As we write this letter in mid-October, with the Russell 3000 Value down 5.6% in the third quarter and down 18.0% year-to-date, it’s hard to believe that the third quarter began with a 11.5% rally through mid-August. Decent earnings reports in July, moderating commodity prices and stable U.S. consumer spending all provided relief. The mood changed quickly as the Federal Reserve telegraphed their commitment to quantitative tightening: over the last six weeks of Q3, rates rose at one of the fastest clips in history, creating a myriad of financial impacts in their wake. After years of rising housing prices and strong demand, both have declined in recent months as mortgage rates hit 15 year highs. Corporate mergers and acquisitions are grinding to a stop as debt is no longer cheap and sharp declines in equity prices have left companies without a currency to purchase assets. Earnings multiples have reset lower as future growth is discounted at a higher rate, and investors are clinging to cash.
Commodity prices continue to rise. Recently OPEC+ approved a two million barrel a day decrease in production, just as Strategic Petroleum Reserve releases wind down and against a decades long backdrop of retiring refining assets globally. Natural gas prices also remain elevated as the European Union built expensive stockpiles in preparation for a winter without Russian gas.
On the consumer front, pandemic stimulus ended last year but demand for goods and services is still healthy – so far. Consumer balance sheets are strong and credit trends remain benign for now. Unemployment levels remain low, with some companies reporting that labor remains tight. Supply chain issues from earlier this year are abating but inventories are too high. Inventory liquidation in the fourth quarter could become a headwind to rising prices.
With consistent messaging from its members, for now, the Fed seems resolute on future rate hikes. We believe that until we see several sequentially moderating Consumer Price Index reports, the Fed will keep raising rates. With a history of being too late with monetary policy, it is quite possible that rates will be too high for too long.
With this economic backdrop, we believe that that corporate margins may have peaked. We expect significant earnings revisions through earnings season as well as conservative 2023 guidance. Most areas of the market now assume the U.S. economy will be pulled into a global recession in the next 6-9 months. The length and depth of that recession will depend upon many factors, including the resilience of the consumer, the ability of wage growth to offset inflation, fiscal and monetary policy decisions, the strength of consumer and corporate credit and geopolitical developments. With higher interest rates pushing bond prices lower and equities selling off, there are few places for investors to hide.
In this stock picker’s market, we may be witnessing a renaissance for the active management of stocks. Recall that the S&P 500 has been long dominated by large growth companies, mostly in Information Technology, Consumer Discretionary and Communication Services, in part due to the low interest rate environment. For over 15 years, a simple passive investment in the index provided the best return because of the performance of those top names. Today, we sit with the S&P 500 down more than many active managers and more than the value-based style indices. If a passive investment is no longer a reliable safe haven, perhaps a curated portfolio of high-quality companies might gain appeal.
Moreover, value style investing tends to perform better in periods of rising rates. With the recent change in the yield curve, we could be entering a period where value stocks outperform growth for the first time since the early 2000s. Many retail and institutional investors’ portfolios have been under allocated to value for several years. We remain optimistic that stocks with strong balance sheets, strong cashflows and improving revenues and profits will attract investors.
Attribution
In the third quarter, the Long/Short Opportunity Fund benefitted from our market hedges and, to a lesser degree, from strategic sector allocation in the long portfolio.
In the long portfolio, our underweight to Communication Services and Real Estate provided upside as those sectors sold off in reaction to rising rates. Conversly, stock selection in the Consumer Discretionary and Information Technology sectors, did not help performance.
Net exposure was 74% at the end of the third quarter. We have been highly selective in the deployment of cash during the recent market sell off. Option premiums on short puts are increasingly lucrative, and we may use capitulating sentiment to carefully add to our highest conviction names. We continued to gradually trim market hedges as the market declined, and may look to add new hedges as opportunities arise.
Contributors
Cardinal Health Inc. (CAH)C shares appreciated as investors supported a management change and the company detailed plans to improve the profitability of its medical products manufacturing and distribution business. We expect CAH will re-rate closer towards its peer group as margins expand.
