August 2018 Portfolio Manager Review
The small cap universe, represented by the Russell 2000 Index, was up 4.3% in August, continuing a six-month run behind continued strong economic growth. Health Care (+8.8%), Information Technology (+8.4%), and Telecommunication Services (+7.7%) were the top performing sectors. Weaker sectors included the commodity-linked Energy (-1.9%) and Materials (-1.5%) sectors, as well as Utilities (+0.8%). According to Barclays, this is only the 13th time that small caps have run for six straight months since the late 1970s.
Growth continues to be a strong outperformer behind the key sectors, with the Russell 2000 Growth outperforming the Russell 2000 Value by 380 basis points during the month, and now up almost 11% over the last year. Small cap stocks outperformed large caps during the month by approximately 90 basis points, up 5.5% over the past year. The valuation of the Index increased somewhat due to price movement, increasing from 13.0x to 13.5x EV/LTM EBITDA, but is down year-to-date on the Russell rebalance and well below the recent peak level of 14.4x. The small cap value premium versus large caps as increased to around 4%, but remains well below historical levels of 14%.
Fundamentally, results remain quite strong and supportive of continued growth. Earnings growth for small caps rose from 8% to 11% during the month, as top-lines continue to be strong and margins have remained stable. On a capital allocation basis, capital spending and leverage rose slightly, and buybacks increased for the fifth straight month, suggesting corporations are using still-inexpensive debt to drive investment. Lastly, fund flows to small cap equities remained strong, driven primarily by core portfolios.
We think SCAP’s approach, which places a premium on discipline, remains well-positioned. Companies that demonstrate fundamental performance improvement supported by quality balance sheets should continue to be attractive opportunities for the portfolio. We look forward to the opportunity to discuss SCAP and our firm with any interested investors. Please reach out to our team or AdvisorShares if you have any questions.
In August, the portfolio underlying the AdvisorShares Cornerstone Small Cap ETF significantly outperformed the Russell 2000 Index, with stock selection the driver of outperformance during the month. The AdvisorShares Cornerstone Small Cap ETF returned 6.1% during the month, while the Russell 2000 returned 4.3%, an outperformance of 180 basis points.
Monthly Performance By Sector
Contributors and Detractors
Information Technology, Financials, and Materials were the largest outperformers versus the benchmark during the month. Specifically, our stock selection and overweight allocation to Information Technology, our stock selection and underweight allocation to Financials, and, as well as our stock selection in Industrials, were the primary positive contributors to our performance. Insperity (NSP), Tactile Systems Technology (TCMD), and Health Insurance Innovations (HIIQ) were three of the largest individual contributors.
- Insperity (Industrials) is a Professional Employer Organization, providing outsourced human resources and insurance solutions. The biggest weight in the portfolio, the company announced strong second quarter earnings, with revenue and earnings each above Wall Street estimates as covered employees increased almost 15% year-over-year, and increased its guidance for both the third quarter and full year. Although downgraded by a Wall Street analyst the next day on valuation concerns, the stock continued to perform well during the month.
- Tactile Systems Technology (Health Care) is a provider of medical devices for the chronic treatment of lymphedema symptoms. The company reported revenues up 30% versus last year, with the primary Flexitouch product the key driver, and initial results out of the new Flexitouch Plus product appear to be strong. Looking forward, management increased guidance for both revenue and margins as Plus ramps and they increase the number of sales reps.
- Health Insurance Innovations (Health Care) is a health insurance broker focused on short-term and limited medical plans. The company reported strong results, with policies increasing 8%, and both revenue and earnings beat Wall Street estimates. In response, the company increased guidance for the year. Additionally, the US government extended the limit on short-term health insurance plans from 3 months to a year, which increases the size of HIIQ’s market.
Performance in the portfolio was partly offset by the Health Care, Consumer Discretionary, and Energy sectors. Our underweight allocation to Health Care and overweight allocation to Energy (each partly offset by positive stock selection), as well as our stock selection in Consumer Discretionary, were the primary negative contributors to performance. Triple-S Management (GTS), Bluegreen Vacations (BXG), and Systemax (SYX, the best-performing stock last month) were three of the largest individual detractors.
- Triple-S Management (Health Care) is an insurance company based in Puerto Rico focused on health insurance. The company reported weak earnings in response to issues arising from property & casualty claims from Hurricane Maria, as well as fewer-than-expected members of its Medicare Advantage business. We exited Triple-S during our most recent reconstitution.
- Bluegreen Vacations (Consumer Discretionary) is an owner of time-share vacation resorts and hotels. While the company announced timeshare sales up 3% and an improving loan loss level, SG&A costs increased and led the company to see a year-over-year decline in EBITDA and miss Wall Street estimates.
- Systemax (Industrials) is a distributor of a wide range of brand-name and private label industrial products. After announcing it would exit its French business last month, Systemax reported earnings that while were in line with Wall Street estimates, showed gross margin declines. We exited Systemax during our most recent reconstitution.
