Although the Motley Fool Small-Mid Cap Growth Fund had a strong absolute performance for the third quarter of the year, advancing 6.81% for the quarter, the benchmark Russell 2500 Growth Index did better, gaining 7.24%. That’s not an especially painful loss for us, given the strong performance for both fund and benchmark, but our shareholders still deserve to know when we underperform.
The third quarter demonstrated the market’s apparent willingness to shake off almost any troublesome news, which is understandable given how strong earnings growth has been for the market as a whole. Companies have shown year-over-year earnings-per-share growth of nearly 30%, aided in no small part by corporate tax cuts, but sales growth, margin improvements, and share buybacks have all made important contributions to the bottom line as well. Although interest rates rose during the quarter, and numerous trade battles and tariffs made the headlines, it was a time of widespread positive public company performance – good enough, through Sept. 30, to keep buyers outbidding each other for shares. The early October performance of the market indicates the fourth quarter is off to a more challenging start for public company shareholders, but we’ll wait until the end of next quarter to make an assessment.
At the Motley Fool Small-Mid Cap Growth Fund, we’re focused on the benefits of long-term buy-and-hold investing, so we typically don’t make major adjustments to the fund in any given quarter. However, last quarter we were more active in our sales than usual. We sold out of American Woodmark, AutoZone, Dorman Products, Eastman Chemical Company, Huntington Bancshares, KapStone Paper and Packaging, and Papa John’s.
Three of these companies were longtime fund holdings: Cabinetmaker American Woodmark, auto-parts supplier AutoZone, and KapStone Paper, maker of paper, cardboard, and packaging. KapStone had announced earlier in the year that it was being acquired, so there was little advantage in holding it any longer. The other two sales arose out of changes we see in the economy. Margins were eroding recently at American Woodmark, historically one of the fund’s best investments, as commodity input costs have gone up and pricing competition in its markets is increasing. In addition, with its high sensitivity to the housing market, we felt that the growth part of American Woodmark’s story was no longer as promising as it had been during most of the six years we’ve held it.
AutoZone is seeing its same-store-sales figures weaken. Its long-term commitment to aggressive share buybacks has benefited shareholders tremendously, but they’ve also been largely fueled by taking on debt. That strategy worked during the long period of near-zero interest rates, but different days appear to be on the horizon. AutoZone continues to be an admirable company, but auto-parts retailers face additional challenges as Amazon.com continues to grow its presence in the space, so we think the fund’s investment dollars are better placed elsewhere.
Some of the money we had in those investments went toward the purchases of Alarm.com Holdings, Everbridge Inc., and Nlight Inc. during the quarter. Each of these companies is more of a “new economy” holding than the paper, auto parts, chemicals, cabinets, and pizza companies we sold out of. While all of our investments and sales are made on an individual and bottom-up investing process, it’s not a coincidence that we found ourselves buying younger and much more information technology-oriented companies. Asset-light companies can have significant advantages in the profitability they can achieve through growth, especially in an environment where employee, transportation, and input costs are critical to the operation of a business. Each of our new investments stands to benefit from these dynamics.
For the quarter, our bottom performers were IPG Photonics (down 29%), TRI Pointe Group (24%), Newmark Group (24%), Diamond Hill Investment Group (15%), Thor Industries (14%), Jones Lang LaSalle (13%), and LCI Industries (8%). There’s less of a theme unifying these companies, though IPG, Thor, and LCI were all victims to varying degrees of tariffs and trade wars. A slowing real estate market echoes through the performances of TRI Pointe, Newmark, and Jones Lang LaSalle.
The best performing stocks were Paycom Software (57%), Teladoc (49%), Paylocity Holdings (37%), Nuvasive (36%), Proto Labs (36%), GrubHub (32%), and Ultimate Software Group (25%). Largely, these are software and information tech companies. That’s not to say future quarters will have the same types of companies at the top of the best-performers list, but it was certainly the story for the quarter just concluded.
Note: The Morningstar RatingTM for funds, or ‘star rating’, is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. As of 9/30/2018, the Motley Fool Small-Mid Cap Growth Fund (Investor shares) was rated in the Mid Cap Growth Funds category, receiving a three-star rating among 540 funds over a three-year period and a four-star rating among 483 funds over a five-year period.
Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10- year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods. Past performance is no guarantee of future results.