The Cambiar SMID Value strategy is an equal weighted portfolio with a starting universe of companies typically in the $2-$10 billion market cap range. The portfolio leverages Cambiar's tenured domestic investment team, who on average have over 21+ years of industry experience.
Andrew P. Baumbusch
Colin M. Dunn, CFA
|Top 10 Holdings||% Weight|
|Advance Auto Parts||2.9|
|Robert Half Int'l||2.9|
|East West Bancorp||2.6|
|% of Total||27.6|
|Market Cap Wtd Avg||7.5 B||4.7 B|
|Market Cap Median||6.4 B||1.1 B|
|Sector Weights||Cambiar||Russell 2500V|
|Risk Statistics*||Cambiar||Russell 2500V|
Market Review (3.31.2018)
The relatively unabated rally in U.S. equities that has been in place for the past two years hit a shallow divot in the first quarter, with the S&P 500 Index posting a return of -0.8% for the first three months of 2018. Stocks started the year on a strong note, with the S&P 500 gaining almost 6% in January – a record-tying 15th consecutive month of positive returns for this index. Equities then corrected by ~10% in February before recovering, only to repeat a similar sequence (though not to the same magnitude) in March. After a placid 2017 in which the S&P 500 registered just eight trading sessions of a 1% move (up or down) for the year, the market has already posted 23 such instances thus far in 2018.
Volatility – A New Paradigm or Return to Trend?
In considering the investment climate of 2018, a look back on market conditions in 2017 is helpful. Last year was in many ways a near-perfect environment for equity investors: a synchronized global economic expansion, continued low-interest rates, favorable corporate earnings, and generally positive economic and political developments. Entering 2018, change within the market was bound to occur – and as these somewhat inevitable shifts have emerged, so too has volatility. We believe the following considerations will play a role in market behavior during 2018 (and beyond).
Positive Real Interest Rate – Monetary policy has been the primary tool to promote the global recovery over the past ten years. With U.S. inflation levels running at close to 2% and with the economy having achieved full employment, the Federal Reserve is now raising rates back to a positive real number. Assuming at least two more rate hikes in 2018, the resulting Fed Funds rate in the 2.25% range would be a positive real rate of return for the first time this decade. As the debt and equity markets have become quite comfortable with an extremely low economic cost of capital, the withdrawal of monetary stimulus is bound to exert pressure on asset prices. While many have anticipated this eventuality, it would be naïve to believe that this process after such a long duration will be a smooth one. We believe the rise in interest rates as an explanatory variable for the rise in volatility exceeds most other factors.
Source: Bloomberg. Formula: US 3 Month Bill - PCE Deflator.
Quantitative Easing (QE) Programs Outside the U.S. are Reaching Their Limits – QE remains to this day a difficult concept to explain. While it looks like money printing, it is in fact the simultaneous creation of bank reserves and the removal of risk-free instruments from the financial system. The objective is to urge financial participants out on the risk spectrum. In this regard, the QE programs of both Japan and Europe have gone further than the U.S. Federal Reserve. In Japan, the vast preponderance of positive-yielding debt has been bought by the Bank of Japan (BOJ); the BOJ has subsequently expanded their purchase activity into the corporate debt equity (via ETF) markets. In Europe, the European Central Bank (ECB) is bumping up against ownership limits for sovereign issues. The result in both cases is a shortage of risk- free bonds of various durations, an essential source of collateral for interbank liquidity. The resulting reduction in liquidity makes longer-term currency hedging prohibitively expensive for market participants such as major Japanese and European manufacturers – and thus blunts the benefit of QE. We believe that Europe’s improved economic performance means that the ECB will begin exiting QE in 2018, and raising interest rates back into positive territory in 2019. Japan’s situation is uniquely complicated and we do not expect QE to end there in 2018; however, given that the QE program is leading to illiquidity and challenges in basic capital market functions, returns appear to be diminishing.
