MARKET ENVIRONMENT
What an ugly quarter for the stock market! The return for the S&P 500 was down -13.9%, the worst quarter for the S&P 500 since September of 2002 when the market declined -17.3%. The foreign markets (as measured by MSCI-EAFE) were also down -19.0%, hardly a refuge from the US markets. Remarkably, given the low level of interest rates, bonds were the winners in the
quarter, up 2.4% (as measured by Barclays Intermediate Government/Corporate index) reflecting
investors move toward safer havens.
The quarter could be characterized as a battle between the big macro issues and relatively good company earnings reports. Some of the macro issues are:
- Greece’s potential default and destabilization of the European sovereign debt markets.
- Deteriorating European bank balance sheets where banks have been hesitant to write off bad loans and address the inevitable write down of sovereign debt.
- Our own government’s front page fiasco on arriving at a solution to lift the debt ceiling. The unwillingness of either political party to arrive at middle ground to address the budget/ deficit problems.
We can go on but you don’t need us to rehash your every day experience of the media onslaught, which continues to focus on the negatives rather than reporting events in a more balanced manner. That is not to say that these issues should not be addressed, but the reporting of the issues should be more evenhanded.
Despite economic uncertainty and political strife, companies reported reasonably good earnings. Profit margins have not rolled over, company balance sheets are flush with cash and valuations at 11 times next year’s projected earnings, has the market looking inexpensive. Companies are buying stock and increasing dividends to shareholders, perhaps, in lieu of new capital investment
or hiring new employees during a period when Washington is incapable of providing direction or a concrete plan that addresses the deficit issues. Companies are slow to expand or commit to new investments when the effects of the tax policy and new costly regulation cannot be determined.
The political backdrop is not healthy when there is no bipartisan agreement to address the problems facing our country. The President wishes to cast the issue in terms of class, saying that the supposedly rich (those earning over $200,000 in annual income) are not paying their fair share, when in reality this segment is paying at a 33% tax rate. The issue is not rich against poor. The issue is a spending problem. We cannot generate enough in revenue to support the entitlement programs that account for 80% of our Federal budget---Social Security, Medicare, Medicaid and Defense. What is needed is an overhaul of the tax code, elimination of special interest groups’ tax credits and a cutback in the entitlement programs that are outstripping our government’s ability to fund. Unfortunately, our opinion is that nothing will be done by either party until after the 2012 Presidential election. What that means is lackluster growth, high unemployment and a housing market that is slow to recover. It does not mean that we slip into a recession, (although the probability has increased) but that the current slow growth and muddle through economics will continue until meaningful policy changes are made to stimulate investment and work force hiring.
OUTLOOK
We don’t see explosive economic growth at this stage of the recovery or the country slipping back into recession. We are saddled with anemic economic growth as the country continues to deleverage. Stock market volatility is unsettling, but it does provide opportunities to buy world class companies on days when the irrational investor discards them for no apparent fundamental reason. Companies are doing well in a slow growth environment. Imagine how well they might do, and how much better off the consumer would be, if we could resolve the major fiscal issues at the Federal and local levels in a bipartisan manner.
We believe that markets compete for dollars based upon perceived expected return for the risk assumed. It is hard not to conclude that quality companies are very attractively priced in comparison with bonds or money market funds. The market is not overpriced based upon price to earnings, price to book and expected earnings growth numbers. The question is whether the macro issues take center stage delaying the expected price appreciation in equities. We believe the market is going to remain volatile until we reach a resolution of tax policy and budget issues.
Meanwhile, global companies are expected to do well, but it’s going to take time for the bigger macro issues to dissipate. How much the macro environment impacts the stock market is difficult to quantify, but the current valuations combined with a 3 to 5 year investment horizon, offers upside reward. The chart below shows that the trailing P/E on the market is more than one standard deviation below its 20 year average.
As to bonds, as we said before, they are risk diversifiers but offer little upside return. If one assumes stocks will have more muted returns (e.g. 7% instead of the 9% historical average) and bonds will return 3% instead of 6%, it is unreasonable to assume pension plans can hit the 7.5% actuarial return target at a 60/40 mix between stocks and bonds. This scenario would create a bigger drag on the economy as state pension funds wrestle with underfunding and reduced expectations for investment return.
Hopefully, as you read this report, we are in the middle of a 4th quarter stock market recovery that recoups what was given up in the 3rd quarter. Our view is that the prospect for the market at this stage of the recovery is more muted, but on an expected rate of return basis, we believe it offers higher return potential than bonds or cash.
MARKET ORIENTED CORE STRATEGY & OUTLOOK
Our Market Oriented Core Equity Strategy was down 12.9% in the third quarter of 2011 compared with the S&P 500 return of -13.9%. For the nine months of 2011, the strategy was down 3.4% vs. -8.7% for the S&P 500. We are pleased with the substantial outperformance during the nine month period, but disappointed that we are not in positive territory. Undoubtedly, concerns about the European debt contagion combined with our own budgetary issues were contributors to the global equity market sell off. The Market Oriented Balanced portfolio was down 8.8%, slightly underperforming the Balanced Index Benchmark return of - 8.4% for the quarter, but outperforming for the nine months period, returning -1.6% compared with -4.0% for the benchmark.
