Episode 6 - Nuance Concentrated Value Semi-Annual Update

Sharpe Focus is a new podcast series featuring discussions with the Nuance Investment Team. We will be covering topics that we believe our partners will find insightful. Nuance is a boutique value manager that is 100% employee-owned.

The team focuses on buying leading business franchises with sustainable competitive positions that are trading at a discount to our internally derived fair value. We aim to outperform our primary and secondary benchmarks on an absolute and risk-adjusted basis, as measured by Sharpe ratio, over the long term.

In this episode, Scott Moore, Darren Schryer, Jack Meurer, D. Adam West, and Paul Gillespie discuss the Nuance Concentrated Value strategy semi-annual update.

The views expressed are those of Nuance Investments as of the date of this podcast and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as investment advice. To view the most current and standardized performance figures available click here for Nuance Mid Cap Value and here for Nuance Concentrated Value. To view the most current top holdings click here for Nuance Mid Cap Value and here or Nuance Concentrated Value.

Investing involves risk, including the possible loss of principal. For more information or a copy of our disclosure brochure, please contact client.services@nuanceinvestments.com. Past performance is not a guarantee of future results.

Scott Moore, CFA

Darren Schryer, CFA, CPA

Jack Meurer, CFA

D. Adam West, CFA

Paul Gillespie

[00:00] Paul Gillespie

Hi everyone, this is Paul Gillespie and I want to welcome you to our Sharpe Focus with Nuance Investments podcast. For our regular listeners, we’ll have a little bit different format today. Historically, we’ve done a webinar for our semiannual calls, which we have hosted in January and July.

With our new podcast, we wanted to move the webinar over to a podcast format. So this will be our first semi-annual call as a podcast. For those listeners who are new to the podcast, but regulars for our semiannual calls, we appreciate you joining us.

Additionally, I want to mention that we do have a presentation, which includes standardized performance and disclosures to go along with the podcast. You can find our podcast site at nuanceinvestments.com backslash podcast. From there, if you navigate to the semiannual call podcast for concentrated value, you will see an option to click on podcast materials, which will have a presentation.

You can also email us at client.services@nuanceinvestments.com and let us know you’d like our Nuance Concentrated Value semiannual call presentation, and we’ll send it over to you.

With all that, let’s get to our Nuance Concentrated Value semi-annual call. I’m joined today by several of my colleagues, Scott Moore, our founder, president, CIO, Jack Meurer, Darren Schryer, and Adam West, who are all portfolio managers on the strategy.

As usual, we’ll begin by giving an update on the firm and the team. We’ll also go through a summary of the investment process and a review of performance. We will conclude our prepared remarks with a discussion on our investment outlook.

Scott, I’ll turn it over to you.

[01:54] Scott Moore

Thanks, Paul.

On page three, we’ll get started with a Nuance firm-wide update. As we enter our 17th year of operations at Nuance, our long-term performance continues to be a point of emphasis and our short-term performance a disappointment. For years, we’ve discussed with clients our own internal performance objective and our expectations of reasonable performance contours, including periods of time when our products might struggle versus broad indices or our primary and secondary benchmarks.

Higher beta years, momentum-only years, or years where valuation just isn’t considered to be a primary factor in the market can be difficult for us. 2024 falls into that broad category of years in our opinion, and we’ll discuss that in depth in our call today. While 2024 was difficult, we continue to be pleased with the long-term performance of our products, our firm, and our people.

The topic of this call, our Nuance Concentrated Value Strategy, is ranked first percentile versus Lipper multi-cap value peers, first percentile versus Morningstar mid-cap value peers, and fourth percentile versus Morningstar large-cap value peers from a sharpe ratio or risk-adjusted return ratio perspective since our inception in 2008. In fact, both our Nuance Concentrated Value product and our Nuance Mid Cap Value product have been fifth percentile or better for each period that we can calculate our primary performance statistic since the inception of our firm. It’s a unique data set history, and we are proud of that consistency for our primary return metric.

Further, both products are Morningstar four-star rated as of 9-30-2024 since their inception for the SMA products. The SMAs are the longest tenured vehicles in each product’s composite. Those results have led to assets under management growth for the firm over the 16 years of our history.

