October 2018 Portfolio Manager Review
The small cap universe, represented by the Russell 2000 Index, was down 10.9% in October, the worst month since 2011, leading to a technical correction in the small cap market. With such a sharp shift in sentiment, it is not surprising that risk-off areas such as Utilities (-2.8%), Consumer Staples (-3.4%), and Real Estate (-6.6%) were the top performing sectors in the benchmark. Weaker sectors included the Materials (-16.1%), Energy (-16.1%) and Health Care (-14.9%) sectors.
In response to the trends during the month, value significantly outperformed, with the Russell 2000 Growth underperforming the Russell 2000 Value by 370 basis points during the month, taking back half of the significant Growth outperformance YTD. The weakness in small caps was emblematic of a broader shift in the market away from riskier assets, as large caps outperformed by over 375 basis points, and now have outperformed small caps YTD.
With the weakness, the valuation of the Russell 2000 Index decreased to 12.0x from 13.3x EV/LTM EBITDA, the lowest level since the mini-recession in 2016, and is 2.5 turns below the recent peak of 14.4x. Small caps and large caps now trade close to the same multiple, which is well below small cap’s historical valuation premium of 14%. To put this in context, this is the first time small caps have traded at parity since the tech bubble. Since then, the Russell 2000 has returned 40% more than the Russell 1000, for an alpha of 70bp a year.
However, fundamental results remain quite strong and supportive of continued growth. Earnings growth for small caps remained at 11% during the month, and margins, even in the face of cost concerns, improved. On a capital allocation basis, capital spending and leverage remain at high levels. Lastly, fund flows to small cap equities did reverse, down $2.6bn, as style portfolio outflows offset core portfolio inflows.
Corrections, which represent 10+% declines in an asset class, are normal (this is the fourth since the financial crisis), and provide an opportunity for active managers in the market to take advantage of situations when stock prices move in a more volatile manner than fundamentals. Even in the face of a seemingly broad-based pullback, correlations remained below levels seen throughout 2013-2016.
It’s a reminder that what you own matters. This pullback brings small cap stocks back to generally close to large cap performance since their run after the 2016 U.S. election. Part of this is coming from a sense that cost increases due to trade policies and wage inflation, as well as potentially less flexible supply chains and customer relationships, may offset some of the other advantages more domestically-oriented companies face. At the same time, according to the Wall Street Journal, leverage among the Russell 2000 is at record levels, and more likely to be floating rate, which adds rate risk. Our goal is to provide small cap upside at large cap risk profiles, and this is why we look for companies that not only are delivering fundamental improvements, but also do it with robust assets and financial flexibility.
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 provide 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 October, the portfolio underlying the AdvisorShares Cornerstone Small Cap ETF performed generally in line with the Russell 2000 Index. The AdvisorShares Cornerstone Small Cap ETF declined 11.0% during the month, while the Russell 2000 declined 10.9%, an underperformance of approximately 11 basis points.
Monthly Performance By Sector
Past performance is not indicative of future results. Source: Factset
Contributors and Detractors
Health Care, Industrials, and Real Estate were the largest outperformers versus the benchmark (Russelll 2000 Index) during the month. Specifically, our stock selection in Industrials, performance from Ameresco (AMRC) and SkyWest (SKYW), our underweight allocation to weak-performing Health Care, and our stock selection in Real Estate, were the primary positive contributors to our performance. eHealth (EHTH), Ameresco, and KEMET (KEM) were three of the largest individual contributors.
- eHealth (Finance) is an online health insurance agency. The company announced strong results that indicated its large Medicare business continues to deliver strong momentum, growing at 30% year over year, and reaffirmed top-line and bottom-line guidance.
- Ameresco (Industrials) is a provider of energy efficiency solutions. In addition to reporting better-than-expected results, the company released very strong order and backlog levels, suggesting it has deals worth between 2-4 years of revenue already on the books.
