THIRD QUARTER 2012
The Economic Climate
A look at the current economic climate is darkened by an array of concerns. In an interview with the New York Times (August 12, 2012), a reporter summed up the comments of John Bogle, former head of the Vanguard complex of mutual funds as follows: "This is the worst time for investors that he has ever seen" in more than 60 years in the business.
Looking at the list of worries, Europe has been there the longest. The unemployment rate in the 17-country Eurozone reached 11.4% in August, an all-time record. The closely watched Purchasing Managers Index (PMI), a gauge of industrial activity, has recorded a level below 50 for each of the past 14 months through September. An index level of 50 serves as the line of demarcation between expansion and contraction. A survey of forecasts from economists and strategists tracked by Bloomberg calls for a contraction in real GDP of 0.5% in 2012 compared to a projection of 1.5% growth made only fifteen months ago. Surprisingly, the U.K. reported third quarter GDP growth of 1.0% from the second quarter, following three consecutive drops.
Growth in the emerging markets, which have been the locomotive of the global economy, is clearly slowing. Brazil is barely in positive territory and the government in India has been plagued by charges of corruption in the awarding of telecommunication licenses and coal contracts, not to mention the threat of power outages. The situation in China bears the closest scrutiny, given its position as the second largest world economy. While China recorded a real GDP gain of 7.4% in the third quarter of 2012, some recent data points are not encouraging. China's PMI index has been below 50 for 11 consecutive months through September. Corporate activity in China is also subdued, resulting in weak profits and reduced demand for global industrial commodities. Companies such as Deere, Cummins, Caterpillar, and Nike, as well as some luxury goods retailers, have recently reduced their expectations for sales growth in China. On the positive side, export growth and oil demand have improved, and the country has a significant capability to expand stimulus programs following the meeting of the 18th Congress in November.
The aforementioned Bloomberg survey also puts the recent consensus forecast for 2012 U.S. real GDP growth at 2.2% compared with a projection of 3.0% 15 months ago. Though second quarter growth was only 1.3%, preliminary third quarter GDP returned to the 2.0% rate of the first quarter. Among the major developed countries, the U.S. has demonstrated the most improvement since the 2008-2009 recession. Indeed, U.S. GDP is approximately 10% higher than the first quarter of 2008, its prerecession peak.
While job gains have been skittish and the unemployment rate only just dipped below 8.0%, two key cyclical sectors of the economy are showing signs of better health. Sales of light vehicles are running at an annual rate of nearly 15 million units, at least four million more than 2009's low of 10.0 million. Housing, which has only been contributing about half as much to GDP as its 30-year average, appears to be mending. In September, sales of existing single family homes were up 40.0% from their 2010 bottom. Housing starts, while still below their 2006 peak, are up more than 50% from their 2009 bottom. Home prices, as measured by the S&P/Case-Shiller Index of 20 major metropolitan areas, gained 1.6% in July from June. The Index, still 30% below its 2006 peak, rose in all 20 areas. According to The Bank Credit Analyst (August 2012 – Vol. 64 – No. 2), "there is no postwar precedent for a recession to occur when the cyclical sectors of the economy are as beaten down as they currently are." An index of U.S. consumer confidence reached its highest level since September 2007.
Investors should brace themselves for more frightening headlines over the so-called U.S. "fiscal cliff." Unless Congress passes new legislation by year end, automatic spending cuts and tax increases are set to begin in January 2013. According to an August 2012 report by the Congressional Budget Office, the spending drag could cause 2013 GDP to contract by 0.5% and unemployment to rise to 9.0%.
Long-Term Earnings Outlook Not Derailed
Corporations have an amazing ability to adapt to change and continue growing. Apple, IBM, Johnson & Johnson, and General Electric are just a few examples. Over time, earnings growth for U.S. corporations has trended at a fairly consistent pace of 5.0%-6.0% annually.
The stock market has retrenched during periods of recession (when corporate earnings contract), but has survived major worries, such as World Wars, the Cuban Missile Crisis, the attacks of 9/11. Indeed, these events appear as mere blips on a long-term price chart.
The biggest market moves are engendered when earnings rise or fall precipitously. Companies in the S&P 500 Index are expected to report an earnings increase of approximately 6.0%-7.0% for 2012 over 2011, some 20% above their previous peak level in 2007. Perhaps this explains why the U.S. stock market was one of only four, among the 30 country markets tracked in a New York Times article (August 25, 2012), trading above the global market peak of October 31, 2007. According to the Barclays U.S. Earnings Scorecard (August 17, 2012), 68% of S&P 500 companies exceeded second quarter estimates on the earnings line, but only 40% surpassed expectations on the revenue line. This pattern is holding true as companies now report third quarter results, which in the aggregate could mark a slight drop from last year. The consensus forecast for 2013 earnings amounts to a gain of over 10%. This appears high, in light of current economic trends and the fact that corporate profit margins are already lofty.