From our $30 million seed capital in 2008, we are managing about $3.5 billion today. While down from last year due to short-term performance issues, we are certainly pleased at the level of assets under management and the trust our clients continue to show us and have shown us over the years.

Turning to page four, you can see the investment team that manages the assets for all of our products.

Our Nuance team emphasizes detailed and thorough fundamental company analysis and strict and deep valuation studies to derive risk rewards and investment ideas to beat our peers and benchmarks each day. The team has been stable over time, but 2024 did bring some change. Former colleague Chad Baumler retired this past summer, while 15-year Nuance veteran Adam West was promoted to Portfolio Manager.

Also, we are proud that Jack, Darren, and Adam are all now owners of the firm. Cumulatively, our team has over 80 years of investment experience and over 50 years in Nuance alone. Importantly, this group largely grew up on the Nuance investment process and [team members] have utilized the approach through business cycles, including the Nifty Fifty and tech boom areas in the mid to late nineties, the subsequent tech bust, the commodity and finance boom and bust of the 2005 to 2008 period, which culminated in the financial crisis that ended in 2009.

That crisis led us to an elongated 10-year economic expansion period that was interrupted by the COVID-19 pandemic, and then towards today’s mega cap Bitcoin and risk-oriented market preferences. Through it all, and since our inception in 2008, our Nuance Concentrated Value product is up 12.26% net of fees with significantly less risk than the market. Our overall goal is to keep this team stable and cohesive for many years to come so our clients can continue to gain confidence and trust in our expertise and depth of knowledge and our ability to handle all the various economic and valuation cycles.

On page five, you can see a single page schematic of our Nuance process. This process has not changed since the inception of Nuance, and you can be assured it will not. Consistency of people and process through cycles is so critical to consistent execution and long-term performance.

The summary is that Nuance is a bottom-up, classic value investment firm searching for leading business franchises to monitor and study and purchase only when the risk reward is better than the market set of opportunities. That is typically when a stock is facing under-earnings due to a transitorily negative event. Those negative items cause temporary under-earnings, which then causes stocks of good companies to go down and get attractive from a riskreward perspective.

Over the years, we have searched for great companies that have the traits of Nuance leading businesses, but only a select group make our Nuance approved list. The search starts in the quantitative part of our process as we search for companies with the traits of leaders. Those traits include above-average returns on capital versus their sub-industry peers, better-than-average balance sheets versus their sub-industry peers, and typically number one or number two market share positions that we believe are sustainable over time.

The next phase of our process is a study of the sustainability of the company’s competitive position and the avoidance of competitive transitions. This is the primary way our team avoids capital destruction and absolute lost dollars for our clients. With those traits and sustainability understood, we then research, model, and study the business in depth for many years, some as many as two to three decades.

Our financial modeling work hinges on forecasting each business to a proprietary mid-cycle or normal set of financial statements. With this mid-cycle or normal set of financial statements, which includes proprietary estimates of earnings, EBITDA, cash flows, dividends, et cetera, we then perform an extensive valuation study of each company. That valuation study emphasizes both a fair or intrinsic value estimate today, along with the knowledge that today’s fair value will be growing into the future.

The study also includes a very important trough value study that focuses on how low we believe a stock can trade during difficult or recessionary-like periods for the economy or the company specifically. We believe that our equal emphasis on reward and risk has led us to over 16 years of first or fourth percentile risk-adjusted returns versus our various peers. With that, I’ll turn the call over to Portfolio Manager Jack Meurer for a discussion of 2024 performance. Jack.

[08:40] Jack Meurer

Thanks, Scott. So I’m going to cover some detail on both performance for 2024, as well as the long-term results for our concentrated value strategy, all within the context of our four primary performance objectives. As a reminder, these objectives are long-term goals that we set forth at the inception of Nuance and are goals that we have consistently conveyed to our clients over the years.

First, we want to beat our primary benchmark more times than not on a calendar year basis. Second, we want to beat our primary benchmark over the long term and do so with less risk. Third, we want to beat our secondary benchmark over the long term and do so with less risk. And lastly, we want to beat our peer groups over the long term with less risk as well.

As for the 2024 calendar year, the results were disappointing for us at Nuance as our concentrated value strategy was up 6.45% net-of-fees, which lagged our primary benchmark, the Russell 3000 Value Index, which returned 13.98% over the same period.

