Deep Value Strategy 2Q 2023 Letter
We have seen ongoing sizable price swings in groups of securities that have become popular or unpopular in marketplace voting. We highlighted in our Q1 letter “Don’t Forget Value and Small” how the fallout from the Silicon Valley Bank failure created near-term stress on the banking system and growing recession fears. With growing uncertainty, longer duration equities with potential for above average growth came back in favor. The NASDAQ 100 and Mega-Cap stocks posted strong double-digit returns for the second quarter in a row. In the second quarter, the five Largest S&P 500 weights, aka “The Top 5,” also produced double-digit returns, 2.5x to 8x higher than the overall market, collectively generating more than 70% of the S&P 500 Index return! Over the past three months, the Top 5 also added a combined market capitalization of $1.7 Trillion, now 3.5x the total market cap of the Russell 2000 Index! With the recent sizable move, the percentage sum of the Top 5 has now returned to its August 2020 highs.
It’s interesting to note that valuation multiples of the Top 5 continue to rise. In March 2000, the Top 5 price-to -sales multiple peaked around 4x, then increased to 5x in August 2018, and by August 2020 had nearly doubled to 9x. With the recent price recovery and Nvidia’s (NVDA) recent entry into the Top 5, price-to-sales of the Top 5 is now a lofty 13x. Besides the Top 5 significantly outperforming, the number of outperformers in the S&P 500 narrowed even more during the second quarter. As the chart below highlights, the 3- month time period ending 5/31/2023 saw less than 30% of the stocks outperform the S&P 500 Index, the lowest market breadth over the past 40 years!
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In our Q3 2020 letter, “Value: A Timely Opportunity,” we discussed the record levels of market concentration at the time and compared the S&P 1500 Growth to S&P 1500 Value and S&P 1500 Pure Value. Revisiting this analysis shows how the top holding and top 10 holdings of the S&P 1500 Growth Index are back above August 2020 levels (highest in 30 years).
The S&P 1500 Value Index concentration has also increased versus three years ago, however lower valuation indexes show significantly less concentration. Market concentration falls even more when looking at smaller market capitalization indexes today.
Another driver of the significant market concentration and crowding in longer duration equities is the significant outperformance of the Technology sector. The S&P Technology sector again led the market, increasing 17% in the second quarter, following a 22% advance in Q1. With the strong first half, one would expect the Technology sector to also be delivering strong earnings growth, however that hasn’t been the case with negative year-over-year revenue growth and muted earnings growth. A sizable portion of the sector’s outperformance year-to -date has been valuation expansion. The Tech sector started the year with a price-to-earnings multiple of 20x and ended Q2 at nearly 28x -more than 50% above its long-term average of 18x! The sector has a forward earnings yield of 3.6%, nearly 1.5% below the 2-year Treasury bond yield.
The Tech sector is discounting significant optimism for improving growth over the coming year and benefits of Artificial Intelligence (AI). While both may happen to a varying degree over time, as valuations increase further there is growing risk that the recovery may end up being less than market expectations or the Al benefits may take longer to play out. Prior interest rate hiking cycles has shown the Technology sector lag the overall market 6 to 12 months after a pause. As the slowing economic backdrop eventually weighs on all market participants over time, those with extended valuation multiples are at risk of valuation multiples resetting lower as earnings fail to meet consensus expectations.
Valuation spreads widened further during the quarter as some value factors (forward price-to-earnings and price-to-book) delivered negative returns for 2023. The chart below compares forward price-to-earnings, price-to-book and price-to-sales across different market indices. Valuation multiples are highest in NASDAQ 100 Index (not surprising as the Index has a 50%+ weighting in Technology and posted its greatest first half returns), while Small Cap Value and the lowest valuation securities remain at a deep discount to the overall market and a significant 40-90% discount to longer duration equities, close to their Covid lows!