Tariffs and Trade Wars? – President Trump has shown a clear willingness to approach negotiations through a confrontational style, including the topic of global trade. Tariffs on steel and aluminum, and possibly on select Chinese manufactures, likely represent negotiating tactics to force some kind of “deal” or reconciliation. Even so, for this to be an effective tactic, there would need to be some willingness to implement stiff tariffs in certain categories, just to prove that these are serious threats. As such, there is some risk that these tariffs “reverse” key stimulative benefits of tax reform and the general economic momentum. Global trade linkages have become deeply integrated – broadly speaking, it would take a lot of regressive tariffs to rupture these relationships. At the margin, protectionist policy is not a favorable development. That said, Chinese IP theft, forced technology transfer, and domestic market protections are difficult to defend as reciprocally reasonable trade policies to tolerate in the long term. Outside the U.S., the EU has proposed a transaction tax on internet businesses, reasoning that these are disruptive to local economies and tend to channel revenue and profits into the cloud and the most favorable tax jurisdictions. With locally sourced “profits” difficult to quantify, the EU may tax revenue. Taken in isolation, these may be reasonable responses to the negative externalities posed by online businesses. As it happens, these are mostly U.S. companies and the largest ones in the global stock market, and they may earn less money than would otherwise have been the case.
Market Structure – Global equity market ownership is vastly different from the pre-GFC timeframe. Index funds, sector ETFs, and quantitative strategies have come to predominant markets, in some cases owning an outright majority of certain stocks and their free floats. On the other side of the markets, active managers have vastly less firepower to deploy as prices move. The consequence is that small fluctuations in market flows can lead to outsized stock price moves. Not unlike the unintended consequences of QE detailed earlier, true stock market and individual stock price liquidity (i.e., the amount of money needed to move a stock price) is lower today than in the past.
The Cambiar SMID strategy (SMID) posted a positive return in the second quarter versus a 2.7% decline for the portfolio’s primary benchmark, the Russell 2500 Value Index. While the objective of the SMID portfolio is to outperform in all market environments, the strategy’s capital preservation in a down market is particularly more gratifying for many investors vs. outperforming in up markets.
The pullback within small-mid value equities was broad-based in scope, with all but three sectors (health care, financials, and technology) in the index posting negative returns. While most stocks thus finished in the red for the quarter, the losses were fairly contained at the sector level – with energy and real estate the notable laggards (each sector returning -8% in 1Q). In a continuance of what has now been a multi-year theme, sectors/companies more associated with growth outperformed, while value again lagged.
Trade activity in the quarter included four new buys and six liquidations. The net result at a sector level was a modest increase in pro-cyclical sectors such as industrials, energy and materials. On the sales side, a number of liquidations were a result of holdings reaching their upside price targets – i.e., the ‘good sale’. One example is XL Corp, which is discussed below. The portfolio ended the quarter with a cash position of ~8%, which we anticipate will be worked down in 2Q as pipeline ideas reach actionable attachment points.
Security selection within the financial services sector provided the largest contribution to Cambiar’s outperformance in the quarter. Rising interest rates have begun to provide a tailwind to financial stocks after years of substantially low-interest rates made positive net interest margins difficult to achieve. Valuations within the sector remain reasonable, and Cambiar’s bank holdings have strong capital positions that can be used to grow their book value and/or return capital to shareholders. The portfolio’s top performing name during 1Q was XL Group, which was acquired by AXA in a $15.3 billion, all cash deal. This was clearly an attractive price for XL shareholders in the short-term, and Cambiar exited the position upon the announcement of the acquisition.
Cambiar’s holdings within the technology sector were a strong contributor to the strategy’s outperformance in the quarter. Representing approximately 19% of the portfolio as of quarter-end, technology comprises the largest sector in the SMID strategy, and is a sizable overweight relative to the approximate 9% allocation in the Russell 2500 Value Index. While tech companies are often associated with higher beta/valuation investment profiles, Cambiar’s technology positions provide diverse exposure to a wide range of endmarkets - management consulting/engineering services, government IT services, airline/hotel reservation software and internet media.