Regarding our first goal, through 2024, we’ve outperformed our primary benchmark 12 of our first 17 years, including the stub year in 2008, and 11 out of 16 years without the stub year.

With regard to our second goal, which is to outperform our primary benchmark over the long term with less risk, since our 2008 inception, we are pleased with our 12.26% annualized return net-of-fees versus the Russell 3000 Value Index, up 11.13% annualized over the same period. I would highlight that we have delivered these results with a net-of-fees standard deviation of 13.31%, which is meaningfully lower than the Russell 3000 Values, 16.07%, which results in a risk-adjusted return measure, or sharpe ratio, of 0.83 net-of-fees versus the Russell 3000 Values, 0.62, which is a solid risk-adjusted result in our view. Our third goal is to outperform our secondary benchmark, the S&P 500, over the long term and with less risk.

Since inception, our annualized net-of-fee return of 12.26% compares to the S&P 500 Index, which is up 14.46% annualized over the same period. Over that period, the risk or standard deviation of our concentrated value strategy has been less than the S&P 500, and our since-inception sharpe ratio net-of-fees for our concentrated value strategy is 0.83 versus the S&P 500’s 0.88. While we’re unhappy with this result, it’s not surprising to us to see this phenomenon after a period in which growth as a style of investing has outperformed value so significantly. Lastly, on performance, our final goal is to outperform our peers over the long term and do so with less risk.

Regarding total return over our now 16-plus year history, the results are 23rd percentile versus the Morningstar Large Value Peer Group, 50th percentile versus the Morningstar Mid-Cap Value Peer Group, and 25th percentile versus the Lipper Multi-Cap Value Peer Group. Looking at risk or standard deviation over this same period, our concentrated value strategy is among the least risky products versus our peer groups. So, on a risk-adjusted return or sharpe ratio basis, the results have been a top-decile ranking versus all of our peer groups since our inception in 2008, and I’d note that this is not a point-in-time observation, but rather a characteristic that has been demonstrated consistently in our strategy’s results over time.

So, moving on to 2024 results, certainly a challenging relative performance year for us as we lagged our primary benchmark, the Russell 3000 Value Index, by more than 700 basis points. I’ll start with negative attribution, where the healthcare sector was our largest detractor from performance, as our investments in dental-related companies, including Dentsply Sirona (XRAY), Henry Schein (HSIC), and Envista (NVST), all underperformed. We continue to believe the dental space remains a significant, one-off, under-earning and undervalued opportunity, which Darren will highlight in our 2025 outlook.

Additionally, our positioning in the Utilities sector detracted from performance, as our investments were primarily in water utilities, which was the worst-performing sub-industry within the utility sector. We continue to favor the competitive position of regulated water utilities within this sector and believe there is meaningful under-earning in several of our water utility holdings due to allowed  return on equity and infrastructure investment spending that we believe is poised to move higher in 2025 and beyond, following supportive regulatory decisions, which I will touch on later. Our positioning within Financials also detracted from performance for the year.

Several of our investments, including Reinsurance Group of America (RGA), Northern Trust (NTRS), and Globe Life (GL), outperformed, but that was offset by our positioning within Banks, where our investment in Independent Bank Corp (INDB) underperformed and our underweight positioning in the Banks sub-industry detracted from performance. Additionally, our underweight positioning within the Communications Services sector was a modest detractor from performance, as was our positioning in Real Estate, where our investment in Healthcare Realty Trust Incorporated (HR) underperformed. Lastly, our cash position was a relative drag on performance in 2024 as well.

In terms of positive impacts on performance, our stock selection in the Consumer Staples sector was a primary positive contributor, as Clorox Company (CLX) showed signs of earnings normalization and the stock outperformed during the second half of the year, where we subsequently reduced our position. Additionally, stock selection in the Industrials sector benefited performance, as 3M Company (MMM) and Mueller Water Products (MWA) were our two best-performing stocks for the year. We exited the majority of our position in these stocks over the course of the year and have added to what we believe are emerging under-earning and undervalued stocks, like Werner Enterprises (WERN) and others in the Cargo Ground Transportation sub-industry, which we will touch on in our outlook as well.

Lastly, our underweight to several sectors, including Materials, Energy, Consumer Discretionary, and Information Technology, contributed positively to performance for the year. And with that, I’ll turn it over to Darren to discuss our 2025 outlook.

