FIRST QUARTER 2012
The Economic Climate
The stock market recorded another double-digit gain in the first quarter of 2012, hitting a post-March 2009 high. The stock market level remains above its 2011 trading range, at a reasonable valuation of 13.7X trailing earnings per share.
The continuation of the positive fourth quarter performance trend can be linked to the growing perception that the U.S. economy and the overall global economy can make net progress despite a European recession. U.S. retail sales in March, the warmest March on record, increased 8.0% from a year ago – led by auto purchases. The pace of bank lending accelerated early in the year to an annualized rate of better than 5.0%, and U.S. manufacturing indices are still pointing toward expansion. Monthly employment gains (non-farm) sputtered in March to 120,000 compared to the average gain of 246,000 in the preceding three months. China recorded a real GDP growth rate of 8.1% in the first quarter, quite respectable compared to the rest of the globe, but the lowest quarterly number since the first quarter of 2009. Similarly, real GDP growth in India slowed to 6.1% in the most recent quarter compared to trend growth of 8.0%; India's central bank just cut the rate at which it will lend to commercial banks by 0.5% in an effort to promote growth.
The consensus forecast for U.S. real GDP growth in 2012, as measured by the most recent Bloomberg survey, is 2.2% (in line with results from the first quarter), an uptick from the 2.0% recorded in October 2011. The comparable survey for Europe is projecting an annualized decline of -0.4%. Industrial production in the 17 countries comprising the Eurozone dropped 1.8% in February from last year, the sharpest monthly decline since December 2009. A recently reported manufacturing index for the Eurozone remained in "contraction" territory in April. Conditions are most challenging in the southern countries of Greece, Portugal, and Spain, pushing overall Eurozone unemployment to a recent high of 10.9% compared to 8.2% in the U.S. Spain's new Prime Minister, Mariano Rajoy, has revised the country's fiscal deficit target for 2012 to 5.8% of GDP versus the earlier commitment of 4.4%. As a consequence, the yield on Spain's ten-year debt shot back to 6.0% from under 5.0% in March. Election results in France and Greece (as well as in the U.S.) could also complicate the picture. Germany remains one of the few bright spots in Europe; GDP per capita has been growing faster than other developed countries, reflected in an unemployment rate of under 6.0%. As a buffer to further deterioration in Europe, the International Monetary Fund has doubled its lending capacity to more than $700 billion.
In addition to uncertainty in Europe, the elevated price of oil remains a risk to corporate profit margins and the economic outlook. The problem appears to be more related to supply than demand. Indeed, demand in the 34 developed countries comprising the Organization for Economic Co-operation and Development (OECD) has fallen by about 10% since 2005. OECD countries, including the U.S., Japan, and Europe, comprise roughly 50% of global demand. Supply has been compromised by declining production rates in older wells and unrest in Middle Eastern and African countries. Iran exports approximately 2.5 million barrels per day (mbpd) of oil from its annual production of some 4.0 mbpd. Iran's exports are equivalent to almost all of the spare capacity residing in the Organization of Petroleum Exporting Countries (OPEC), the vast majority of which is in Saudi Arabia. Therefore, the imposition of sanctions on Iran should absorb some of this excess capacity and tighten the overall supply-demand balance. Attention has focused on the Strait of Hormuz, which borders Iran and acts as the shipping lane for one-half of OPEC's production or more than 15% of global consumption.
We are emphasizing an overweight exposure to equities relative to fixed income investments. Stock valuations are fair and corporate balance sheets are healthy enough to provide for future dividend increases. Falling interest rates, which have been pushing bond prices upward for the past 30 years, are unlikely to provide as much of a catalyst in future years. In deference to the stated policy of the Federal Reserve to endeavor to keep interest rates at a low level for at least the next year, bonds should still occupy a significant position in most portfolios because of their more predictable returns and lower volatility. Within fixed income portfolios, we are still positioned with a lower average maturity to guard against the eventual upward bias in interest rates. (The ten-year Treasury rate actually increased by about 30 basis points or 3/10 of one percent during the quarter.)
