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U.S. Exception-alism

September 2021 Newsletter

U.S. Exception – alism

The U.S. stock market is the most valuable market in the world at roughly $46 trillion. Part of what has driven this very strong number is sterling performance. U.S. equities have outperformed those in the rest of the world in eight out of the last ten years. The U.S. stock market can often serve as the proverbial “North Star” for investors the world over. We’ve all witnessed the trading pattern where European markets travel aimlessly for most of the day, only to grab a meaningful direction once U.S. markets have opened and established the tone for the day. Given it’s current largesse and unrelenting outperformance, the U.S. stock market for good reason holds that “North Star” status today.

Of our two strategies at Ballina, only one, Global Small Cap Value, considers the U.S. as part of it’s remit. We never take a view on markets from the top down. Therefore, this massive force in global capital markets is not much of a focus for us. A deep market like the U.S., however, is fertile hunting ground for an active stock selector. There are bound to be stocks that are out of favor. When we began the strategies in late 2017, Global Small Cap Value had a strong presence in U.S. stocks with a little over 50% weight. Since then, the only direction has been down. By early 2019, the weight was in the low 40’s. In the Summer of 2020, it started dropping again, and landed at roughly 33% by the end of 2020. Today, the U.S. weight in Global Small Cap Value is just 24%. This still makes it the largest country represented in the strategy. We notice something even more stark as we run through our process on a daily basis in 2021.

The U.S. just doesn’t have that many good Small Cap Value opportunities right now. There, we said it. (We can’t opine on the relative scarcity of U.S. Large Cap Value ideas because they have never been part of our remit) We believe a few things are going on. 1) U.S. Small Cap Retail was flooding through our screens from 2017-2019. We owned several of these companies over that period. The volatility was stunning. However, the number of U.S. Retailers passing our screens is now reduced dramatically. Many have had dramatic increases since the worst of the COVID declines settled[1]. The market has clearly decided that these companies have made the proper adjustments to the new realities. 2) The U.S. continues to have companies delist or consolidate. The U.S. equity market has had a broad decline in the number of listed companies for many years[2]. We notice that more than a few of our U.S. listed shares, Waddell & Reed as one example, have been acquired. 3) Finally, we just think the market just may be overly optimistic about most U.S. small cap companies. We continue to scan for new U.S. ideas from our screens. When we do some work on the U.S. companies that are passing our screen, however, they do not appear attractive to us. And we notice that the U.S. stocks in the screens are increasingly of the “misfit toys” variety – For Profit Prisons, Guns, and Limited Partnership units. There are also quite a few U.S. Financials coming through the screens, and while we would not be prepared to describe Banks and Insurers as “misfit toys”, they haven’t exactly been “leading the dance” in the last decade. The obvious answer to what is going on here is that investors in U.S. equities are often discounting something more than what we would.

To explore this a little further, we collected some data. We reviewed the current forecasts for Sales and Net Margins, and compared these to the averages from the last five years. We did this for the constituents of the S&P 500, the Ishares Russell 2000 ETF, and the Ishares MSCI EAFE ETF, and we analyzed the Median results, in order to not let the size of the massive companies dictate the outcome. See results below. We had a few takeaways. 1) Margin expansion is broadly expected all over the world, 2) the margin expansion expectations are much more significant in the U.S., and 3) Sales growth rates are expected to expand, but the gains are expected to roll over for Small Cap U.S. companies in FY2 (in most cases FYE December 2022). Admittedly, there are a myriad of problems with the data: 1) Many of the U.S. companies that the sellside expect to keep churning out a significant improvement in FY2 are either commodity companies or Travel related companies. And this may be appropriate. 2) There is also the issue of timing. The benefits of re-opening are a bit more delayed Internationally than they are for much of the U.S. economy, and this may be impacting the FY2 Sales growth expansion for International companies we are seeing in the analysis. 3) It also appears that the Small Cap U.S. companies, many of which are more domestically focused than their Larger Cap peers, may be benefitting disproportionately from the sugar high of U.S. stimulus, thereby dampening their FY2 sales gains versus history. All that being said, there is support for one view that we see on almost a daily basis - U.S. companies are forecast to have unbelievable margins.