[15:09] Darren Schryer

Thanks, Jack.

As Jack alluded to, this has been a very challenging market environment for us, for our philosophy, and for our process. What we’ve observed is a market that we believe is highly risk-seeking, highly speculative in nature. Just as an example, on almost a weekly basis, you see people out there chasing new scam crypto projects, thinking they can get rich quick.

Gosh, one of the best performers in the value benchmarks in 2024 was essentially a Bitcoin holding company in Microstrategy (MSTR) that has traded at a massive premium to the market value of the Bitcoin it does own. It’s also been a market that has simply not cared about valuation, in our opinion. A variety of valuation metrics suggest it’s a market that’s expensive by historical standards.

For a second straight year, growth benchmarks have significantly outperformed value benchmarks, even though, based on market history, value stocks do outperform growth stocks over the long-term. And it has echoes of other highly speculative periods to us, which is a challenging stylistic backdrop for our very risk-aware philosophy and process.

That being said, we are seeing some very interesting pockets of under-earning and undervaluation and we’re pretty excited to be able to own a portfolio of leaders that are under-earning and trading at just under 13 times normalized earnings power when the benchmarks are trading at over 20 times earnings.

So specific to portfolio positioning, and we’re on slide nine if you’re referring to our associated slide deck, the first sector to discuss is HealthCcare, which has been a large overweight for us and a short-term drag on performance, but remains a very high conviction idea. The majority of our weight is in the dental space within Health Care. Dental has long been a great fit for our process.

The industry enjoys several advantages, including a broadly stable demand profile over time, including tailwinds from growing access to dental care around the globe and also an aging population. We believe the barriers to entry in the space are relatively high and customers are very quality-oriented. Recently, we believe the majority of the dental space has been under-earning due to cyclical weakness and demand for new equipment and also for elective and high-end procedures such as full-mouth restorations.

Demand for those products was elevated during the 2021 and 2022 time periods and has been below normal for the past two years. Using Top 10 Holding Henry Schein, ticker HSIC, as a specific example, Henry Schein (HSIC) is the leading global distributor of dental supplies and equipment. We believe they’re the only dental distributor with global scale.

They have a long history as the clear market leader, and distribution is a key function in dental as Henry Schein (HSIC) and other distributors provide services like equipment installation and repair. They’re also a leading provider of practice management software, which we believe strengthens their competitive position. Henry Schein (HSIC) is expected to report earnings of around $4.75 for 2024, and they’re under-earning our view of normalized earnings power, which is more like $5.50. In addition to the cyclical weakness and demand for equipment and certain procedures that I mentioned, Henry Schein (HSIC) also suffered a cybersecurity breach near the end of 2023, which caused lingering direct costs, promotional activity, and lost sales throughout 2024 as they relaunched their e-commerce site, which served to exacerbate the cyclical under-earning.

At year-end, the stock was trading at under 13 times normalized earnings, which is much less expensive than the company’s own history in the high teens and the broader market, which I mentioned is trading in the 20s at year-end. We think it represents a top risk-reward opportunity.

Elsewhere in dental, we continue to own leading manufacturers in Envista Holdings (NVST), ticker NVST, at around 14 times normalized earnings power, and Dentsuply Serona (XRAY), ticker XRAY, at under 10 times normalized earnings.

X-Ray is our top overall holding, and we spoke about it in detail on our last semiannual call, in addition to our earlier dental podcast episode. Since then, several one-off company-specific issues, including a tax inquiry in Germany and a regulatory hold on certain direct-to-consumer orthodontic products, have further soured investor interest in Dentsuply (XRAY) and caused it to trade to a recessionary-type evaluation level. Our analysis suggests both of those issues are manageable without a material impact on competitive position, balance sheet strength, or normalized earnings power, but they’ve allowed us to buy more shares at what we view as truly an asymmetric risk reward opportunity.

Beyond dental, elsewhere in healthcare, I would highlight life science tools leader QIAGEN (QGEN), ticker QGEN. QIAGEN (QGEN) is a global leader in sample preparation and assay technologies. Their equipment and consumables are used to prepare biological samples for testing.

They enable disease research, diagnostics, drug development. They’re also a leader in blood-based tuberculosis testing. We believe QIAGEN (QGEN) is currently under-earning our normalized earnings power of around $2.30 per share due to a build-out of capacity over the last few years that is currently progressing towards normal utilization levels.

