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Chip Rewey's Rewey Asset Management 4th Quarter Shareholder Letter

- By Holly LaFon

Dear Friends and Clients,


The fourth-quarter 2018 ended with a whimper. The Russell 2500 Value index (small/mid-cap) declined by 17.14%, the Russel 2000 Value index (small-cap) declined 18.68% and the S&P 500 declined by 13.52%.1


In our opinion, the market retreat was fueled by three key investor concerns.


  • First, the Federal Reserve raised their target interest rate another 25 basis points on December 18th, marking the fourth such raise in 2018 and the ninth raise this cycle. The Fed commentary that accompanied this release suggested that since economic conditions currently remained favorable, one to two more rate hikes were likely in 2019 and "quantitative tightening", allowing its portfolio of bonds to mature without reinvestment, would continue. The market began to worry that the Fed was acting too aggressively, and might even bring about a downturn in the business cycle.




  • Second, trade concerns also buffeted the market. Although the December 31st deadline for increased China tariffs was delayed by 90-days, investors grew nervous about the lack of progress on an actual deal and feared the extra time would be insufficient to solve such a complex problem.




  • Third, investors grew concerned about the potential for more uncertainty and gridlock out of Washington. Mid-term elections gave democrats control over the House, a number of senior-level members of the Administration departed, and the government ended the year under a partial shutdown.





In reality, none of these concerns were actually new, but taken collectively however, investors became skittish. The Fed forecast was not new, and in fact, was watered down both in tone and direction from prior forecasts of as many as four potential hikes in 2019. The mid-term elections historically are periods where the incumbent party loses seats and the democrats were widely expected to win the House majority. Finally, Trump's administration has been unconventional since his candidacy was declared, and has continually experienced high turnover among senior ranking officials. Regardless, where the stock market is concerned, 'it matters when it matters' and these concerns provided the impetus for a 4th quarter pullback following the strong market performance earlier in the year.


We also believe the 4th quarter market decline was amplified by computer driven, or quantitative trading strategies, which have gained prominence with the rise of exchange-traded funds and quantitative hedge funds. Quantitative strategies often accelerate one-directional moves in the markets as part of their trading patterns and we believe we saw this impact in the quarter, as selling pressure accelerated on weakness and valuation did not seem to be a factor.

Looking forward, we believe quantitative trading strategies will continue to drive dramatic market swings over shorter time frames. Our philosophy however will not change and remains focused on buying only at discounted valuations and selling at full value. Our strongly researched investment cases and targeted levels for buying and selling, in our opinion, will be critically important to take advantage of opportunities created by these market swings. Instead of chasing the momentum, we will patiently wait for valuation driven opportunities, and act with conviction when they arise.


It Matters When It Matters


Our notion of "it matters when it matters" is foundational to the three fundamental pillars of our investment philosophy: i) a strong financial position, ii) companies that can grow profitably, and iii) a purchase discount of at least 30% from our estimate of appraised fair value. By focusing on these three pillars, we look beyond both short-term periods of over confidence and fear. Our investment philosophy and our investment process, based on both financial statement analysis and appraisal of a company's strengths and weaknesses, yields an investment decision rooted in clarity, with a target ownership period of at least three to five years.


While we will of course follow and analyze changes in the macro narrative including interest rates, economic strength and government policies, we do not need to constantly re-think our investment cases based upon shifting short-term concerns. Our investment cases are based on company-specific fundamental factors, and do not depend on ever-changing economic or policy factors. Our valuation process builds in a margin of safety to our investment cases which captures the short-term volatility that always exists in some form.


Portfolio Highlights


As expected, we looked through the high level of negative sentiment in the market and opportunistically increased our ownership position in many of our portfolio names, including LKQ Corporation, Eagle Materials and Ultra Clean Technologies. We also initiated several new holdings, including Milacron Holdings, Interfor, and Lincoln National Corp.


