SECOND QUARTER 2012
The Economic Climate
The second quarter of 2012 became a battleground between falling expectations for global economic growth and expanding policy initiatives to arrest the fear of fiscal chaos in Europe. This "tug of war" resulted in a 3% contraction in U.S. equities, bringing the year's gain to less than 10%. On the last trading day of the quarter, global stock markets jumped over 2.0 % on the announcement of a new European pact to recapitalize Spanish and Italian banks and to coordinate the supervision of all European banks under the ECB (European Central Bank). The prevailing interest rate on the 10-year government notes of Spain and Italy both dropped, to 6.32% and 5.81%, respectively. All of this was reversed during July. Notwithstanding a cut in benchmark interest rates by the central banking authorities in China and Europe, the rates on those same 10-year notes shot back above 7.0% (Spain) and 6.0% (Italy). The value of the euro has shrunk by more than 5% relative to the dollar since March 2012.
Both domestically and globally, economic indices are increasingly concerning. The PMI (Purchasing's Manager's Index), an indicator of the direction of industrial activity, has been contracting for the Eurozone since the beginning of the year. The June PMI for the United States was 49.7 after 34 consecutive months of reports above 50.0. A reading under 50.0 reflects contracting industrial activity. The pace of employment growth has not matched the recovery in U.S. real Gross Domestic Product (GDP). In our last letter, we pointed out that monthly employment gains (non-farm) had "sputtered" in March to 120,000 from the 246,000 average of the preceding three months. Since then, the monthly rate of increase has been under 100,000, with the most recent report for June at only 80,000. According to the Economic Cycle Research Institute, comparable drops in job growth have typically been a precursor to recession.
On the positive side, we note recent gains in U.S. single family housing starts, overall building permits, and vehicle sales. June showed a 22% year-over-year gain in U.S. vehicle sales. All in, the consensus projection for U.S. 2012 real GDP growth has been cut to 2.1% from a forecast of about 3.0% one year ago. However, unless Congress acts soon, the expiration of tax benefits and initiation of automatic spending cuts effective in 2013 could bring growth in the economy to a halt.
While Europe is recognized as already engulfed in the throes of another recession, the rate of growth has also lessened in some of the larger developing economies. Real GDP growth in India was reported at 5.3% in the first quarter, the weakest gain since 2003. In Brazil, where GDP growth has struggled to remain at 1.0%, some 8% of consumer loans are overdue by more than 90 days, the highest level since late 2009. Retail sales slumped 0.8% in May from April, the largest monthly fall since November 2008. The Financial Times (July 5, 2012) reported, though officially unconfirmed, that Sany Group, China's largest manufacturer of construction machinery, has implemented its first round of layoffs in ten years. The company recently reduced its 2012 forecast for excavator sales to 10.0% from 40.0%. Calendar 2012 GDP projections for China have fallen into a range of 7.0%-8.0% compared to the average annual rate of 10.0% since 2000. The preliminary report for 2Q GDP growth was 7.6%, the most subdued trend in three years, though in line with Government estimates. Electricity production, a coincident indicator, slipped in June from a year ago. In the aggregate, global GDP may advance 3.5% this year according to the International Monetary Fund compared to the 4%-5% trend prior to the 2008-2009 recession.
We continue to find equity valuations attractive relative to prospective bond returns which are based on historically low coupon rates. Moreover, investor psychology towards equities is already quite negative. The July 2, 2012 Wall Street Journal reported that the flow of investor money out of domestic, equity mutual funds continued in June, bringing the cumulative outflow since the start of 2007 to $350 billion. On the other hand, U.S. bond funds have enjoyed an inflow of over $1.0 trillion during that period. Nevertheless, we are more cautious regarding near-term corporate earnings, and now have a larger reserve to capitalize on valuation opportunities.