We completed the quarterly reconstitution of the portfolio underlying the AdvisorShares Cornerstone Small Cap ETF during the month. As a reminder, we have developed a strategy for small cap equities focused on identifying stocks exhibiting four key characteristics:
- Upside opportunity through identifying companies that are (1) demonstrating improving fundamentals and (2) have a history of achieving market expectations; and
- Downside protection through ensuring those companies have (1) robust cash flows and (2) real assets
Our portfolio holds approximately 240 stocks, which provides diversification and limits the idiosyncratic risk of individual small cap securities. Each calendar quarter, based on that screening process, we replace the weakest 25% of the portfolio with the most attractive available securities in our small cap investable universe. As such, 60 new securities that rank well in our valuation analysis were initiated in the portfolio, and we exited 60 weaker names currently owned in the portfolio.
Security Selection Update
One of the key elements of our process is that it is rules-based, which helps minimize the behavioral biases common to investment managers. Particularly in the small cap space, it is easy to fall prey to individual stories about unique disruptors or potential customer wins, even when it may be time to sell a security. We also exit positions when they no longer would be included in our small cap investible universe, such as by getting too large or small. The 3 largest positions we sold were the following:
- Portable oxygen concentrator company Inogen (INGN), which is up over 5x during our 2-year ownership period, and at $5 billion in market capitalization, is now too large for our investible universe. [Purchased March 22, 2016, returned 480% on a total return basis during that time period versus Russell 2000 return of 62%]
- Industrial distributor Systemax (SYX) saw estimates decline significantly during the quarter as it reported weaker-than-expected results on lower margins. Additionally, it announced the sale of its French distribution business to focus exclusively on North America. [Purchased May 25, 2017, returned 160% during that time period versus Russell 2000 return of 27%]
- Automotive sensor provider Stoneridge (SRI) announced quarterly results that were in line with estimates, but suggested that the rest of the year would be weaker due to by currency, tariffs, and customer production declines, with earnings likely be at the low end of their guidance range. [Purchased August 23, 2017, returned 96% during that time period versus Russell 2000 return of 27%]
We also exited stocks currently being acquired, and during this quarter, sold university accommodation REIT Education Realty Trust (EDR, purchased May 2018, returned 21% versus Russell 2000 return of 6%), which announced it would be acquired by private residential real estate developer Greystar.
In their place, we purchased 60 new names for the portfolio. Among the top-ranked securities we purchased were the following:
- Medical device and in vitro diagnostic provider Surmodics (SRDX), which significantly increased guidance and is now expected to be profitable this year behind significant growth in its medical device segment
- 3D printing company 3D Systems (DDD), which is demonstrating strong acceleration in printer shipments and has new product releases upcoming this year.
- Pain management product company Avanos Medical (AVNS), which has re-focused towards medical devices by divesting its low-technology surgical and infection prevention business.
Top 10 Holdings by Weight
Among the top 10 holdings, there was not a material shift. We sold portable oxygen concentrator supplier Inogen (INGN) and industrial distributor Systemax (SYX), and relative strength out of cloud service provider Carbonite (CARB), off-road shocks supplier Fox Factory (FOXF), and home health care company Amedisys (AMED) led them to enter the top-10. While still a high weight in the portfolio, liver disease-focused company Enanta Pharmaceuticals (ENTA) is no longer a top-10 weight.
|3||DNR||Denbury Resources Inc.||Energy||1.02%|
|4||MMSI||Merit Medical Systems, Inc.||Health Care||0.88%|
|5||TCMD||Tactile Systems Technology, Inc.||Health Care||0.79%|
|6||CARB||Carbonite, Inc.||Information Technology||0.79%|
|7||GDOT||Green Dot Corp cl A||Financials||0.75%|
|8||JBT||John Bean Technologies||Industrials||0.74%|
|9||FOXF||Fox Factory Holding Corp.||Consumer Discretionary||0.72%|
|10||AMED||Amedisys Inc.||Health Care||0.72%|
Note: Cash (including accrued dividends) represents a 0.3% weight in the portfolio.
Sector Allocation Update
The process underlying SCAP is bottom-up, and driven by the attractiveness of individual companies with the goal of providing actual stock diversification, rather than by just a few top-down sector or industry bets. As such, our sector exposures can vary significantly versus the benchmark as a whole. During the most recent reconstitution, we materially increased our exposure to the Information Technology sector. IT continues to have companies which demonstrate significant economic strength this year, generate twice the FCF margin as the market, and have little leverage. On the other side, we materially reduced our exposure to the Health Care sector. The industry has seen some weakness in estimates due to continued pressure on drug pricing and few new blockbuster drugs having hit the market.
Currently, our largest overweight exposures are to the Information Technology and Consumer Discretionary sectors. Our largest underweight exposures are to the Financials and Health Care sectors.
Portfolio Weight by Sector
Source: Factset. Weights as of 8/31/2018. Excludes cash and unassigned.
Very Truly Yours,
Cornerstone Investment Partners
Portfolio Manager of SCAP