At the end of December, we held 21 positions in our model portfolio and were just under 95% invested, with a residual 5.1% in cash.2 The average price earnings ratio of the owned companies in the portfolio is compellingly low in our opinion, at a price/earnings ratio of 9.5x based off Bloomberg estimates.3 Another measure of valuation that is attractive is the price to book ratio of 1.53x, or 1.08x excluding the health care names of Trinet and Cerner. Moreover, eleven of the portfolio names trade under 1.0x book value.4

Milacron Holdings


Neglect, manifested as investor misunderstanding, can be a powerful driver of value investing opportunities and we believe Milacron is an excellent example. We believe investor perception of legacy Milacron (MCRN), stands in sharp contrast to its current structure, its earnings and its recurring free cash flow levels.


Milacron is a $827 million market-capitalization company based in Cincinnati, OH. Many investors remember the 'old' Cincinnati Milacron that went bankrupt in 2009. Memories can be long and we believe the tainted memory of this predecessor company still dominates investor perception.


Through its bankruptcy period, Milacron cut both costs and debt, and in 2012 was sold to CCMP Capital, a private equity firm. CCMP continued to cut costs and reorganize the company, most dramatically by completing the Mold Masters hot-runner acquisition in 2013. The Private Equity firm no longer maintains an ownership stake, following their 2015 initial public offering and 2017 secondary offerings.


Today, the 'new' Milacron operates in 3-segments. It makes plastic blow molding and injection equipment, it produces plastic hot runners, highly technical components tied to new product introductions, and it has a fluids unit that makes lubricants and coolants for industrial processes. Management estimates that over 65% of Milacron's sales and 85% of its EBITDA are based on recurring industrial activity as opposed to capital goods orders. Milacron has over 27,000 customers and sells into diversified end markets including packaging, consumer goods, electronics, healthcare and automotive, where light weight applications, such as plastic bumpers, are gaining market share.


Milacron has a strong financial profile across its income statement, cash flow statement and its balance sheet. Its adjusted 3Q18 year-to-date financial margins of 18.5% show dramatic improvement since its 2015 IPO, and are forecast by the company to grow to over 20% by 2020. Management projects its


2018 free cash flow to be $80 million, including $55 restructuring expense to move German production to India, setting up management projections for 2019 of $120 million in free cash flow. This represents a 14.5% free cash flow yield at year-end 2018 market value. Income and free cash flow should continue to grow due to sales growth, as plastics continue to take share in manufacturing, in expense reduction as Milacron matches its production footprint with global sales, and through the utilization of its $136 million U.S. net operating loss carryforward. Milacron's balance sheet remains strong, with management reducing debt by $100 million in 2018, and likely more in 2019. Moreover, all of its debt is termed out to 20235.


Our $22 AFV target represents 85% upside over year-end closing price of $11.89, and is conservatively derived from triangulating a targeted 8% free cash flow yield, 9x EBITDA and 11.5x PE ratio based on our modeled 2019 estimates6. These ranges are within recent trading ranges for Milacron and can be considered conservative due to the operational, margin and balance sheet improvement of the company. Additionally, our target looks very conservative when compared to 10-K named peer companies such as Barnes Group, Quaker Chemicals, Graham Corp. and Fuchs (Germany), which trade at significantly higher multiples despite similar, if not lower, profitability levels.7


Connecting the Dots to Interfor


Investor fear and neglect also ran rampant in the housing sector, despite actual data that implies the sector remains healthy. Housing starts, provided by the U.S. Census Bureau, came in at an annual pace of 1.256 million for November, 1.217 million for October and 1.237 million for September, continuing a slow but steady improvement since 2009, still below levels from 1993-June 2007, and significantly below the September 2005 peak of 2.15 million.8 Mortgage rates also softened into quarter-end, a positive for housing, finishing with the December 14th Mortgage Bankers Association 30-year contract rate at 4.96%, almost unchanged from the September 28th level of 4.94%.9 Despite this steady data, our Lennar B position sold off from $38.50 on September 28th to close the year at $31.33. Our conviction in our investment case in Lennar remains solid, bolstered by the November 30th sale of its Rialto Investment and Asset Management business for $340 million, which further de-levered their balance sheet and continued the progress to become a pure-play home building company.


