Virtus Quality Small Cap Fund
3Q 2016 COMMENTARY
Small-cap value stocks had a strong third quarter, adding to the year’s gains. Technology and health care drove market performance as investors’ appetite for risk grew, while defensive sectors lagged, such as utilities and consumer staples.
Given the market trend toward higher risk, lower quality, the Fund with its high-quality focus lagged the benchmark in the quarter. Negative stock selection within producer durables and financial services was largely behind the underperformance, while the portfolio’s underweight to utilities was a positive.
The presidential election and prospect of a Fed rate hike in December will create some short-term uncertainty and headwinds for the market, but our outlook continues to be that the U.S. will grow over the next year at 1.5% to 2.5% in GDP, and that corporate earnings growth will drive equity returns of approximately 6% to 8% over the next 12 months.
Stock market returns were robust in the third quarter following a solid second quarter. Reduced investor anxiety over Brexit, better economic data, improved stability in the oil markets, and accommodative monetary policy worldwide helping propel markets to all-time highs. Small-cap value stocks, as measured by the Russell 2000® Value Index, increased 8.87% in the quarter, bringing the year-to-date return to 15.49%. Risk appetite continued to accelerate, with performance driven primarily by technology and health care, while the utilities and consumer staples sectors lagged.
In this favorable environment for lower quality risk assets, the Fund lagged the Russell 2000 Value Index during the quarter. The underperformance was driven primarily by negative stock selection in the producer durables and financial services sectors. Performance was helped by an underweight to the underperforming utilities sector.
Positions that contributed the most to performance in the quarter were Thor Industries and G&K Services.
Shares of Thor Industries performed strongly, driven by investor enthusiasm over the company’s early July 2016 acquisition of a rival RV manufacturer, Jayco, which is a leading player in both the towable-trailer and motorized-RV segments. The reasonably priced acquisition provides Thor with additional scale while expanding its fast-growing towable-trailer platform.
G&K Services rose sharply in mid-August following an announcement of the company’s acquisition by a larger competitor, Cintas, for $2.2 billion — a nearly 20% premium to the previous day’s closing price. With the shares trading at a level representing an insignificant discount to the acquisition price, we exited our position in the company during the quarter.
Positions that contributed the least to performance in the quarter were National Beverage and CEB.
With National Beverage’s shares price up meaningfully over the past year supported by the company’s consistent reports of robust top-line growth and profitability expansion, some selling pressure was evident in the latter part of the quarter. In addition, two days prior to quarter-end a short-seller released a report questioning the integrity of the management team, adding further downward pressure on the shares. We do not agree with key allegations presented in the short-seller’s report, while independent third-party sales tracking data gives us confidence in the fast-growing consumer demand for the La Croix brand.
CEB’s shares were weak, driven by the company’s reports of more cyclical-than-expected operating results. In addition, CEO Tom Monahan announced that he was stepping down after eleven years at the helm. Despite recent changes, we remain confident that the value of CEB’s products will be realized, resulting in strong product and customer growth over the long term.
PURCHASES AND SALES
Two holdings, Sally Beauty Holdings and Scott’s Miracle-Gro, were added to the portfolio during the quarter.
Sally Beauty Holdings is a beauty distributor and retailer. The company pioneered the hair color supply market. Over time, its mix has moved more strongly towards the retail consumer, where it has a plethora of strong private label brands. The company seeks to offer consumer professional quality products at a very attractive value. Sally’s business model is characterized by low capital intensity which results in solid free-cash-flow generation with the company consistently returning excess capital to shareholders in the form of opportunistic share repurchases.
- Scott’s Miracle-Gro manufactures and sells lawn and garden products. These products consist of four main brands: Scott’s (lawn care); Miracle-Gro (soil and plant food); Ortho (insect and weed killer); and Roundup (weed and crab-grass killer). Brand is important to many consumers as most only make one soil or one weed killer purchase each year. At a relatively low price point, consumers are willing to pay a little more for a superior brand that will work the first time. All four brands possess strong brand awareness and market share. This pervasive strength translates into pricing power.
We sold G&K Services (discussed earlier) during the quarter.
As we enter the final quarter of the year, we continue to face the uncertain outcome of the presidential election and the prospect that the Fed will raise interest rates slightly in December. This will create some short-term uncertainty and headwinds for the market, but we recommend staying the course for the long term. Investors have had plenty of time to process the election and the Fed’s outlook for the rate increase, so we do not believe either will have a meaningful impact on equity prices over the long term.
Our outlook continues to be that the U.S. will grow over the next year at 1.5% to 2.5% in GDP, and that corporate earnings growth will drive equity returns of approximately 6% to 8% over the next 12 months.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Limited Number of Investments: Because the fund has a limited number of securities, it may be more susceptible to factors adversely affecting its securities than a less concentrated fund.
Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund.
Prospectus: For additional information on risks, please see the fund's prospectus.
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