SCAP: March 2019 Portfolio Manager Review
Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than original cost. Returns less than one year are not annualized. For the fund’s most recent standardized and month-end performance, please click www.advisorshares.com/fund/scap.
It’s strange that a 2% decline feels like a breath of fresh air (unlike here in Atlanta, where pollen has added a yellow haze to the city and requires lungs of steel). But given the volatility of the last few months, a stable-ish market provides an opportunity to reflect and focus on fundamentals. Following the worst month in almost a decade (December 2018) and the best start to a year in almost two, the small cap universe, represented by the Russell 2000 Index, declined 2.1% on a total return basis for the month. YTD, it is up 14.6% and up 2.1% for the last twelve months.
Small caps were actually the only capitalization range to fall during the month, as the Russell 2000 missed the Russell 1000 Index by 385 basis points (bp) in March, and now are up only 60bp vs. large caps YTD. However, this was not matched by the traditional risk-on/risk-off heuristic, as the Russell 2000 Growth outperformed the Russell 2000 Value by approximately 155bp in March and is now up 520bp YTD. Instead, sector performance seemed to be driven by a response to interest rates, which fell during the month. As such, dividend paying sectors like Utilities (+3.1%) and Real Estate (+1.8%) outperformed, and the yield curve-exposed Financials (-5.8%) sector was weak.
With the decline in the market, valuations have pulled back somewhat. The Russell 2000 trades at a 12.2x EV/EBITDA multiple, down from 12.5x last month, but up from 11.0x at the end of the year. Valuations generally remain in line with the five year median of 12.6x, but well below highs we saw last year before small caps fell. Relative to large caps, small caps are back to parity (December’s discount was the first time since the tech bubble, so parity is rare), and so they continue to be inexpensive on a relative basis. Versus a long-term median premium of 14%, this divergence remains visible. In response, small cap companies continue to increase buybacks significantly (according to Barclays, buybacks are at all-time highs), and leverage remains near post-crisis peak levels.
Earnings growth stabilized and somewhat recovered, as the EBITDA of Russell 2000 constituents has grown 8.9% year-over-year. This remains a material deceleration from recent peaks (12.1% in January), but significantly above levels from a few years ago. Like the last few months, margins have also remained relatively consistent, providing evidence that companies have been able to broadly support their bottom lines in the face of well-discussed cost increases such as labor and freight (although not as well as large caps have been, given the 850bp spread in EBITDA margins, up 25bp from just last month). For 2019, estimated earnings still suggest that profits decelerate somewhat, but the evidence does not suggest we are at the cusp of a major recession.
We don’t know what’s going to happen next, as the last few months suggest that the market is struggling to respond to external factors including fixed income markets, economic data, geopolitical sentiment, trade policy, and corporate earnings. Each day often feels different, and particularly in this type of market environment, we think SCAP’s approach, which places a premium on discipline, remains well-positioned. The longer-term evidence suggests that things are not as bad as feared, and over time, evidence outweighs fear. To us, it brings us back to our core investment philosophy, “stock prices are more volatile than fundamentals.” Particularly in a more volatile environment, companies that demonstrate fundamental performance improvement supported by quality balance sheets and cash flows 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 March, the NAV of the AdvisorShares Cornerstone Small Cap ETF was down 2.1%, performing in line with the Russell 2000 Index, which was down 2.1% as well. The AdvisorShares Cornerstone Small Cap ETF declined 2.2% during the month, also performing in line with the Russell 2000 Index.
Monthly Performance By Sector
Past performance is not indicative of future results. Source: Factset; as of 03.31.2019.
Contributors and Detractors
Financials and Industrials were the two biggest outperformers versus the benchmark during the month. Specifically, our underweight position to and stock selection in Financials, as well as our stock selection in Industrials and Real Estate, were the primary positive contributors to our performance. Glu Mobile (GLUU), Bandwidth (BAND), and Vera Bradley (VRA) were three of the largest individual contributors.
- Glu Mobile (Information Technology) is a provider of video games for mobile devices. While there was no news particular to Glu, the video game space was strong during the month, with Glu, and other domestic and Chinese game companies all outperforming.
- Bandwidth (Information Technology) is a provider of cloud-based communication services. During the month, the company, which initially IPO’d at the end of 2017, issued shares in a secondary public offering. Demand for the issuance was high, and investors drove the valuation and price upwards afterwards. We exited Bandwidth during the quarterly reconstitution, as falling forward estimates, which did not seem to impact demand for the share issuance, led it to be one of the least attractive securities in the portfolio based on our analysis.
- Vera Bradley (Consumer Discretionary) is a designer and marketer of accessories. The share price spiked after the company announced comparably strong 4th quarter results, as sales declines somewhat decelerated, margins continued to improve, and long-term guidance was well ahead of Wall Street estimates.
Performance in the portfolio was partly offset by the Information Technology, Health Care, and Utilities sectors. Our stock selection in Information Technology and Health Care, as well as our underweight position to Utilities, partly offset overall performance. Tactile Systems Technology (TCMD), Ascena Retail Group (ASNA), and Clearwater Paper (CLW) were three of the largest individual detractors.