One sector where SMID struggled for the quarter was energy, as Cambiar’s positions lagged the benchmark (after outperforming in 2017). While not attempting to be contrarian in our view, Cambiar believes that the negative sentiment toward energy stocks is misplaced. Global oil demand remains healthy, and an increased focus on improved returns/fiscal discipline at the corporate level should result in a more measured supply response from U.S. producers. Valuations within the sector reflect the market’s pessimism – on an absolute basis, as well as relative to many other more expensive areas of the small-mid cap universe. At a holdings level, RPC Inc. was a notable detractor in the quarter; the oilfield services company declined after a disappointing earnings report due to a slowdown in spot market activity. We anticipate that well activity will increase for RPC in the coming quarters, and the company’s strong balance sheet and dividend yield is viewed as an additional backstop. Lastly, RPC’s footprint in the highly-regarded Permian basin is another tailwind for the company.
The SMID strategy posted solid gains within the consumer discretionary and materials sectors, which were somewhat offset by below-benchmark returns in consumer staples and healthcare.
From a positioning standpoint, the SMID strategy remains well diversified, and Cambiar continues to emphasize diversity in return drivers as part of the portfolio construction process. Given the high leverage that exists within a significant percentage of the small-mid cap universe, a continued emphasis on free cashflow and balance sheet strength within our companies remains a priority. The portfolio’s modest cyclical tilt is primarily a function of exposure to technology, consumer discretionary and industrials. Conversely, traditional defense via exposure to rate-sensitive sectors such as real estate and utilities may be less effective, given that we are in the midst of a Fed tightening cycle. We anticipate the uptick in volatility to be a precursor for the balance of 2018, and should provide attractive entry points along the way.
What does the balance of 2018 hold for equity investors? An old Wall Street axiom is ‘So goes January, so goes the year’. Will this saying ring true in 2018? It is worth noting that in all the years when the S&P 500 rose more than 5 percent in January, the full-year return has never been negative (the S&P 500 returned 5.7% in January).
The increase in market volatility should not be misconstrued for an imminent decline in stocks. Equities continue to have a number of tailwinds – including solid GDP growth, strong corporate profits, and an additional boost via last year’s tax reform bill. Yet unknowns in the form of a new Fed Chair and the pace of additional rate hikes, a possible escalation in tariff/trade barriers, and continued personnel turnover within the Trump Administration may make for a bumpier ride within the equity markets.
As discussed in our 4Q commentary, Cambiar believes that security selection will take on increased importance in 2018, in contrast to a ‘set it and forget it’ passive investment approach. While advocating active management is an admittedly self-serving recommendation, we are encouraged that we have been able to validate this view via solid investment returns across Cambiar’s domestic strategies.
Quarterly Top & Bottom Contributors
|Top Contributors||Avg. Weight||Contribution||Bottom Contributors||Avg. Weight||Contribution|
|XL Group||1.87||1.40||Aqua America||2.30||-0.32|
|Advanced Auto Part||2.80||0.47||TreeHouse Foods||1.99||-0.51|
|RSP Permian||2.04||0.34||RPC Inc||2.21||-0.77|
A complete description of Cambiar's performance calculation methodology, including a complete list of each security that contributed to the performance of the Cambiar portfolios mentioned above are available upon request. Please contact Cambiar at 1.888.673.9950 for additional information. Past performance is no guarantee of future results.
Certain information contained in this communication constitutes “forward-looking statements”. Due to market risk and uncertainties, actual events or results, or the actual performance of Cambiar’s client accounts may differ materially from that reflected or contemplated in such forward-looking statements. All information is provided for informational purposes only and should not be deemed as a recommendation to buy the securities mentioned. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the portfolio will continue to hold the same position in companies described herein, and the portfolio may change any portfolio position at any time. The specific securities identified and described do not represent all of the securities purchased, sold, or recommended by Cambiar and the reader should not assume that investments in the securities identified and discussed were or will be profitable.