Very often, investment ideas come from continued research on our owned portfolio companies. Our work on Lennar allowed us to connected the dots and identify Interfor (IFP.TO). The company is a $728 million market cap manufacturer and marketer of lumber and logs. While based in Vancouver, B.C. and traded on the Toronto exchange, it is the fourth-largest lumber company in North America and has 78% of its sales and 66% of production capacity in the U.S., which aligns with our criteria of having substantial U.S. operations.


Interfor has transformed itself since 2013, acquiring its dominant Southeastern U.S. production portfolio which now represents over 45% of its production capacity, anchored by its cluster of 7 mills in Georgia and one in South Carolina. Since year-end 2015, Interfor has reduced its net debt position by $327 million, to a zero net debt level, and built a strong balance sheet which is also free from legacy employment or other obligations. Looking forward, Interfor has shifted its growth ambitions in the U.S. from acquisition to organic capital driven improvement, with plans for incremental production capacity of 425 million board feet, or over 30% from 2019-2021.


In our opinion, CEO Duncan Davies, who has been with the company since 1998, and his team have been excellent allocators of Interfor's capital, a key criteria that defines a top management team. In the fourth-quarter, Interfor again demonstrated capital discipline, when it announced it was indefinitely deferring plans for a new greenfield production facility in the Southeast U.S., as the market-demand environment currently does not support its 20% return on capital investment threshold. Instead, the company announced that it had doubled its share repurchase authorization, by adding 3.4 million shares to the mandate, bringing the program's capacity to 10% of its market capitalization. As Interfor shares, in U.S. dollars, sold off from a high of over $21 in June 2018 to less than $10 at December lows, we think this more aggressive repurchase plan is not only prudent but timely. We believe that repurchase activity should only be undertaken when returns meet or exceed the returns on invested capital for internal investment or M&A, and that companies that repurchase shares at peak valuations are not effectively allocating capital.


Interfor shares closed under $10 on December 18th, that day of the accelerated repurchase announcement, representing a compelling value in our opinion, as it was trading under its September 30th 2018 book value of $11.06, at an approximate P/E of under 7x and an EV/EBITDA ratio of under 3.1x on Bloomberg 2019 estimates5.

Part of the misunderstanding impacting Interfor's valuation, in our opinion, is a belief that its lumber sales are entirely linked to new housing starts, which are cyclical. The above chart, sourced from Interfor's December 2018 update and Forest Economic Advisors (FEA), shows that U.S. housing starts remain well below the 2005 cycle peak levels. Further, as shown, new housing demand in 2018 as a percentage of U.S. lumber usage was approximately 31% of total lumber use, with the less cyclical Industrial and Repair and Remodel segments dominating the end use of lumber at 69% of U.S. demand.

Thus, with a net-debt free balance sheet, compelling long-term organic investment opportunities, positive long-term demand growth forecasts and a management team that is skilled in capital allocation, we believe Interfor represents a compelling addition to our portfolio, with 60% upside versus its 2018 closing price of $10.58 to our 2019 AFV estimate of $176. This AFV estimate incorporates 2019's anticipated lower market lumber prices versus 2018 peak levels. If lumber prices recover over time, as we expect, our target would be significantly higher.


Lincoln National Corp.


We initiated a position in Lincoln National Corporation (LNC), a financial services company based in Radnor, PA. Lincoln is an originator and distributor of Life Insurance, Annuities, Disability and Dental Insurance and other services.


Lincoln has, in our opinion, been under earning its full potential for several years due to the low interest rate environment, as the bonds maturing out of its investment portfolio are replaced with lower yielding securities. With further moderate rate increases projected by the U.S. Federal Reserve, management estimates that by the year 2020 this spread pressure will completely abate.