HF Sinclair Corp (DINO) appreciated as the company posted signs of improving execution at its key refineries. Supported by the rise in margins for refined products, DINO generated significant cash flow and began executing on a large share repurchase. With demand for gasoline and jet fuel returning to normalized levels as well as a reduction in global supply capacity, the outlook for refining margins remains healthy.
Biogen Inc. (BIIB) share price spiked after a key clinical trial with its partner Eisai Co. showed the therapy lecanemab slowed the progression of Alzheimer’s disease. The findings mark a major milestone for researchers who have been trying for decades to stop the inexorable decline tied to the disease.
The results bolster the so-called amyloid hypothesis: a long-held theory that the buildup of amyloid, a toxic protein that clutters the brain, is one of the main causes of the disease. We continue to hold the position and anticipate further appreciation in its share price.
Detractors
Kohl’s (KSS) negatively impacted performance as the company posted disappointing results in the face of weakening consumer demand. Despite the weakness in the quarter, KSS reiterated its long-term margin guidance and is executing on its accelerated share repurchase. We believe that in a normalized environment, KSS earnings can improve significantly.
Mohawk Industrials (MHK) shares continued to sell off into the 3Q due to fears about a European recession and higher natural gas prices or even worse, a reduction in industrial production should the winter weather be colder than normal. MHK has significant business in Europe and utilizes natural gas to manufacture ceramic tiles.
ARGO International (ARGO), a specialty insurer, fell as the company announced that the CEO was leaving for health reasons and that they entered loss portfolio transfer for the legacy US construction reserves. The cost of the transaction was a concern to some analysts, and an immediate downgrade sent shares into decline. A small cap name, this company does not get much attention from investors and trades at almost half of tangible book value despite a complete transformation on expenses, volatility, pricing, and reserve adequacy.
Looking Ahead
Despite the recent upheaval in the stock market, our portfolio remains well positioned in the current environment. We are confident in the portfolio’s overweight to Financials, where the Fund is focused on banks poised to benefit from a steepening yield curve. We continue to see opportunity in the Energy sector as higher oil prices are driving earnings growth and companies are using excess free cash flow to fund variable dividend payouts and share repurchases. We believe much of the bad news is already priced into the Consumer Discretionary sector and remain confident in a short list of strong companies that are navigating choppy economic waters. Finally, we are overweight materials as these are the prime beneficiaries of an inflationary environment.
We continue to scour the market for new ideas as the continued sell off creates even more opportunities. New ideas abound in sectors that are usually too pricey for us to consider – namely in Information Technology and Communication Services.
Looking into the upcoming quarters, the key variables for investors will be the magnitude and duration of a possible recession as well as the speed and effectiveness of inflation fighting measures. As the Fund continues to own companies with compelling business fundamentals, skilled management teams, and recurring cash flows, we believe our portfolio will be resilient through the economic cycle. We look forward to communicating our progress to you over the next few quarters.
| 9/30/2022 | QTD | YTD | 1-Year | 3-Year | 5-Year | 10-Year | Since Inception 4/28/2006 |
|---|---|---|---|---|---|---|---|
| I Shares | -4.76% | -13.80% | -8.71% | 6.23% | 4.78% | 7.46% | 5.12% |
| Morningstar Long/Short Equity Category | -3.37% | -12.70% | -8.52% | 2.48% | 2.30% | 3.46% | 2.14% |
| Russell 3000 Value | -5.56% | -17.97% | -11.79% | 4.37% | 5.11% | 9.08% | 6.27% |
Performance data quoted above is historical. Past performance does not guarantee future results and current performance may be lower or higher than the performance data quoted. The investment return and principal value of an investment will fluctuate, so that shares when redeemed may be worth more or less than their original cost. Investors cannot directly invest in an index, and unmanaged index returns do not reflect any fees, expense, or sales charges. For performance information current to the most recent month-end, please call 888-814-8180.
