businesses benefit from high switching costs. Also added was life sciences company Meridian Bioscience, Inc. (VIVO), a leader in providing diagnostic test kits, antigens and reagents to agri-bio and pharmaceutical companies. The QSV team has owned VIVO on and off for many years and believes its fundamentals and current share price offer a compelling opportunity.
The QSV Quality Value Midcap Strategy returned 5.38% and 4.96%, gross and net of fees, lagging the 6.40% return of the Russell Mid Cap Value Index and the 7.46% return of the Russell Mid Cap Index. Relative to the Value Index, QSV’s performance was helped by an overweight and stock selection in Technology companies. An underweight and security selection in the Consumer Cyclical sector detracted from performance as highly cyclical companies held by the index in that sector rallied on optimism of the economy reopening. Year-to-date, the QSV strategy returned (.09%) and (.96%) gross and net of fees, comparing favorably to returns of (12.84%) and (2.35%) for the Russell Mid Cap Value and Russell Mid Cap Indexes.
Quality Value Midcap Top Contributors
Copart Inc. (CRPT) and Varian Medical Systems Inc. (VAR) were the leading contributors to performance for the QSV Quality Value Midcap strategy during Q3 2020.
Concerns over fewer miles driven during the pandemic weigh on Copart, Inc., but its business performance continues to be strong, with better than expected revenues and improving margins. CRPT is the largest player in the automotive salvage market, providing auction and related services to approximately 40% of the North American market. CPRT has a long history of generating real economic returns, supported by its competitive moats, and delivers a robust 26% return on invested capital. Its strong balance sheet has supported an increase in capital expenditures including expansion into non-U.S. markets, particularly in Germany, and over 50 expansion projects that the company has in the construction and engineering phases.
Varian shares rose significantly during the quarter on news that the company would be acquired by Siemens Healthineers AG in an all cash transaction worth $177.50 per share, a 24% premium to the company’s share price prior to the announcement of the deal. Varian Medical Systems designs, manufactures, and sells radiation technology for use in its oncology systems and proton therapy segments. VAR benefits from tremendous scale in radiation therapy and has a market share that is nearly double that of its nearest competitor, Elekta.
Quality Value Midcap Top Detractors
The Energy sector was the sole index sector in the red during Q3. Within that, Quality Value Midcap holdings Oil Services International, Inc. (OIS) and Core Laboratories (CLB) were the leading detractors from performance during the quarter.
Our commentary on Oil Services International is noted above.
After serving as a top contributor last quarter, Core Laboratories was a leading detractor to performance in Q3 2020. QSV had opportunistically purchased shares of CLB in April, quickly benefitted from a substantial increase in share price during Q2 and trimmed its position in June. Core Laboratories helps oil and gas companies improve production levels and economics with core and reservoir analysis. Its core analysis business has been virtually unchallenged for three decades. While its end markets are currently challenged, QSV believes the competitive advantages of CLB to be sound and sees shares of the company to be selling at a significant discount.
Quality Value Midcap Activity
As with QSV’s Quality Value Smallcap accounts, activity was focused on lowering cyclicality while upgrading the quality of the Quality Value Midcap strategy. Oil Services International and Kohl’s were sold, as was global money transfer and payment processing firm Euronet Worldwide (EEFT). Risks to EEFT that were previously identified by QSV included currency risk and a sensitivity to global tourism and the business grew more challenged because of the COVID economy. Proceeds from these and other sells funded the purchases of ACI Worldwide (ACIW), MSA Safety (MSA), Aspen Technology (AZPN), and Qualys Inc. (QLYS). ACI is a leader in providing payment processing services to the financial services industry and benefits from 75% recurring revenues. MSA Safety offers essential safety products to municipal fire departments and other customers. Aspen Technology performs software development and IT services for clients with contracts of five to six years, supporting 90% recurring revenues. Qualys is a leader in cloud security, serving 46% of the Forbes Global 500 and producing Returns on Invested Capital of 17%. These high quality companies have been on QSV’s radar for some time and the volatility late in the quarter provided attractive entry points for each.
The QSV Select Value Strategy returned 3.37% and 2.99% gross and net of fees, lagging the 3.54% return and the 5.88% return of the Russell 2500 Value and the Russell 2500 Indexes, respectively. The portfolio’s overweight and stock selection in Healthcare helped performance, while security selection in the Financial sector detracted. Year-to-date, the QSV strategy returned (4.46%) and (5.27%) gross and net of fees, comparing favorably to returns of (18.39%) and (5.82%) for the Russell 2500 Value and Russell 2500 Indexes.
Select Value Top Contributors
Reflecting the “best ideas” nature of the Select Value strategy, Varian Medical Systems Inc. (VAR) and Copart Inc. (CPRT), both top contributors in the Quality Value Midcap strategy, were leading contributors to the Select Value in Q3 2020. Each is discussed above.
Select Value Top Detractors
Paysign (PAYS) and Citizens & Northern Corporation (CZNC) were leading detractors to the performance of the Select Value strategy during the quarter; Paysign is discussed above in our commentary for QSV Quality Value Smallcap.
Shares of Citizens & Northern Corporation fell 20% during the quarter, detracting from performance of the Select Value strategy. CZNC operates as a holding company for community bank operations in North Central Pennsylvania and Southern New York State. QSV’s sale of this position and the investment of its proceeds are discussed below.
Select Value Activity
Drawing from the best ideas of QSV’s Quality Smallcap and Quality Midcap strategies, positions were added in Aspen Technologies, MSA Safety, NIC, Inc., all of which are discussed above. These purchases were funded through the sale of companies including Kohl’s, Vail Resorts, and Euronet Worldwide. Citizens & Northern Corporation was sold to take a tax loss, as were the strategy’s other bank holdings, Civista Bancshares (CIVB), Premier Financial Corporation (PFBI), Southern First Bancshares (SFST), and West Bancorp (WTBI). QSV’s team saw an opportunity to replace these banks with what it believes to be higher quality banks in states showing population growth. Positions were initiated in Synovus (SNV), FB Financial Corp. (FBK), Glacier Bancorp (GBCI), and Bank OZK (OZK).
Focused on the Long Term
In our commentary last quarter, we noted that it is important to consider that recent gains were driven by stimulus efforts, by an optimistic view that the worst of the pandemic is over and that progress on potential vaccines will soon yield results. Our thoughts remain the same as they were three short months ago; risks persist and should be managed. As investors, QSV’s team must balance optimism about the prospects for our holdings with risk management, both at the macro level and in assessing the potential challenges to the companies in our portfolios. One pundit recently noted that historians in the future will need to specify in which quarter of 2020 they specialize, given the continuous stream of events and surprises the year has presented to us all (and may yet offer). Despite the risks we know and those that we do not, QSV sees complacency on the part of many investors. We believe it is better in this environment than offense. We play defense by owning high quality small and mid-cap companies, purchased at reasonable valuations, and monitored closely by experienced analysts. As always, we remain personally invested alongside our clients and welcome questions and opposing views.
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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