- KEMET (Industrials) is a producer of capacitors. One of our worst performers last month, KEMET announced very strong earnings and refinanced its debt. Additionally, future prospects look strong, as it announced higher prices and a production capacity increase, as the capacitor industry supply remains tight.
Performance in the portfolio was offset by the Energy, Information Technology, and Consumer Discretionary sectors. Our stock selection in Energy, Information Technology, and Health Care, as well as our underweight allocation to Utilities, hurt overall performance. Denbury Resources (DNR), Spartan Motors (SPAR), and Stitch Fix (SFIX) were three of the largest individual detractors.
- Denbury Resources (Energy) is an oil and gas exploration and production company, with a focus on tertiary oil recovery. With its position in the oil and gas value chain, changes in expected oil prices and US production levels can have a meaningful impact on the company. Given the weakness in oil prices during the month, Denbury traded down materially, but remains well above the initial purchase price.
- Spartan Motors (Consumer Discretionary) is a producer of specialty vehicles, including buses, fire trucks, and trucks for industrial, freight, and utility applications. The company announced weak results for the quarter, and while its long-term contract to provide truck bodies for the US Postal Service remains strong, weakness in other markets have led expectations for revenue and profitability to deteriorate. As an example, backlog has declined 10% year-over-year.
- Stitch Fix (Consumer Discretionary) is an apparel retailer utilizing a subscription box distribution model. The company, which IPO’d about a year ago, had been a strong performer on expectations that subscriber growth would continue to grow quickly. However, net additions of approximately 50,000 were well below analyst expectations of around 150,000 on lower TV marketing spend, and a very high valuation led investors to reduce exposure in response. However, gross margins remain strong, and the company is still growing quickly.
We did not initiate or exit any names in the strategy underlying the AdvisorShares Cornerstone Small Cap ETF during the month.
Top 10 Holdings by Weight
While many of the top 10 holdings remained major positions, two companies exited the top 10 and two new ones joined. Oil and gas E&P Denbury Resources (DNR) was the weakest performer in the portfolio during the month, as the energy sector dropped on falling commodity prices and many U.S. oil and gas companies discussed reducing production growth plans. Auto and bicycle part maker Fox Factory (FOXF) was also a relatively weaker performer as the market penalized high-multiple companies in discretionary sectors with overseas production. After the month, it did report better-than-expected earnings and has since re-joined the top 10. On the other side, Industrial machinery producer Harsco (HSC) announced impressive earnings behind strong performance in its rail products business and Sunrun (RUN) continued to be strong on better sentiment.
|Rank||Stock Ticker||Security Description||Sector||Portfolio Weight %|
|3||MMSI||MERIT MEDICAL SYSTEMS INC||Health Care||0.99%|
|4||TCMD||TACTILE SYSTEMS TECHNOLOGY I||Health Care||0.89%|
|5||GDOT||GREEN DOT CORP||Financials||0.77%|
|6||CARB||CARBONITE INC||Info. Technology||0.75%|
|7||JBT||JOHN BEAN TECHNOLOGIES CORP||Industrials||0.75%|
|10||AMED||AMEDISYS INC||Health Care||0.73%|
Note: Cash (including accrued dividends) represents a 0.9% weight in the portfolio.
Portfolio Weight by Sector
As a reminder, our sector weights are an output of our bottom-up investment process, and we seek to generate alpha versus the Russell 2000 benchmark primarily from stock selection, rather than sector allocation. Given we did not make any trades during the month, we continue to maintain similar sector exposures as we did last month, with a material (greater than 2%) overallocation to Information Technology and Industrials, and a material underallocation to Financials, Health Care, and Utilities. The new Communication Services sector represented approximately 3% of the Russell 2000 benchmark as of 10/31/18, and the exposure in the portfolio is relatively close, at 4.5%.
Source: Factset. Weights as of 9/28/2018. Excludes cash and unassigned.
Very Truly Yours,
Cornerstone Investment Partners
Portfolio Manager of SCAP