Source: Morningstar Direct. 70%/30% Blended Index: 70% Russell 3000 Value TR and 30% ICE BofA 3 Month U.S. Treasury Bill Index. Prior to June 29, 2018, the Fund was named the Snow Capital Opportunity Fund.
The Fund’s management has contractually waived a portion of its management fees until November 5, 2023 for I, A, C and R6 Shares. The performance shown reflects the waivers without which the performance would have been lower. Total annual operating expenses before the expense reduction/reimbursement are 1.29%, 1.51%, 2.28% and 1.29% respectively; total annual operating expenses after the expense reduction/ reimbursement are 1.29%, 1.51%, 2.28% and 1.23% respectively. 5.75% is the maximum sales charge on purchases of A Shares.
The Fund’s investment adviser has contractually agreed to reduce and/or absorb expenses until at least November 5, 2023 for I, A, C and R6 Shares, to ensure that net annual operating expenses of the fund will not exceed 1.30%, 1.55%, 2.30% and 1.00%, respectively, subject to possible recoupment from the Fund in future years.
About Easterly Investment Partners
Easterly Investment Partners (EIP) is the advisor of the Easterly Long/Short Opportunity Fund. EIP is the traditional, fundamental based investment arm of Easterly Asset Management’s multiaffiliate platform. EIP’s current investment line-up spans the entire value equity market cap spectrum. Guided by a consistent contrarian investment philosophy, our value strategies are led by industry veterans and experts that have refined their craft and delivered strong performance through multiple market cycles. As of March 31 2022, EIP had approximately $2.6 billion in AUM.
Glossary
Long/Short Morningstar Category: Long-short portfolios hold sizeable stakes in both long and short positions in equities and related derivatives. Some funds that fall into this category will shift their exposure to long and short positions depending on their macro outlook or the opportunities they uncover through bottom-up research. Some funds may simply hedge long stock positions through exchange- traded funds or derivatives. At least 75% of the assets are in equity securities or derivatives.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888-814-8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.EasterlyAM.com.
Past performance is not a guarantee nor a reliable indicator of future results. As with any investment, there are risks. There is no assurance that any portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. The Easterly Funds are distributed by Ultimus Fund Distributors, LLC. Easterly Funds, LLC and Easterly Investment Partners, LLC are not affiliated with Ultimus Fund Distributors, LLC, member FINRA/SIPC. Certain associates of Easterly Funds, LLC are registered with FDX Capital LLC, member FINRA/SIPC.
Risks & Disclosures
Short sales involve unlimited loss potential since the market price of securities sold short may continuously increase.
Diversification does not assure a profit nor protect against loss in a declining market.
Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
Mutual fund investing involves risk; principal loss is possible. Investments in smaller companies involve additional risks such as limited liquidity and greater volatility. Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks are greater in emerging markets. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The fund may invest in lower-rated and non-rated securities which present a greater risk of loss to principal and interest than higher-rated securities. The fund may invest in other investment companies, and the cost of investing in the Fund will generally be higher than the cost of investing directly in the shares of the mutual funds in which it invests. By investing in the Fund, you will indirectly bear your share of any fees and expenses charged by the underlying funds, in addition to indirectly bearing the principal risks of the funds. The fund also invests in ETFs. They are subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of an ETF’s shares may trade at a discount to its net asset value (“NAV”), an active secondary trading market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact the Fund’s ability to sell its shares. The Fund may use options and futures contracts which have the risks of unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of the securities prices, interest rates and currency exchange rates. This investment may not be suitable for all investors. Small- and Medium-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Performance over one year is annualized.
THE OPINIONS STATED HEREIN ARE THAT OF THE AUTHOR AND ARE NOT REPRESENTATIVE OF THE COMPANY. NOTHING WRITTEN IN THIS COMMENTARY OR WHITE PAPER SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.
15870075-UFD 10/28/2022