We believe the U.S. is on the threshold of making a meaningful dent in its dependence upon imported oil. New energy recovery technologies, such as hydraulic fracturing and horizontal drilling, are stimulating production from shale and other non-porous hydrocarbon formations. After a flat trend for more than 25 years, U.S. natural gas production has jumped over 20% since 2005. U.S. natural gas prices are a fraction of those in Europe and Japan, and are now competitive with coal for power generation. Natural gas and coal account for 24% and 45% respectively of U.S. electric power generation. Domestic production of petroleum had fallen about 25% from 1970 to 2005, but has since increased by more than 10%. According to the U.S. Energy Information Administration, imports now account for less than 50% of U.S. petroleum consumption compared to a peak of 60% in 2005. These new drilling techniques come with environmental risks, including the potential for aquifer contamination if not situated and cemented properly. Our forthcoming TrustLetter will contain an article which addresses the pros and cons of hydraulic fracturing and horizontal drilling.
Major beneficiaries of an expansion in the production of domestic energy sources include industrial manufacturers, basic materials companies, and U.S. regional banks serving the Midwest. As a percentage of employment, the contribution from the manufacturing sector has been cut in half since 1980. However, a range of companies, such as Whirlpool, Intel, and Siemens have announced plans to expand U.S. facilities. The April 3, 2012 Financial Times highlighted a $1.0 billion planned investment by GE to expand its Louisville, Kentucky appliance facility. In March, the manufacturing sector contributed 37,000 of the 120,000 new non-farm jobs added to U.S. payrolls. Within our equity portfolios, we have over-weighted exposure to both the industrials sector and the related materials sector. Regional banks, with lending operations serving the Midwest, are also represented.
Following 2012's strong relative performance, the equity income strategy ended the first quarter trailing the sharp rise in the S&P 500, although broadly in line with other managers of a similar strategy. The largest sector, technology, recorded the greatest appreciation, led by Accenture and Microsoft, which both appreciated over 20%. Financials were the second best performing sector in the equity portfolios. Utilities, the best performing S&P sector in 2011, lagged the most; the equity income strategy maintained an overweight position in higher yielding utilities. (See Model Performance Chart)
Significant Portfolio Changes
During the quarter, we sold Johnson Controls. The company reported another problematic quarter, due to a combination of company-specific execution issues, such as higher plant startup costs and a battery plant shutdown in China. Johnson Controls still trades at a premium to its peer group. This follows a partial sale that was made last summer at higher prices.
We sold American Express, which has been a strong performer. In our view credit interchange (over 50% of the company's revenue) is likely to be under pressure later in 2012, and even with the recent dividend increase, the stock carries just a 1.3% dividend yield, with little upside bias in our view.
We also eliminated our position in Novartis, as the initial concerns that prompted us to reduce the position last December appear to be increasing in severity, while the stock is still essentially flat. These key risks include: issues with key pipeline/recently launched drugs, specific challenges within its generics division (Sandoz) including a recent warning letter addressing quality issues in three U.S.-based manufacturing facilities, and a recall in its consumer health division.
Three new positions were added to the portfolios.
Validus is one of the leaders in property catastrophe reinsurance, a portion of the insurance sector that is attractively positioned for a better pricing environment. Validus was born after the 2005 U.S. hurricane season. The firm's ROE approaches 20% over its histories, near the top of the reinsurance sector. We feel Validus is an attractive way to gain exposure to a high return industry with positive near term drivers.
Merck is a global pharmaceutical company with strong prospects, including a late stage pipeline with 19 programs in Phase III testing. The company expects to file over five new drugs for approval in 2012 and 2013. Merck has limited patent exposure compared to other major pharmaceuticals following the 2012 expiry of the asthma drug, SINGULAIR® (11% of revenue), and has strong growth opportunities in emerging markets and in its animal health division. Merck currently pays a 4.3% dividend and is moving through an aggressive share repurchase program. At 10.4x 2012 earnings, Merck trades at a 10% discount to its peers, and a 20% discount to the S&P 500.
Along with other non-U.S markets, the German iShares declined over 15% in 2011, given the mounting uncertainty in the European political and economic climate. As the situation begins to stabilize (we recognize this could be bumpy), we believe it is an opportune time to begin to increase our exposure to emerging and selected developed markets. The German economy – though slowing – is relatively healthy and competitive. The largest positions in the German iShares Fund consist of global leaders, such as Siemens, BASF, BAYER, SAP, and Daimler. Furthermore, the financial exposure contains more insurance than banks. (See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)