Longer duration equities and Mega Caps may continue to receive ongoing marketplace votes over the coming months. However, with widening valuation spreads, there appears to be a more attractive long-term reward/risk opportunity in the out-of-favor areas of the market (Low Valuation securities and Small Caps). The Russell 2000 Index has been in an extended bear market, posting negative rolling 12-month returns for the past 17 months. A rare historical event, only happening one other time since 1982! In fact, there have only been ten occurrences over the past 40 years when small caps’ trailing one-year returns were negative for more than 6 consecutive months. In each instance, smaller cap stocks’ forward 1-year returns were not only positive but posted average returns greater than 25%. Small Caps as a percent of the total equity market is quickly closing in on 4% (similar to 2020 lows), almost half their long-term average. In fact, you would have to go back nearly 90 years ago to find a time period under 4% weight. These unloved portions of the market are currently at wide price-to-value gaps which we believe will eventually attract investors interest as the marketplace broadens out, rebalancing the market scale.
For the second quarter, the Deep Value Select strategy was down 2% net-of-fees, behind the overall market and the S&P 1500 Value Index. Year-to-date, the strategy is down 6%, also behind the overall market and the S&P 1500 Value Index. Lower valuation and smaller cap stocks lagged the overall equity market during March to May and we saw significant valuation compression in our Deep Value Strategy holdings. Looking back over the past five years, the underperformance during this three-month time period is approaching extreme levels previously seen last summer and March and April of 2020, the post-Covid time period. However, as we have highlighted in previous letters, these periods of greater underperformance were regained over the following year.
During the quarter, our largest positive contributor was Gannett (GCI), whose share price rose in excess of 20%. Management’s quick action undertaking an aggressive $240M cost reduction program have begun to offset inflationary pressures and stabilize their transformation plan. This point in time for Gannett appears remarkably similar to The New York Times transformation 10 years ago. NY Times’ share price rose 10-fold since then as the company successfully eliminated $1B corporate debt and scaled their digital subscribers to stabilize cash flow generation and return to growth. We believe Gannett potentially has a greater monetization opportunity due to their larger 180M monthly visits to their digital platforms. By further expanding their digital offerings and developing new high-margin content partnerships, Gannett appears positioned to return to growth over the next 12-18 months. In addition, Gannett recently announced an anti-trust lawsuit against Google which follows similar actions by the European Central Bank (ECB) and various states. Winning the case has the potential to accelerate the transformation, as anti-trust cases have treble damages which can award up to three times compensatory damages, potentially leading to a future award well in excess of $1B, versus a current market capitalization of approximately $370M.
Our two largest detractors during the quarter were Quad Graphics (QUAD) and Nabors Industries (NBR) with share prices down 12.1% and 23.5%, respectively, during the quarter. Shares of both companies are significantly mispriced in our opinion, providing potential long-term upside multiples of their current share prices.
Quad’s transformation from a printing company to a marketing experience company continues to pick-up steam. The company has built out an extensive marketing solutions portfolio that provides not only high-volume print, but content, digital, technology and analytic solutions to their clients. We see significant long-term opportunity as the company further expands its services to the 2,900 large corporate clients. With a market cap near $200M the shares look severely mispriced to us, versus the company’s $3B+ revenue base. Current valuation is extremely attractive at .2x Enterprise to Revenue and 3.5x Enterprise to Earnings Before Income, Taxes, Depreciation, and Amortization (EBITDA). With limited Wall Street coverage, we see significant upside potential as the marketplace becomes more familiar with Quad’s attractive positioning and long-term growth story.
Nabors’s underperformed during the quarter due to a pullback in domestic drilling activity from recent weakness in the oil market. The lack of incremental capacity by the land drillers over the past couple of years should allow rig margins and cash flow generation to remain strong in the near term and we expect the spending environment to improve over the coming 6-12 months. Meanwhile, we think the market is overlooking Nabors’s international operations, proprietary drilling solutions segment, and new energy transition businesses. These efforts have the potential to contribute meaningfully to total company profitability and free cash flow over the next 3-5 years. With the recent pullback in the shares, Nabors’s market cap is now below its expected 2023 EBITDA and supports an attractive >40% free cash flow yield. Over the past 4 years, management has significantly improved the balance sheet, having reduced debt by $1.8B since early 2018. Nabors should end the year below 2x net debt leverage, and looks well positioned to deliver $400M+ a year of annual debt reduction; combined, this should unlock significant equity value over the next few years.