- Tactile Systems Technology (Health Care) is a provider of medical devices for managing lymphedema symptoms. Although earnings were in line with the company’s strong pre-announcement, Tactile disclosed it received a qui tam lawsuit by a competitor that alleges Tactile engaged in kick-backs. That lawsuit has since been unsealed, and while some analysts have reviewed the case and suggest the risks are manageable, investors have pressured the stock.
- Ascena Retail (Consumer Discretionary) owns a collection of women’s apparel retailers, including Ann Taylor and Justice. During the month, the company reported quarterly results that were in line with expectations, but declined to provide annual guidance and quarterly guidance was quite weak, with a material loss expected for 3Q. In response, Wall Street analysts significantly cut forward estimates, and Moody’s downgraded the company’s credit rating. Later in the month, the company announced the sale of its Maurice’s brand and is rumored to consider selling Dress Barn as well as a way to pay down debt. We exited Ascena during the quarterly reconstitution.
- Clearwater Paper (Materials) is a provider of paper products. The company reported quarterly results that hit the high end of the company’s guidance. However, Clearwater wrote down the remaining goodwill in its Cellu Tissue business and suggested that the tissue market may be weak for the foreseeable future, while at the same time increasing capex expectations for a large tissue facility.
We completed the 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 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 investable universe, such as by getting too large or small. The 3 largest positions we sold were the following. All were strong performers during our ownership period and became too large for our investable universe:
- Online health insurance broker eHealth (EHTH). At the time of its sale, it was the 2nd largest position in the portfolio.
- Cloud-based enterprise communication company Bandwidth (BAND). At the time of its sale, it was the ninth-largest position in the portfolio.
- Home health care company Amedisys (AMED). At the time of its sale, it was the tenth-largest position in the portfolio.
We also exit stocks currently being acquired, and during this quarter, we sold two companies for that reason:
- Student loan software company Ellie Mae (ELLI) is being acquired by PE firm Thoma Bravo
- Luxury hotel company Belmond (BEL) is being acquired by French luxury good conglomerate LVMH Moet Hennessy (MC.PA)
In their place, we purchased 60 new names for the portfolio. Among the top-ranked securities we purchased were the following:
- Medical device and diagnostic company Surmodics (SRDX, Health Care) provided forward guidance well ahead of Wall Street expectations, suggesting margins are improving as revenues grow.
- Subscription-based clothing retailer Stitch Fix (SFIX, Consumer Discretionary), which is continuing to deliver strong growth behind both higher numbers of clients and revenue per client.
- Oil and gas equipment supplier Dril-Quip (DRQ, Energy) has delivered better than expected revenue as the offshore market slowly recovers, and business model shifts to allow the company to be more cost-flexible and a cash-rich balance sheet provide downside protection.
Portfolio Weights by Sector
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 (greater than 1%) increased our exposure to the Health Care and Industrials sectors. We did not materially decrease our exposure to any sectors.
As of the end of March, our largest overweight exposures are the Information Technology and Industrials sectors. Our largest underweight exposures are to the Financials and Utilities sectors.
Source: Factset. Weights as of 3/29/2019. Excludes cash and unassigned.
Top 10 Holdings
Three names changed within the top 10. During our quarterly reconstitution, we exited home nursing company Amedisys (AMED) and HR software company Paylocity (PCTY), as they became too large for our small cap investible universe, and eHealth (EHTH) became one of the least attractively-ranked stocks in the portfolio. In their place, home healthcare LHC Group (LHCG), which has been in and out of the top 10, call center software company Five9 (FIVN), and cloud-based residential and commercial alarm system Alarm.com Holdings (ALRM), moved up. The top 10 holdings now represent 8.4% of the portfolio.
|Ticker||Security Description||Sector||Portfolio Weight %|
|MMSI||MERIT MEDICAL SYSTEMS INC||Health Care||1.06%|
|GLUU||GLU MOBILE INC||Information Technology||1.04%|
|FOXF||FOX FACTORY HOLDING CORP||Consumer Discretionary||0.87%|
|GTLS||CHART INDUSTRIES INC||Industrials||0.84%|
|ENTA||ENANTA PHARMACEUTICALS INC||Health Care||0.81%|
|LHCG||LHC GROUP INC||Health Care||0.72%|
|TCMD||TACTILE SYSTEMS TECHNOLOGY I||Health Care||0.71%|
|FIVN||FIVE9 INC||Information Technology||0.69%|
|ALRM||ALARM.COM HOLDINGS INC||Information Technology||0.67%|
Note: Cash (including accrued dividends) represents a 0.60% weight in the portfolio. As of 03.31.2019.
Very Truly Yours,
Cornerstone Investment Partners
AdvisorShares Cornerstone Small Cap ETF (SCAP) Portfolio Manager
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The views in this commentary are those of the portfolio manager and may not reflect his views on the date this material is distributed or anytime thereafter. These views are intended to assist shareholders in understanding their investments and do not constitute investment advice.