MARKET SUMMARY
U.S. stock markets posted strong gains in the first quarter, largely on the belief that a combination of tax reform, infrastructure spending, and a lighter regulatory environment would positively impact domestic growth. Though such policy moves have not yet taken shape, the broader market climbed and volatility was scarce. Other notable events capturing investors’ attention included the Federal Reserve’s interest rate increase and the House of Representatives’ failed repeal of the Affordable Care Act.
As tracked by the Russell indices, stocks in all capitalization ranges climbed higher, with large cap stocks readily in front. Mid caps and small caps followed the upward trend. After a strong fourth-quarter performance, value-oriented stocks of all capitalizations lagged their growth counterparts.
FUND PERFORMANCE
For the first quarter of 2017, The Meridian Growth Fund (the “Fund”) returned 7.04% (net) during the quarter, outperforming its benchmark, the Russell 2500 Growth Index, which gained 6.25%.
Our investment process prioritizes the management of risk over the opportunity for return. Our goal is to build an all-weather portfolio that can perform in a variety of market conditions. We look to build a portfolio that can mitigate capital losses on the downside and, secondarily, provide 100% upside participation. While our risk-first approach is particularly effective during heightened volatility, Q1 was characterized by scarce volatility.
From a sector perspective, leading drivers of outperformance included industrials and information technology, where strong stock selection drove gains. Particularly positive were selections in the commercial & professional services industry group. Investments in consumer discretionary held back relative performance as the retailing industry group faced notable headwinds. Another detractor was our lack of exposure to the materials sector, which posted strong gains during the period. Given that materials names tend to exhibit levered balance sheets and are more influenced by commodity price swings, we typically avoid this sector.
TOP THREE
The three largest contributors to the Fund’s performance during the period were CEB, Inc. (CEB, Financial), Exact Sciences Corp. (EXAS, Financial), and Cadence Design Systems, Inc. (CDNS, Financial).
CEB, Inc. (CEB, Financial) is a business services company that provides best-practice and technology insights to businesses in a wide range of industries. We were first attracted to CEB for its recurring revenue business model and its low market penetration. IT research firm, Gartner, Inc., also found value in CEB’s platform and acquired the company during the first quarter in a cash and stock deal worth roughly $2.6 billion. By combining CEB’s existing client partnerships with Gartner’s operational expertise and distinct sales network, we believe the acquisition should be accretive.
Exact Sciences Corp. (EXAS, Financial) develops noninvasive molecular screening tests for the early detection and prevention of colorectal cancer. We originally invested in the company because Cologuard, its revolutionary product, exhibited low market penetration and significant opportunity for continued adoption. Test accuracy versus other non-invasive tests has led to improved adoption rates and recent annual revenue growth in excess of 150%. Large commercial insurer, Aetna, recently announced its decision to cover the screening for qualified members. In this positive environment, Exact Sciences raised its test volume expectations to 415,000 for the year and noted meaningful gross margin improvement as its business model continues to scale faster than expected. As such, we are maintaining our position.
Cadence Design Systems, Inc. (CDNS, Financial) provides “mission critical” electronic design automation (EDA) software to the semiconductor industry. Our investment in the company is based on its predictable and recurring revenue base as well as its ability to consistently raise prices, a rarity in the semiconductor space. The company reported a strong quarter highlighted by market share gains in both its digital and emulation segments. Cadence also finalized a $1.2 billion stock buyback program and announced a second program in the amount of $525 million. Though the news was positively received, we trimmed our position as the company’s share price appreciated towards our target price. We still remain invested due to Cadence’s shareholder-friendly practices and attractive risk-reward profile.
BOTTOM THREE
The three largest detractors from the Fund’s performance during the quarter were Sally Beauty Holdings, Inc. (SBH, Financial), INC Research Holdings, Inc. (INCR, Financial), and National CineMedia, Inc. (NCMI, Financial).
Sally Beauty Holdings, Inc. (SBH, Financial) is a specialty distributor and retailer of beauty products to salons and consumers worldwide. We own the company because of its history of consistent earnings growth and promising international opportunities. Management cut forward guidance during the quarter as lighter retail traffic to the company’s strip mall locations led to negative same-store sales growth in its Sally Beauty Supply segment. Its Beauty Systems Group segment, which distributes directly to beauty salons and is more structurally insulated from broader retail weakness, made up for that decline as the company posted positive same-store sales growth overall. Efforts to broaden its reach through a revised loyalty program and enhanced social media activities should help combat some of the structural headwinds. We continue to hold our position.
INC Research Holdings, Inc. (INCR, Financial) is a global contract research organization (CRO) that operates primarily in the clinical development market. With a broader market that is 50% outsourced today, we are encouraged by INC’s single-digit market share and competitive global network. The stock declined following Q4 bookings that came in lighter than expected as two larger awards within their pipeline did not materialize. Although near-term bookings were impacted, we believe the company’s long-term prospects remain intact. Of particular strategic value is INC’s global network, which enables its comprehensive suite of consultative and operational services to be that much more effective. Thus, we maintained our position.
National CineMedia, Inc. (NCMI, Financial) displays advertisements to U.S. consumers in movie theaters, online, and through mobile devices. Among the many things we like about this company is its healthy dividend yield, strong EBITDA (earnings before interest, taxes, depreciation, and amortization) margins, low capital intensity, and long-duration contracts with leading theater groups. Although the company reported stronger-than-expected quarterly revenue and EBITDA for its fourth quarter, guidance for 2017 was below expectations. Additionally, AMC Entertainment, one of National CineMedia’s largest shareholders, announced plans to divest the majority of its stake in the company in order to comply with the Department of Justice’s Final Order on AMC’s acquisition of Carmike Cinemas. We believe business fundamentals remain intact and therefore continue to hold a position in the stock.
OUTLOOK
During the first quarter, we were surprised by the lack of volatility. In fact, there was only one day during the period in which the Russell 2500 Growth Index sold off more than 2%; and, prior to this, the previous day with a 2% or greater sell-off occurred over six months ago on September 9, 2016. While broader economic data has been positive, climbing interest rates, apparent gridlock in Washington, D.C., and rising geopolitical concerns may soon disrupt the complacency. We will aim to take advantage of opportunities if volatility picks up and will continue to look for companies with predictable and recurring revenue streams, strong competitive advantages, and increasingly large market opportunities.
2Listed holdings are presented to illustrate examples of the securities the Fund has bought and do not represent all of the Fund’s holdings or future investments. Information about the Fund’s holdings should not be considered investment advice. There is no guarantee that the Fund will continue to hold any one particular security or stay invested in any one particular sector. Holdings are subject to change at any time and are as of the date shown above.
