Market highlights
US stocks were broadly lower in September, as investor sentiment was seemingly weighed down by several developments, including higher interest rates, rising gasoline prices, a strike by auto workers and the resumption of student loan payments. The broad market S&P 500 Index fell -4.8% for the month.
At its September meeting, the US Federal Reserve (Fed) voted to hold the Fed Funds rates steady, noting that more hikes were possible and that rates could stay higher for longer than previously expected. Inflation data were mixed, according to the most recent monthly figures from the Bureau of Economic Analysis. The Personal Consumption Expenditures Price Index (PCE) was up 3.5% in August from a year earlier. The Core PCE, which excludes food and energy prices, was up 3.9% in August. The US personal savings rate ticked lower in each of the past three months. At 3.9%, the current savings rate is now well below its long-term average of 8.8% as consumers continue to draw down excess savings derived from pandemic-era stimulus programmes (source: Bureau of Economic Analysis).
Performance and attribution
In September, the PrivilEdge – Delaware US Large Cap Value posted a negative total return of -5.3%, underperforming the Russell 1000 Value Index’s -3.9% loss.
At the portfolio level, stock selection caused the largest drag on relative performance. Sector allocation had a modestly negative effect. Stock selection in consumer staples, information technology (IT) and industrials detracted the most from relative returns, partly offset by stock selection in healthcare and financials. The portfolio’s underweight position in energy was the leading detractor in terms of sector allocation.
Discount retailer Dollar General Corp. (Dollar General) was the leading detractor in the portfolio for the month, down -23.6%. Dollar General’s shares traded significantly lower after the company reported quarterly results in late August 2023 and remained under pressure in September. The group’s sales and earnings per share (EPS) came in below expectations as the sales mix (increasingly skewed towards lower-margin consumables), shrink (i.e., theft) and inventory markdowns drove profitability lower. The company also lowered its guidance for the full year, citing inventory-reduction efforts, expectations for higher shrink and softer sales trends as key drivers. In addition, Dollar General announced an additional 170 million (mn) US dollars (USD) in incremental investments (adding to the USD 100 mn announced earlier this year) to support labour productivity, more competitive pricing and inventory reduction. Its weaker-than-expected quarterly results, lowered full-year guidance and missteps around inventory management are disappointing to us, especially as this was the second consecutive quarter of weak results and revised guidance. That said, the team believes the company is taking the appropriate and necessary steps to improve traffic and profitability and that its business is not structurally impaired.
Aerospace and defence company RTX Corp. (formerly Raytheon Technologies Corp.) was another significant detractor in the portfolio, declining -16.4% in September. The stock traded lower following the company’s earnings announcement for the second quarter (Q2) of 2023, in which it disclosed that part of its GTF jet engine fleet (manufactured by its Pratt & Whitney subsidiary) needed accelerated removals, enhanced inspections and heavy overhauls due to potential problems with a material used to manufacture certain engine parts. This affects approximately 1,200 GTF engines in the current fleet of 3,000. The company will be removing engines from the fleet for inspections and overhauls likely through the middle of next year. Currently, the market cap decline in RTX’s stock since the GTF announcement (equal to about USD 30 billion [bn]) appears to be significantly higher than the company’s projected all-in cost of remediation. That said, it is still early going, in our view, as full remediation – including customer compensation for grounded planes – is expected to play out over the next few years. As a team, we are still in the process of collecting and analysing relevant data. As new information comes in, we will evaluate the company’s prospects and the risk-reward profile of its stock in the context of other investment opportunities.
CVS Health Corp. (CVS), a provider of health insurance, pharmacy benefit management and retail pharmacy services, was a leading contributor, gaining 7.1%. During the month, CVS reaffirmed its full-year guidance for both EPS and cash from operations. CVS’s shares have been under pressure for much of the year. In the team’s view, the selling has been overdone, especially given the company’s consistent cash flow generation and discounted valuation – a price-to-earnings (P/E) ratio of 8.1x next fiscal year’s earnings. In September, the stock received upgrades from two Wall Street analysts that cover the company.
Global insurance provider American International Group Inc. (AIG) was a strong contributor, up 4.2%, outperforming the financials sector in the benchmark. In general, insurance stocks held up relatively well compared to banks, credit card companies and other more credit-sensitive groups within the sector. While higher interest rates have a negative mark-tomarket effect on insurance company investment portfolios, insurers generally see a longer-term benefit from higher reinvestment yields. A firming property/casualty pricing cycle also appeared to benefit companies such as AIG.