Lincoln has done an excellent job from a management perspective as long-time CEO Dennis Glass has excelled at capital allocation and bolstered its product offerings, by introducing market indexed annuity and variable life insurance products, which as a category, has grown in demand. Additionally, the May 2018 acquisition of Liberty Life Assurance of Boston should not only provide the tailwind of a targeted $100 million in cost reductions, but also increase market exposure and distribution into morbidity (life) products, building on Lincoln's established strength in income-protection products.


Undoubtedly, the most compelling and most confusing aspect for Lincoln in the fourth quarter was the market reaction to the December 10th announcement that Athene would reinsure a $7.8 billion fixed annuity portfolio. Lincoln will keep 20% of the block and retain the administration and record keeping for the accounts, i.e. it will keep its customer facing relationships. Lincoln also announced an immediate an ASR, or accelerated stock market repurchase of $500 million with the proceeds, which represents roughly 5% of its market cap. Management noted this deal would be accretive to 2019 EPS, and we applauded the deal, as it freed up trapped capital to opportunistically repurchase shares a discount to book value.


Interestingly, LNC shares traded off post this announcement from about $55.33 upon announcement to $51.22 at year end, or .73x book value as of 9/30/185. This is a clear-cut example of the impact of broad-based quantitative selling on all stocks regardless of valuation or fundamentals. The positive for shareholders, due to this price decline, is that the company's ASR was likely active at much lower prices than deal announcement, leading to a greater number of shares repurchased and greater earnings accretion.


Our AFV price target of $80 is just over 1x mid-year 2019 book value and 8.5x EPS based on our estimates, and represents compelling upside potential of more than 55% above its year-end closing level of $51.306. Although we were early in our initial purchases, with our average cost around $62 per share2, we strongly believe Lincoln represents a compelling opportunity today.


Looking Forward


We expect the markets to continue a volatile path into mid-2019, as there is still considerable uncertainty around trade policy, federal reserve rate policy, U.S. economic strength and the unconventional approach of the current administration. The market in the short-term is an auction, and uncertainty prevents the efficient match up of sellers with buyers, especially in an environment where computer driven trading can overwhelm natural buyers or sellers.


While the markets do not like uncertainty, it does provide an excellent opportunity to identify securities that are misunderstood and undervalued. Our long-term investment philosophy allows us to look past current uncertainties and sentiment, with an understanding that the current market prices are not an efficient mark of value. We do not try to time the resolution of negative market sentiment, but rather to uncover companies with fundamental strengths that are currently undervalued, which will likely emerge over our investment horizon to provide clarity and drive higher prices.


Thank you for your continued trust and support. Please do not hesitate to contact us for client service, to discuss our commentary or to just opine on the market and stocks.


-Chip


1 Index performance levels are sourced from Bloomberg.


2 All portfolios are based off our model portfolio. Individual portfolios may hold slight deviations in position sizes and names held due to reasons including tax loss selling and our philosophy of investing newer portfolios over time.


3 Bloomberg 2019 earnings estimates as of 12/31/2018 for FY 2019, and excluding KCLI as no Bloomberg estimate published.


4 Book value estimates based of company documents, SEC filings and Bloomberg reporting for period ending 9/30/18, or most recently reported fiscal quarter.


5 Historical stock prices and financial information sourced from Bloomberg.

6. Projections are estimates sourced from Rewey Asset Management proprietary analysis.

7. Peer company financial statistics sourced from Bloomberg and Bloomberg consensus estimates.

8. Source U.S. Census Bureau data as reported by Bloomberg

9 Source Mortgage Bankers Association data as reported by Bloomberg


Advisory services offered through Rewey Asset Management, a Member of Advisory Services Network, LLC.


All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results. All views/opinions expressed herein are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. These views/opinions are subject to change without notice. The information and material contained herein is of a general nature and is intended for educational purposes only. This does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. There is no assurance that any securities discussed herein will remain in the portfolio at the time you receive this report or that the securities sold have not been repurchased. Securities discussed do not represent the entire portfolio and in aggregate may represent only a small percentage of the portfolio's holdings. Before investing or using any strategy, individuals should consult with their tax, legal, or financial advisor.

This article first appeared on GuruFocus.