Meridian Contrarian Fund Q3 2014 Letter To InvestorsVW Staff
Meridian Contrarian Fund
During the third quarter of 2014, the Meridian Contrarian Fund returned -4.59%, which compares to a return of -5.35% for its benchmark, the Russell 2500 Index.
Outperformance of 0.80% during the quarter was driven primarily by the strength of our investments in the information technology, consumer discretionary and utilities sectors. Strength in our technology investments was broad, and we remain overweight in this sector due to what we view as promising secular trends in data growth, security, mobile broadband and the emerging industrial Internet, or “Internet of things.” Our consumer discretionary companies are cautiously optimistic in an environment that they view as tough but gradually improving; however, we are approaching the sector with caution and look for companies that should be able to succeed despite a tepid consumer environment. As with all of our companies, we seek successful turnaround strategies, superior growth characteristics and/or strong market demand. The Fund’s lone investment in the utility sector – Hawaiian Electric – had strong fundamental results and outperformed significantly after lagging in the first half.
The top three contributors to performance during the quarter were:
•Servicemaster Global Holdings (SERV) is a leading provider of termite and pest control services, home warranties, and other residential services. We identified the company after marketing and service missteps at its lawn care division, which was spun off earlier this year. We invested in Servicemaster because of its dominant positions in fragmented markets. The stock outperformed during the quarter due to better than expected revenue and profit growth despite a weather- weakened termite season. Upside came from pricing, market share gains and cost efficiencies. We added to our position due to the encouraging quarterly results and an outlook for steady, low double digit earnings growth achieved through continued market share gains, operating margin expansion and debt reduction.
•Chiquita Brands (CQB) is a global leader in bananas and the U.S. leader in packaged salads. Our original investment came after the company’s earnings declined due to market share losses in salads, tough European markets and foreign exchange losses. We believed new management had a strong history and a compelling plan to improve consistency of results and capital allocation. Chiquita stock performed well in the quarter due to a buyout offer from a Brazilian conglomerate in an attempt to trump Chiquita’s existing plans to merge with a European partner. We took advantage of the strength in the stock to reduce our position and may continue to do so.
•ICON (ICLR) manages clinical trials for the biotech, pharmaceutical and medical device industries. Our investment in the company materialized when earnings were pressured by an industry slowdown in clinical trials at the same time that ICON was investing in its own capacity expansion. We viewed the slowdown in demand as temporary, caused by the elimination of many duplicative drug development programs. In addition, we thought ICON’s investments in technology positioned the company to gain market share in a growing industry as pharmaceutical customers increasingly outsourced clinical trial work. Strong stock performance in the quarter was driven by revenue and margins coming in above street estimates and a positive management outlook. We continue to hold shares in ICON based on its positioning as a technology leader in the clinical trial industry and the potential to further expand operating margins
The top three detractors from performance during the quarter were:
•Halcon Resources (HK) is an independent, U.S.-based oil and gas exploration and production company. At the time of our investment, the stock was out of favor due to a combination of high levels of investment spending and poor drilling results at select wells. This created an opportunity to invest in the management team, which has an excellent record of finding and developing energy assets, and their ability to deliver improved exploration results and production growth. Halcon’s stock underperformed meaningfully in the quarter, reversing strong performance in the first half of 2014. As a development-stage company with a leveraged balance sheet, the company’s stock demonstrated greater volatility than the sector as a whole and declined significantly more than the price of oil. Despite short-term volatility potential, we believe the company has the ability grow reserves and production and could potentially be an acquisition target over the long term.
•Endologix (ELGX) is a medical device company with products that treat aortic abdominal aneurisms (AAA). Recently the company experienced a decline in sales growth after the conclusion of a clinical trial rollout. We believed the revenue issue was temporary and were very excited about a new product called Nellix that has the potential to more than double Endologix’s market share in AAA procedures. During the quarter, share performance disappointed after the company disclosed that sales would again miss expectations, this time due to an intensifying competitive environment. While management outlined an aggressive response, including product enhancements intended to further improve upon the lowest complication rate in the AAA industry, we have reduced our position until we can gain greater clarity on how effective these efforts will be in the market.
•Del Frisco’s Restaurant Group (DFRG) is a fine dining company that operates 45 steakhouses across three brands. We initiated our position when earnings were pressured by underperformance in the Sullivan’s Steakhouse brand and the investment in a new growth brand, Del Frisco’s Grille. We like the fact that the company overall has outperformed the overall restaurant sector the past few years. The company underperformed in the quarter due to delays in new store openings and some location-specific issues that hurt revenue growth. We continue to believe that Del Frisco’s offers an appealing product with high unit growth potential and have added to our position on the recent price weakness.
Equity market volatility increased in recent weeks due to a litany of macro fears. Concerns include pressure on corporate profits from the rapidly appreciating U.S. dollar, looming Fed tightening and crashing commodity prices. On the positive side, U.S. unemployment fell below 6% for the first time since 2008, and lower commodity prices have a positive impact on consumers. Our strategy is to remain conscious of the macro picture without attempting to predict it and to take advantage of market volatility to find opportunities in individual companies that have attractive business economics and improving fundamentals. For example, we currently see excellent opportunities in such out-of-favor sectors as agriculture and energy but are proceeding with caution as unfavorable macro trends could hurt these sectors for some time. Our highest priority for new investments are companies that should experience minimal impact from macro conditions yet have seen their equity valuations decline based on overall market fears.