In addition to the ongoing dislocations in Europe and a slowdown in key developing markets, the drop in the rate on the U.S. 10-year Treasury note to less than 1.5% from the range of 2.0%-2.5% earlier in the year, coupled with the fall of about 10% in commodity prices during the second quarter, are coincident indicators of weaker demand. The July 11, 2012 auction of new 10-year Treasury notes was priced at a record low auction yield of 1.46%. Financial results so far reported for the second quarter reveal a moderation in revenue gains. Corporate profit margins are already bumping up against their 2007 peak, further rendering earnings comparisons more challenging. Companies ranging from Proctor & Gamble, to Ford and Nike, as well as Cummins and a variety of smaller software providers have already preannounced a shortfall in earnings relative to earlier expectations. In this environment, we plan to put cash back to work selectively in equities where we have been waiting for better prices.
During the second quarter of 2012, our portfolios using the equity income strategy outperformed their respective benchmarks. The stock holdings had superior relative performance compared to the S&P 500 Index of over 2.0% in a down market. Several factors were noteworthy during the quarter: the technology and industrials sectors were the strongest performers; during May, Cooper Industries received a takeover offer (stock and cash) from Eaton Corp. at a value more than 20% above where it was trading at the time; and, our portfolios benefitted from their lower volatility and higher dividend-paying holdings, such as utilities, as overall market volatility increased. Within our equity portfolios, our international exposure remains underweighted relative to the static benchmark. As represented by the MSCI All Country World ex U.S. index, international equities declined more than 7% during the quarter compared to the 2.8% fall in the domestic S&P 500 index. However, one of our consumer stocks with significant international exposure, Anheuser-Busch Inbev, gained more than 10% on the prospect of stronger earnings.
(See Model Performance Chart)
During the quarter, two stocks were sold from the portfolios.
JP Morgan was sold following the disclosure of a surprising trading loss, which the company underestimated, in its securities portfolio.
We also sold our position in the Apache Mandatory Convertible Preferred. The proceeds were swapped into Seadrill, which has a higher and more sustainable yield (the Apache converts to common stock with a low yield in August 2013).
Four new positions were added.
Unilever has long enjoyed a stable of strong brands, leading market shares, favorable emerging market exposure, strong cash flow, and high returns on capital and equity. A mini-turnaround began in the mid-2000s, but was cemented and accelerated when a new CEO took the helm in 2009. The results over the last three years have been impressive across almost all metrics, including market shares, relative growth acceleration, margin improvement, cash flow acceleration, corporate structure improvement, and innovation. Due to the high emerging market exposure (54% of sales), there is the potential for organic revenue to accelerate.
Wisconsin Energy offers above average earnings visibility. Management indicated it plans to increase the dividend at a double-digit rate through 2014 with a goal of achieving a 60% payout ratio. Longer-term dividend growth is supported by 4-6% earnings growth, which could prove conservative. Historically rate cases have created buying opportunities in regulated utilities and Wisconsin Energy filed its most recent rate case on March 23. The largest utility in Wisconsin, Wisconsin Energy, serves 1.1 million electric customers and 1.0 million gas customers.
Seadrill is the second largest offshore driller in the world and boasts the youngest, most modern and the highest-specification fleet of drilling rigs across the entire industry. The combination of higher average dayrates for rig rentals, improving utilization across all areas of the drilling industry (including a resumption of activity in the U.S. Gulf of Mexico), a strong focus on returning cash to shareholders (7.5% dividend yield), a young and highly specialized fleet of rigs, a $12.9 billion backlog of business, and an "income-oriented" investor base should allow Seadrill to maintain a premium valuation to the peer-group and drive strong operational performance as industry conditions continue to improve.
Mattel offers a defensive earnings profile driven by a best-in-class toy brands and a focused growth strategy. BarbieSM, American Girl®, Hot Wheels/Match Box®, Thomas & Friends™, and Fisher-Price® collectively represent 70% of sales with growth led by sales to an expanding middle class population in Asia and Latin America. The 2012 acquisition of HIT Entertainment addresses what had historically been Mattel's weak spot (boys), and the expansion of HIT's Thomas brand is expected to be a key growth driver, along with international expansion of select brands (Monster High), entertainment partnerships (Disney/Pixar, WWE, etc.) and ongoing cost reductions. Mattel's most recent quarterly earnings report was strong as earnings per share was above consensus and gross margin improved.
(See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)