Additionally, one of the customer groups for QIAGEN (QGEN) is the biotech industry. Biotech is coming out of a funding trough, which should support higher spending levels into 2025. We built our position in QIAGEN (QGEN) between 17 and 19 times normalized earnings.

This is a business that has historically commanded a premium valuation, which does make sense to us given the company’s excellent competitive position, high and stable returns on capital, and strong balance sheet with less than a turn of net debt. Many of QIAGEN’s (QGEN) life science tools peers currently trade at a significant valuation premium to QIAGEN (QGEN), which we do not think is warranted when we line up the businesses. Our theory is that this valuation disconnect is related to QIAGEN’s (QGEN) organizational structure.

QIAGEN (QGEN) is headquartered in the Netherlands, and they have shares that are listed in Germany and also shares that are listed in the U.S. Around half of their revenue comes from the Americas, and they have a significant U.S. operating footprint, but they are largely excluded from U.S. indices. U.S. fund flows have trended increasingly towards passive investing over time, and therefore companies that are in the indices enjoy the benefit of a large, consistent, price-insensitive buyer. We believe this phenomenon is contributing to a widening valuation gap in the case of QIAGEN (QGEN) and also more broadly in the case of international stocks in general.

And you’ll see we do have a significant weighting in international stocks in the portfolio. For QIAGEN (QGEN), the company is opportunistically repurchasing shares, which we think makes sense to us. We also think they make a highly attractive acquisition candidate for many of their U.S.-based competitors.

It’s a compelling risk reward opportunity, in our opinion, even without a potential takeout multiple. But given they’ve been an acquisition target in the past and given that they are currently trading at a discount to the group, we do think a potential additional upside exists in that scenario. With that, I’ll turn the call over to Adam to discuss Consumer Staples.

[22:56] D. Adam West

Thanks, Darren. Similar to recent years, we continue to find reasons to be overweight in Consumer Staples, but the opportunity set has shifted somewhat. We have previously highlighted opportunities in companies like Clorox (CLX) and Kimberly-Clark (KMB) due to under-earning caused by input cost inflation in resins, pulp, and supply chain costs.

Those companies are closer to our normal earnings estimates at this point, as they have increased prices to offset inflationary inputs, and we’ve reduced the weightings as the stocks have outperformed. Henkel (HENKY) remains a large position, as it is still slightly under-earning due to input costs, and the valuation remains attractive, in our opinion. Estée Lauder (EL) was a new name that we purchased in 2024, and it quickly became one of the largest weights in the portfolio.

The company is a global leader in beauty products, which we view as an attractive category longer term, as skincare and cosmetics have historically seen stronger growth than most consumer staples categories. The company has leading brands at premium price points, including Estée Lauder (EL), Clinique, La Mer, The Ordinary, and several other brands. Estée Lauder (EL) had seen strong growth for most of the past 20 years due to market share gains in Asia, and invested heavily in its manufacturing and supply chain infrastructure to keep up with growing demand.

However, new government regulations in China on travel retail duty-free outlets caused this important end market to see a swift drop in demand in 2023, and an elongated period of inventory destocking has followed. Additionally, general weakness among the Chinese consumer caused beauty categories in general to shift from double-digit growth to low single-digit growth. This has caused further destocking, as beauty companies had shipped products to retailers expecting much stronger demand.

Importantly, our research shows that Estée Lauder (EL) has maintained market share with the end consumer in these regions. But, in our opinion, the company is now dramatically under-earning its normal earnings power due to under-utilization of facilities, excess product discounting to clear inventory, and inventory obsolescence charges. Due to these factors, gross margin reached a historical low below 70% in 2023, and has only improved slightly since then, still 5 to 6 percentage points below historical averages of the past 10 to 15 years.

Additionally, the company is committed to not reducing R&D or marketing spend, which we believe is a good decision for the long-term, but further limits its near-term earnings power in this environment. Consensus expectations for earnings per share this year are around $1.50, which is much lower than our estimated normal earnings power, around $5.25. We have ran some scenario analysis on this company, attempting to value the company on a sum-of-the-parts basis for geographical exposure, and we believe that when the stock was trading below $70 per share in November of 2024, the market was essentially ascribing negative value to the entire Chinese business. We don’t believe those assets are worthless, and longer term they should earn a return on capital comparable to the company’s history.

