For the three months ending September 30, 2017, the VL Capital Systematic U.S. Equity Strategy returned -4.05%, net of management fees, while the benchmark S&P 500 Index returned 3.96%. Year-to-date, the VL Capital Systematic Value Strategy has returned 4.07%, while the S&P 500 has returned 12.53%.
The overall underperformance by the VL Capital Systematic U.S. Equity Strategy during the third quarter was primarily driven by a confluence of unfavorable earnings results by 6 out of 20 portfolio holdings. While the strategy always holds 20 stocks to help eliminate company-specific risk, when such a large number of holdings perform poorly it inevitably drags down overall returns. As such, we expect periods of underperformance to occur and remain confident that outperformance versus the benchmark will continue over a multi-year period.
The single largest contributor to performance during the third quarter was Tempur Sealy International, Inc. (NYSE:TPX), which returned 20.85%. Tempur Sealy, the well-known manufacturer of bedding products, has seen a strong recovery in share price since the January 27th termination of their retail agreement with Mattress Firm. Mattress Firm represented 21% of Tempur Sealy’s 2016 sales and because of the termination, the stock dropped almost 30% in January (please note VL Capital Management did not hold Tempur Sealy stock prior to July 7, 2017). From a fundamental value standpoint, this one-off event significantly discounted Tempur Sealy’s stock and provided an attractive entry point. Since the break-up with Mattress Firm, Tempur Sealy has seen rapid market share gains suggesting the brand value lies with the Tempur Sealy name.
The single largest detractor from performance was American Outdoor Brands Corp. (NASDAQ:AOBC), which returned -31.17% for the quarter. American Outdoor, previously known as Smith & Wesson, reported quarterly earnings on September 7th that missed analyst estimates. The company also provided full year profit guidance that was well below Wall Street’s expectations. American Outdoor pointed to soft order trends in their firearms business as the primary driver for the shortfall. On a positive note, it has been reported in recent weeks that President Trump is expected to sign an executive order this fall, which will ease restrictions on U.S. weapons sales abroad. If this development materializes, it will have a significant, positive impact on U.S. gun manufacturers. We continue to favor firearm companies because they remain undervalued and are well positioned in a favorable political environment.
Turning to the economy, trends continue to suggest an improving pace of economic activity in the U.S. Inflation remains below the Fed’s 2% target and thus the probability of raising interest rates prior to December 2017 remains low. It is important to note that since World War II, tighter Fed conditions have resulted in a recession 92% of the time. Therefore, the Fed will be required to maintain a very disciplined approach to raising rates. What is most crucial to the future direction of the Fed is who President Trump appoints to fill the role of the Federal Reserve Chair when Janet Yellen’s term expires in February. Yellen could easily be reappointed, but other candidates are under consideration as well. The key point will be how dovish or hawkish the new candidate will be with respect to their views on monetary policy.
Looking to the fourth quarter, we expect a rather muted environment for stocks. Historically speaking, when equity markets are positive for both August and September, there is a high probability for a follow-through into year end. As such, there may be the potential for continued gains in the final quarter of 2017. In terms of potential market risks, geopolitical events seem to top the list with North Korea among the most prominent of all. We believe most investors view the risk of war on the Korean Peninsula as a binary event, it will either happen or it will not. Should an actual war break out, it would be detrimental to global financial markets, but until such an event occurs there will likely be little impact on U.S. markets.