The team completed a full-position sale and purchase during the month. They sold the portfolio’s position in Broadcom Inc., a leading global technology company that develops semiconductors and infrastructure software; the team had added a position in Broadcom to the portfolio in early 2019. At the time, Broadcom had recently completed its acquisition of enterprise software developer CA Technologies – a transaction that surprised the market (it was Broadcom’s first foray into software) and led to a meaningful decline in Broadcom’s stock price. While the shares eventually retraced their losses, their valuation remained attractive, in the team’s view. The stock scored in the second-cheapest decile in the team’s opportunity screen and offered a dividend yield of 4.2% following a 51% increase in payout in the previous quarter. They saw Broadcom as having appealing balance sheet and cash flow characteristics. The company expected to distribute 50% of free cash flow as dividends, with the remainder directed towards share buybacks, opportunistic acquisitions and debt repayment. At the portfolio’s purchase price, the stock offered a free cash flow yield of approximately 8%. Broadcom’s stock price more than tripled during the portfolio’s holding period, with much of the stock’s rise occurring in 2023. The company’s offerings include products that support artificial intelligence (AI) technology, and strong investor enthusiasm for companies exposed to AI contributed to the stock’s surge. From a valuation perspective, Broadcom looked fully valued to the team. The shares were trading at 20.2x next fiscal year’s earnings – a 35% premium to their five-year average and near an all-time high. Broadcom’s stock price was also near its all-time high. In the team’s opinion, a lot of good news was already priced into the stock and its long-term risk-reward profile was no longer attractive to the team. In addition, the team believes there is the potential for key-man risk should the CEO decide to step down, as well as the possibility of execution risk associated with Broadcom’s impending acquisition and integration of cloud infrastructure provider VMware Inc.
Proceeds from the sale of Broadcom were used to purchase a 3% target weight position in Teledyne Technologies Inc. (Teledyne). Teledyne is an industrial technology company that operates in diverse end markets that include factory automation and condition monitoring, aerospace and defence, air and water quality monitoring, electronics design and development, medical imaging and pharmaceutical research, oceanographic research and deepwater energy (E&P). The company’s products often have mission-critical applications, and many operate in extreme conditions, such as underwater or in space. Teledyne has historically had a core competency in acquiring and effectively integrating businesses.
In January 2021, Teledyne announced the acquisition of FLIR Systems Inc. to expand its presence in digital imaging (a market the team believes has attractive growth potential). The USD 8 bn deal was Teledyne’s largest to date. The acquisition of FLIR closed in May 2021. In Q2 2022, Teledyne reported total company margins that were approximately 1 ppt below consensus estimates, driven primarily by challenges in the digital imaging segment. At that time, the company was facing difficulty securing digital imaging product components owing to supply chain issues. As a result, Teledyne’s share price moved lower and remained under pressure for much of the year. Despite its history of frequent mergers and acquisitions, Teledyne tends to maintain sound balance sheet fundamentals – its net debt-to-EBITDA target range is 1.5x to 2.0x – and generate consistent levels of free cash flow (its free cash flow margin has averaged 13% over the past five years). Other key attributes that made Teledyne an appealing long-term investment included:
• Attractive valuation: At the time of purchase, the stock’s P/E ratio was 20.1 based on next fiscal year’s estimated earnings, below its five-year average of 29.1. The stock also traded at a five-year-low P/E relative to the S&P 500 IT sector.
• A well-regarded management team: Our research found that Teledyne’s management tends to get high marks from investors given its history of providing reasonable guidance and exceeding expectations. Management’s visibility into the company’s end markets and the drivers of profitability in each business allow for consistency in operational results.
• Disciplined capital allocation: The company has a history of acquiring margin-accretive businesses. Teledyne targets a margin increase of 50 basis points (bps) each year and a cash return of 10% over three years for each of its acquisition targets (1 bp is a hundredth of a percentage point). In addition, the company primarily uses free cash flow to fund acquisitions and pay down debt. Overall, we viewed Teledyne as a differentiated, high-quality company in the IT sector, with an attractive relative valuation and sound balance sheet attributes. Our sale of Broadcom and purchase of Teledyne left the portfolio’s target weight in the IT sector unchanged at 15%
Outlook and positioning
The portfolio’s performance has been disappointing this year, having lagged the benchmark and peer group by a large margin. Several factors have contributed to this: the significant outperformance of large-cap growth stocks, the portfolio’s more defensive positioning and ongoing pressure on the Fund’s regional bank holdings since the remise of Silicon Valley Bank, Signature Bank and First Republic Bank during the spring. In addition, the team has had several other holdings that have not performed as expected. The team has reviewed the fundamentals of these businesses, and with the exception of RTX, which is still under review, they believe the businesses are structurally sound. While the team is not happy with the way they got here, they believe the portfolio’s positioning is especially strong right now. 11 stocks (a third of the portfolio) trade at a discount of at least 15% to their five-year average P/E ratios. The portfolio’s P/E based on next fiscal year’s estimated earnings is 13.4 compared with 14.5 for the benchmark and 19.3 for the broad market S&P 500 Index. Meanwhile, the portfolio’s cash flow return on invested capital (ROIC) is 9.4% compared with 4.4% for the benchmark. Looking at debt relative to EBITDA, the portfolio’s net debt/EBITDA is 2.0 compared with 2.2 for the benchmark (source: FactSet, as of 30 September 2023).
We believe the full effects of the Fed’s aggressive rate hikes on the economy and corporate profits still lie ahead. Historically, an inverted Treasury yield curve and increasingly tight bank lending standards have led to more challenging economic and market conditions. In the team’s view, a discounted portfolio of companies with higher-quality attributes represents a compelling offering in the current environment, with the potential for downside protection and attractive long-term total returns (see below for important information about investing risks).
Source: Delaware Investment Advisers