And the clear question is, is this reasonable? Unless you’ve been living under a rock for the past nine months, there is this open question of whether inflation is rampant and out of control in the global economy? Many companies are using this time to complain about the “unprecedented cost push” they are experiencing. See the U.S. Producer Price Index below. According to Factset, the latest earnings call from FedEx Corporation (“FDX”) achieved a Sentiment Score of -90 on the issue of Operating Costs (The metric only goes as low as -100). Now if an economic bellweather like FDX is struggling with supply chain and costs to that degree, some smaller U.S. companies are also going to have some issues. We at Ballina don’t have a strong view on whether these inflation pressures will be as enduring as has been suggested, but we are pretty certain that cost pressures don’t lead to margins that expand by 400-600 basis points versus history. Perhaps all these U.S. companies will push peak margins to much greater peaks? We just do not want to pay for that.

We also think it helps to look at the absolute figures, i.e. where the Median Growth and Margins for companies in our analyzed groups actually land under these forecasts. See Below. A few takeaways: 1) US Large Cap has a strong track record of profits and growth, and the market seems to very much expect this to continue, 2) US Small Cap has been remarkably unprofitable, yet with strong growth in the past, but the market seems to think that the good times are finally here as far as profits, and 3) International has a relatively solid, if unspectacular, past and projections. When you dig through the many U.S. Small Cap companies that are expected to move from a spotty record of profits to strong margins, you find quite a few Technology and Financial companies that have been losing money about 50% of the time. It could be that sellside analysts are trying to justify the improved stock prices of these companies by looking at the “glass half full version”. For us at Ballina, we do our work on a case by case basis. If we own something already, and the company and stock are doing well, we will try to look at the more promising scenarios. But there is a limit to our generosity. When it comes to a new stock, we are far from generous. And we believe this explains the falling weight in our Global Small Cap strategy. Circumstances have taken some U.S. positions out. And International stocks have been the more competitive replacements, with more sober assumptions underlying them.

Strategy Performance

International All-Cap Value returned 0.83% (gross basis) in September 2021 versus -3.45% for the benchmark. Year to date performance was 22.13% (gross) versus 6.83% for the benchmark.

Global Small Cap Value returned 0.85% (gross) in September 2021 versus -3.5% for the benchmark.[3] Year to date performance was 20.7% versus 11.57% for the benchmark.

Top Contributors and Detractors

International All-Cap Value’s top contributor in September was Banco de Sabadell SA. The Spanish Banking stock gained 17.43% as investors reacted positively to a Spanish banking sector that is cutting costs and consolidating. The strategy’s top detractor in May was Sun Hung Kai Properties, which declined 13.01%. The Evergrande debt crisis came to a greater pinnacle in September, and there was fallout for the stocks of all companies with Property exposure in China. As we sometimes do, we used our sell discipline to cut our losses on Sun Hung Kai, and have exited the position for the time being.

Global Small Cap Value’s top contributor in September was Alliance Resource Partners. The stock returned 25.3% in September, as investors reacted to the shrinking global coal inventories. The top detractor in the strategy for September was Hisense Home Appliances. The Chinese Appliance Manufacturer declined 19%, as investors are worried about domestic housing related demand, as well as supply chain and cost issues globally.

[1] The SPDR S&P Retail ETF (XRT) has returned 89.1% in the year to 9/21/21. [2] According to Wilshire Associates, the number of Wilshire 5000 stocks declined by 7% from 2015 to 2020. [3] Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)

The opinions expressed herein are those of Ballina and are subject to change without notice. Past performance is not a guarantee or indicator of future results. The information contained herein is not investment advice. You should not consider the information and commentary published herein as a recommendation to buy or sell any particular security. You should not assume that any of the securities discussed in the commentary published herein are or will be purchased for your account, or are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in commentary. Consider the investment objectives, risks, and expenses before investing.

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