It was a tough quarter because good valuations, increasing profitability, accelerating free cash flow, stock buybacks and increased dividend payouts are usually positive factors that lead to price appreciation. So much for expectations! The big macro concerns dominated as heightened worries about the European banking system, Greece’s problems and our country’s inability to address our own financial failings at the federal and the state level, led to a sell off in equities.
Outperforming the S&P 500 in the third quarter is better than substantially underperforming, but we believe the performance of the companies we owned would have been better recognized, if not for the “macro factor malaise”.
We benefitted in the quarter from outstanding performance from a handful of companies and avoiding some of the worst performing sectors. However, it was similar to swimming upstream against the current; no consistent progress could be achieved and investors could not overcome the propensity to sell regardless of price, perhaps viewing the current crisis as a harbinger of another 2008 global financial implosion.
We had excellent positive performance from a diverse group of companies. American Tower, AutoZone, Cerner, Costco, Consolidated Edison and IBM achieved positive returns in a down quarter. Our underweight of the Financial sector also positively affected our performance as the banking system continues to come under scrutiny by state attorneys general and Washington legislators. It is always interesting to us that the government agencies, complicit in not correcting the flagrant abuses of the financial industry, are now potentially over regulating when the primary objective should be to create an atmosphere that restores confidence and economic growth.
OUTLOOK
We are cognizant that we are two and half years into a recovery that could be characterized as being weak in comparison to the two previous recoveries. It cannot be denied that we received less economic growth per dollar of fiscal stimulus than in previous recoveries. The deleveraging of both corporate and consumer balance sheets has not been without economic costs. Unemployment at 9.1% and a housing market that is struggling with declining home prices and foreclosures are headwinds that will be with us for a couple of years. The private sector is “making do with less” yet taking their frustrations to the streets in the form of protests. Businesses ask “why invest in new plant and equipment and hire new employees when there is great uncertainty about tax policy and new government regulations?” Buying in stock, improving return on equity and increasing dividend payouts is a short term panacea while corporations await Washington’s clarification of tax and regulatory policy.
In 2011, what we are also seeing is a rotational shift away from those early economic recovery companies to the later recovery companies in the more defensive sectors. Although we build our portfolios bottom up based upon both quantitative and fundamental analysis, it is interesting to examine how the exposure comparison to the S&P 500 has changed since December 31, 2010. Consumer Cyclical and the Healthcare sectors have remained our most overweight sectors relative to the S&P 500. The consumer is still healthy and the 91% that are employed are spending money even though consumer confidence measures have faltered. Healthcare is a late cycle defensive play where both valuation and consistent earnings visibility are important market characteristics when moving into the later stages of a recovery. Not surprisingly, the Financial sector, which we have been consistently and correctly underweight, has been one of the worst performing sectors and continues to have the lowest rankings in our research. Technology, that was 19% as of December 31st June 30th has fallen to 13%, as both the public and private sectors have revised their IT budgets.
Our view is that earnings visibility, bigger, high quality global companies and those with the ability to self finance, should be in a position to hold their own as we sort through the bigger macro factors that characterize the current market environment. We still believe our portfolios are well positioned to participate in the later stages of the recovery that started in March of 2009. However, one can expect the returns to be more muted as the world works to resolve the bigger global macro issues.
Our Worldwide Equity Strategy was down 15.8% for the 3rd quarter of 2011 compared with the Global Equity benchmark’s return of -14.9%. For the nine months of 2011, the strategy was down 9.7% vs. the Global Equity benchmark return of -9.9% and the S&P 500 return of -8.7%. Essentially, we held our own for the first nine months, but in hindsight, we would have liked to have defended better in the quarter.
The Worldwide Balanced accounts also underperformed, returning -11.3% for the quarter and - 6.3% for the nine month period compared to the Global Balanced benchmark returns of -8.2% for the quarter and -4.0% for the nine months of 2011. The biggest contributing factor to the underperformance was our shorter maturity bond portfolio in comparison with the index and the strong rally in the US treasury market even though rates appeared to be at the bottom when entering the quarter.
The quarter was not exceptional, but then again, we do not worry about short term fluctuations in the market. In some instances, the market volatility allowed us to add to companies at lower prices. Although we build portfolios on a bottom up basis selecting individual companies, the net result of our overweight in the Technology, Healthcare and Consumer Staples sectors in the quarter helped the equities defend relatively well. Our continued underweight in the Financial sector was also was a positive contributor to performance.
We sold Schlumberger during the quarter, reducing our exposure to the oil service sector while adding two relatively defensive names, Johnson and Johnson and the Travelers Companies Inc Johnson and Johnson is a world class healthcare company that we believe has finally solved some of the quality standard manufacturing issues for some of its proprietary drugs and is arguably undervalued in comparison to competitors. It also pays a 3.6% dividend with our expectation of future dividend increases from strong operating cash flow.