During the quarter, we initiated positions in Western Alliance (WAL) and Gray Television (GTN). Western Alliance is a leading national commercial bank with strong regional markets. The company has a capital-light business model (less branch focus). Following the Silicon Valley Bank collapse, Western Alliance saw significant share price weakness as the marketplace tried to draw similarities between the two companies. While initially experiencing deposit weakness, that has subsided and returned to growth as Western has a significantly more diversified business model with long-term customers having multiple products and services. The company’s underwriting capabilities and operations are best-in-class in our opinion. Management also appears fully aligned with shareholders and focused on shifting underwriting to a lower risk portfolio of loans. The company has taken incremental actions that should have accretive benefits to enhance capital ratios starting this quarter and further improving into 2024. Western’s share price is down 60%+ from its 52-week high, a deep discount to book value and 30%+ normalized earnings yield. We anticipate Western’s earnings troughing in the near term and improving over the next 6 to 12 months.
Long-term growth should remain above the peer group, ROAs at the high end of the industry, supporting Return on Tangible Common Equity (ROTCE) of 18-20%, with possible upside to 20-22% as the mortgage market improves over time. Both estimates are nicely above consensus long-term expectations. Over the next 3-5 years, returning to normalized EPS and valuation expanding back towards its historical average would support upside potential near three times current price levels.
Gray Television is the second largest broadcast company in the U.S., located across the country in 113 markets, reaching 36% of U.S households. The company appears attractively positioned, with 70% of its markets with the #1-ranked local TV stations and another 20% with the second-ranked station. Gray has a good distribution profile, growing its retransmission revenue in the mid-single digits over the past five years. Given their strong local stations, the company leads the industry in political revenue during election cycles. The stock price is down more than 60% from its 52-week high as the marketplace has been concerned about limited political revenue this year along with ongoing fears of a pullback in advertising spending from economic weakness. However, we see the potential for earnings and free cash flow to dramatically improve next year as political advertising reaccelerates and retransmission contracts are expected to renew at favorable rates. In addition, Gray recently spent $200M to develop Assembly, a state-of-the-art Film & TV studio, with 20 sound stages on 43 owned acres in Atlanta. NBC Universal signed a 15-year lease to manage the studio for Gray and will begin filming new TV series and movies in the back half of this year. There are low expectations in Gray’s stock price from the Assembly asset, as no analysts are currently including any future economics in their business projections. We agree with management’s outlook of meaningful free cash flow generation from the Assembly asset upon maturity.
In addition to lifting the long-term free cash flow power of the company, it should also materially reduce the cyclicality in non-election years. While the company has a higher debt load from prior station acquisitions, there are limited maturities over the next couple of years. We see strong free cash flow generation over the next five years (potentially >$2.5B) that could allow the company to rapidly delever over time. With greater than 50% forward earnings and free cash flow yield, Gray’s long-term upside potential is multiples of the current share price.
We believe the Deep Value Select strategy is significantly different than the overall market. We have very concentrated investments in what we see as significantly mispriced cyclicals and companies going through multi-year transformations. Our investment holdings tend to have a limited number of analysts following the company, allowing us to take advantage of greater marketplace inefficiencies. While some of our investments may require a longer investment time horizon, identifying multiple value drivers should provide an additional margin of safety and greater understanding of long-term upside potential.
We thank our clients for their ongoing patience and remain disciplined and focused on generating attractive long-term returns.
Deep Value Select Strategy Composite Performance (%) as of 6/30/2023
|Since Inception (10/1/18)
|Deep Value Select Strategy (Gross of Fees)
|Deep Value Select Strategy (Net of Fees)
|S&P 1500 Value Index