For the third quarter of 2023, the iMGP SBH Focused Small Value portfolio slipped 1.26%, outperforming the 2.96% decline for the Russell 2000 Value benchmark. The fund also outperformed the Morningstar Small Value category’s 2.11% loss.
Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. Short term performance is not a good indication of the fund’s future performance and should not be the sole basis for investing in the fund.To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.imgpfunds.com. Returns less than one year are not annualized. The Advisor has contractually agreed to limit the expenses of the fund through April 30, 2024. Without this limit the fund’s net expenses would be higher the return would be lower.
Market Overview and Strategy Performance
For the third quarter, the portfolio outperformed its benchmark, losing 1.26% versus a 2.96% decline for the Russell 2000 Value Index. While the portfolio outperformed in the quarter, at the mid-quarter (July end), the fund was trailing the value benchmark by over 300 basis points (bps) on a relative basis due, in a large part, to the poor relative performance of its Industrial holdings. Despite this, we remained strong in our conviction of the value we believed had yet to be unlocked within the Industrial stocks and, by quarter end, the Industrial sector was the largest relative contributor to overall performance. The inflection points for many of the companies’ margins and return on invested capital (ROIC) began to affirm and in some cases, reveal themselves through the second-quarter earnings period.
Within the Russell 2000 Value benchmark, only two sectors—Energy and Financials—had positive returns. Energy was the standout, with a return of over 18%, while Financials returned just 1%. As we mentioned in our second quarter letter, we were looking to increase our exposure to the Energy sector by identifying the “right” capital allocators. We were successful in doing this, which added to the portfolio’s relative performance for the quarter. We also mentioned last quarter that we were not looking to increase the portfolio’s exposure to regional banks given our concerns about both the banking sector’s higher cost of capital and the risk of a potential credit cycle emerging over the next several quarters. As of now, our thinking has not changed. That said, the significant relative underperformance in the Financials sector is leading us to build out a more robust watch list to move this sector weight higher in the portfolio when we judge the time is right.
Contributors to Return
The three sectors that contributed most to the portfolio’s performance relative to its benchmark in the quarter were Consumer Discretionary (driven by selection), Industrials (driven by selection), and Information Technology (driven by allocation and selection). Within Industrials, Sterling Infrastructure was the top performer in the quarter. Sterling has almost flawlessly executed its strategy to remix its revenue from low margin and higher risk end markets to significantly higher margin and lower risk projects. The management team at Sterling has allocated capital with the sole purpose of finding a higher margin and faster-growing end markets and this has finally been rewarded by the market. Given the portfolio’s significant gains in this position we did exit the position fully in the quarter.
Within Consumer Discretionary, Modine Manufacturing was the top performer. Modine has seen significant success in deploying an 80/20 culture which has allowed for a less complex, higher margin, and higher growth business, which we believe has significant potential in the next several years. The 80/20 practice is a long-standing business strategy that companies apply to increase profit margins. It boils down to a simple statement which can be adapted to your business model: Companies should focus on the 20% of inputs that create the majority (80%) of their outputs. We always seek to identify those stocks that have the leadership and culture in place to drive an inflection point in ROIC and, in our experience, those companies adopting an 80/20 focus throughout the organization can create a pathway for value creation.
Detractors from Return
The three sectors that detracted most from the portfolio’s performance relative to its benchmark in the quarter were Materials (driven by selection), Financials (driven by allocation), and Energy (driven by allocation). Materials holding Summit Materials was a top detractor within the sector. The underperformance was not a result of the new management team’s execution or the company’s prospects for structurally higher ROICs. Rather, market sentiment turned negative on the company when it decided to acquire a large cement business, which carries lower margins initially, rather than purchase an aggregates business where margins have shown historically more stability. Our confidence has not wavered given that we know Summit’s management team well and the CEO has demonstrated success many times in her past, driving higher margins and, cash flows, and most importantly, higher ROICs. We believe Summit will execute on that same strategy with these new assets which should unlock significant value over the next several years.
Glacier Bancorp was the top detractor within Financials. After reporting its first quarter earnings, Glacier suffered as its net interest margin (NIM) contracted more than expected. When Glacier reported second quarter earnings it disclosed it did not expect NIM to bottom out until early 2024. The management team is modeling in two additional rate hikes by the Federal Reserve (which we do not foresee happening at this time), giving us insight into the conservative nature of the company. This leaves room for NIM to surprise on the upside and given Glacier has always been one of the strongest underwriters in the regional bank space, we feel it is still a valuable holding for the portfolio.
During the third quarter, the portfolio’s downside protection was not as strong as we would have liked it to be. Sectors traditionally thought to be defensive in nature (e.g., Health Care, Consumer Staples, and Utilities) underperformed thereby not providing downside protection this quarter. The ramifications of materially higher costs of capital are still working through the economy and companies alike, and this is without regard to sector. The importance of management teams being focused on ROIC versus cost of capital has been the cornerstone of our strategy since inception.
Whether there is a soft landing, hard landing, or no landing, the cost of capital being materially higher (nearing 10%) is the adjustment that many companies will be forced to address by bringing down outstanding debt and focusing on improving productivity of assets. Our companies have been doing just that in recent quarters, understanding that there is a time for leverage and a time to deleverage accordingly. As we look to the final quarter of 2023, we are starting to see relative value return to the market in the sense that there are more companies starting to have a favorable reward-to-risk ratio that we view as potential investments. We are hopeful this window of opportunity stays open far longer than it has in the last few years to a point that it can be measured in quarters instead of mere weeks.
Portfolio Breakdown as of 9/30/2023
|Health Care & Pharmaceuticals||4.4%|
|By Market Cap||Fund|