We added Travelers as we believe the insurance pricing cycle has bottomed which should help premium growth offset lower interest rate returns on their investment portfolio. We also believe the management team, led by Jay Fishman, is one of the most experienced in the business.
OUTLOOK
Where we go from here is the most obvious question. We are cognizant that we are two and half years into a recovery that could be characterized as being weak in comparison to the two previous recoveries. It cannot be denied that we received less economic growth per dollar of fiscal stimulus than in previous recoveries. The deleveraging of both corporate and consumer balance sheets has not been without economic costs. Unemployment at 9.1% and a housing market that is struggling with declining home prices and foreclosures are headwinds that will be with us for a couple of years. The private sector is “making do with less” yet taking their frustrations to the streets in the form of protests. Businesses ask “why invest in new plant and equipment and hire new employees when there is great uncertainty about tax policy and new government regulations?” Buying in stock, improving return on equity and increasing dividend payouts is a short term panacea while corporations await Washington’s clarification of tax and regulatory policy.
With all things considered, our watch list is expanding. We are finding companies that are undervalued that offer significant upside potential despite the big macro factors overhanging the market. We believe the Eurozone problems will be addressed and the worry about contagion from Greece will be resolved or contained. It is plausible that once some certainty can be established for the global financial system, we can begin to focus on our own problems at home (i.e. unemployment, fiscal deficits, entitlement programs, tax policy, etc.). We can’t put a timetable on when these issues will be addressed by a dysfunctional Washington, but Washington cannot continue to “kick the can down the road forever.”
We still believe our portfolios are well positioned to participate in the later stages of the recovery that started in March of 2009. Our companies are selling at reasonable price earnings multiples and have excellent balance sheets. We do not believe this is a repeat of 2008; the US banking system is healthier and more liquid, while companies are performing well in a tepid business environment. However, one can expect the returns to be more muted as the world works to resolve its bigger global macro issues. We are optimistic that these issues will ultimately be resolved. optimism.
WORLDWIDE DIVIDEND PLUS STRATEGYAND OUTLOOK
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Our Worldwide Dividend Plus Strategy was down 6.9% for the 3rd quarter of 2011 compared with the S&P 500’s return of -13.9%. For the nine months of 2011, the strategy was down 0.1% vs. the S&P 500 benchmark return of -8.7%.
Obviously, we are pleased by the results in the quarter and for the nine months. The portfolio can be characterized as having a dividend yield twice the dividend yield of the S&P 500, generally selling at a lower price earnings multiples and exhibiting less volatility in both up and down markets. For the nine months and for the quarter, which was the worst performing S&P 500 return quarter since the 3rd quarter of 2002, the portfolio performed as expected (it gave up less in a down market). Of course, there is no guarantee that this will happen over short periods of time, but in general, less volatile, higher paying dividend stocks defend better in down market periods and lag higher earnings expectation stocks in up markets.
What makes this strategy more appealing today is that one is not sacrificing that much in future earnings expectations than one did 10 to 15 years ago. Companies such as Intel and Microsoft are now providing dividend returns of over 3% with the expectation of further increases. Many make the statement that the higher dividend reflects reduced growth expectations for these companies; we could not disagree more. These are two high quality companies with highly differentiated products with sterling reputations for delivering quality. The earnings growth rates are not what they have been in the past, but are far superior to other companies that do not have such a generous dividend payout. We are not sacrificing much in future price appreciation for a dividend 50% higher than the market’s dividend return.
OUTLOOK
Where we go from here is the most obvious question. We are cognizant that we are two and half years into a recovery that could be characterized as being weak in comparison to the two previous recoveries. It cannot be denied that we received less economic growth per dollar of fiscal stimulus than in previous recoveries. The deleveraging of both corporate and consumer balance sheets has not been without economic costs. Unemployment at 9.1% and a housing market that is struggling with declining home prices and foreclosures are headwinds that will be with us for a couple of years. The private sector is “making do with less” yet taking their frustrations to the streets in the form of protests. Businesses ask “why invest in new plant and equipment and hire new employees when there is great uncertainty about tax policy and new government regulations?” Buying in stock, improving return on equity and increasing dividend payouts is a short term panacea while corporations await Washington’s clarification of tax and regulatory policy.
This strategy is not immune from market risk factors. We will sell stocks regardless of yield depending upon prospects and outlook for the stocks and sectors. We are still using the bottom up fundamental research that we use for our Worldwide Equity strategy, but focusing more on dividend yield, capacity to grow dividends and company specific prospects. We are also more aware of sector influences. For example, future regulatory changes or interest rates could have a major impact on utilities regardless of the dividend yield. Our focus is on total rate of return, but with more of the return coming from dividends rather than appreciation.
Again, we are pleased about the nine month results and look to finish in positive territory if the market provides a rally in the fourth quarter.