At the beginning of 2022, this stock was trading north of $350 per share, and we believed it was a solid market share leading business in an attractive category, but over-earning and over-valued, so we didn’t own it. We believe transitory issues have caused the under-earning opportunity and the stock price to drop below $70 last November, a level it hadn’t seen in decades since 2014. In our opinion, this has created an attractive opportunity to invest in a high-quality business trading well below our view of fair value.

And with that, I will turn it back over to Jack to discuss opportunities in Utilities and trucking companies.

[26:44] Jack Meurer

Great, thanks Adam. So one of the sources of opportunities we’re finding today is the higher interest rate environment, which is notably creating opportunities in the Water Utility sub-industry.

Specifically, I would highlight our investments in water utilities operating in the United Kingdom, which underperformed over the course of 2024, despite the regulatory environment being supportive of improving fundamentals in coming years. United Utilities Group, PLC (UUGRY), ticker UUGRY, is a great example of this opportunity. United is a regulated natural monopoly providing essential water and wastewater services to a population of more than 7 million customers throughout the northwest of England and has an industry-leading balance sheet.

In the UK, water utilities are subject to a regulatory cycle occurring every five years where the regulatory authority determines base returns on equity, spending allowances, and other key regulatory items for each water utility. The UK water sector, including United Utilities (UUGRY), received final determinations from the regulator just last month, which take effect in April of 2025. Notably, the result of this decision supports both improving base ROEs off of historically depressed levels as well as an inflection in capital investment for at least the next five years as the regulatory decision has clearly prioritized addressing the UK’s aging water infrastructure.

This is a notable positive change versus prior regulatory periods, which saw underinvestment in water infrastructure assets. At year end, United Utilities was trading at around $26 per ADR share, or around 11 times our internal estimate of normalized earnings. We believe the combination of an improving fundamental environment and the company trading at a substantial discount to both its own history as well as its US water utility peers makes for a compelling risk reward opportunity from here.

Another emerging opportunity to highlight is the cyclical under-earning conditions within truckload companies in the ground transportation sub-industry, and we’ll use our investment in Werner Enterprises (WERN), ticker WERN, as the example here. As a backdrop, companies serving the truckload freight market experienced a cyclically elevated pricing environment that peaked in late 2021. This was due to the effects of temporarily constrained truckload supply and stimulus-driven demand that resulted in tight market conditions.

The ensuing above-normal pricing and peak returns on capital within the truckload industry attracted new incremental supply among both existing operators and new entrants, which has subsequently led to excess capacity, declining pricing, and now troughed returns on capital for our favorite truckload operators like Werner Enterprises (WERN). Werner (WERN) is a best-in-class operator with leading market share serving large retail and consumer product companies with its differentiated dedicated truckload offering and top-tier customer retention. The company also has a strong balance sheet, which is particularly valuable given the current difficult freight market conditions.

As truckload pricing has gone from peak to trough, Werner’s (WERN) earnings have declined materially, and the company is expected to earn less than $0.70 per share in 2024 per Wall Street consensus estimates, which is significantly below our estimate of around $3.25 per share in mid-cycle earnings power. These cyclical forces I’ve discussed have led to a steady stream of capacity exits, numerous bankruptcies of poorly capitalized carriers in the industry, and capital spending cuts from the larger operators. We believe this will result in a more balanced supply and demand environment, ultimately paving the way for the recovery of freight pricing and allowing a company like Werner (WERN) to return to mid-cycle earnings power.

Werner (WERN) has underperformed in 2024 and as of year-end trades at around $36 per share, or around 11 times our estimate of normalized earnings. A valuation level that we believe is reflective of short-term cyclical concerns and provides an excellent risk reward to a patient, long-term-oriented investor, which is why Werner (WERN) is a top 10 holding in our Concentrated Value strategy today. With that, I’ll turn it back over to Paul for some closing remarks.

[31:04] Paul Gillespie

Thanks, Jack. I want to thank everyone for taking the time to listen to our semiannual podcast, and we’d love to hear from any of our listeners with any feedback or follow-up questions they might have. We’ll see you soon for our next Sharpe Focus with Nuance Investments podcast.