In regard to the outlook for sustaining the long-term earnings record of major corporations, some observations on the world's two largest economies provide encouragement. The pace of innovation in the U.S. and China stands out among major economies. The October 4, 2012 issue of the Financial Times carried an editorial which outlined the technological lead the U.S. has amassed in mobile broadband and the production of shale oil and gas. A surge in domestic natural gas production since 2005 has improved the competitive position of U.S. manufacturing vis-à-vis Europe and Japan. The number of patent applications filed and granted in the U.S. and China has more than tripled in the past 30 years.
Labor productivity growth in the U.S. has been holding at a modest 1.0% or so since 2006, but expanding by more than 8.0% annually in China. The U.S. has a demographic advantage because its working age population (ages 15-64) is projected to increase at a rate of 1.0%-1.5% annually over the next 25 years; China's is projected to begin a long-term decline commencing before 2020 (“Investing in U.S. Manufacturing Renaissance,” ISI International Strategy & Investment, March 5, 2012). In the 2011 listing of the top 100 global brands by the consultancy firm Interbrand, U.S. firms occupied all top ten spots. Although China did not make this list of 100, a similar ranking by Marketing Week (May 24, 2012) included three Chinese companies—China Mobile, China Construction Bank, and Baidu—among the top 25. Thus, long-term earnings growth of well-run companies in these two economies should continue, providing a positive catalyst for equity returns.
While all of the models underperformed their respective static benchmarks during the third quarter, those with a balanced or income objective were ahead of their respective benchmarks for the past year.
For the third quarter, fixed income performance was favorably impacted by the holding in the SPDR Barclays High Yield Bond Fund, which appreciated almost 4.0% compared to 1.7% for the benchmark. Equity markets continued to rally in the quarter despite slowing global economic growth, particularly in Europe and Asia. The equity portfolios benefitted from healthy midyear earnings results from General Electric, Travelers, Accenture, Phillips 66, and VF Corp. The portfolios' international equity underweight position relative to the static benchmarks was a modest drag as international equities outperformed the U.S. equity market, reversing their underperformance recorded in the first half of the year.
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During the quarter, we sold Cooper Industries, which will be acquired at a premium later this year by Eaton in a taxable transaction. Sales warnings by several industrial peers have continued into the present quarter, leading us to realize our gains by selling the Cooper position.
We also sold Procter & Gamble, which has reduced earnings expectations three times in the last six months, and recently referenced the soft underlying growth in developed markets, a slowdown in China, and a negative foreign exchange impact as contributing factors. Management execution has been questionable and the company has underperformed the peer group, the sector and the market, year-to-date.
Two new names were added during the quarter.
M&T Bank is a conservatively managed regional bank with a long history of strong underwriting and superior return on capital. M&T maintained its dividend through the financial crisis and the stock yields 3.59%, with dividend increases likely to resume in 2014. Founded in 1856 and headquartered in Buffalo, M&T's low cost funding (90% of deposits are core, with average cost of deposits of 0.22%), and successful focus on capital returns make the stock attractive. Moreover, the company has a stable shareholder base (10.37% owned by senior management and board, ~5% by the ESOP and other benefit plans, and 4.25% owned by Berkshire Hathaway.
Once the poster child for the failure to develop drugs to bridge impending patent cliffs, Pfizer's new CEO has taken several shareholder-friendly actions and set a clearly defined strategy. In addition, Pfizer has several near-term pipeline opportunities and is one of the cheapest stocks in the health care group with almost no value assigned to pipeline assets. The balance sheet is strong with $24b in cash and $39b in debt against $186b in total assets; operating cash flow should roughly equal free cash flow at around $19b. The board targets a 40% payout ratio of adjusted EPS over time, and it is reasonable to think that there should be continued dividend increases given the expected cash build up from the planned divestiture of noncore assets and modest earnings growth.
We received shares of Phillips 66 as part of a spin-off from Conoco-Phillips in May 2012 and have now increased the position. Phillips 66 represents an integrated downstream company with leading positions in all three of its business lines: Refining & Marketing, Gas Gathering & Processing, and Petrochemicals. With a portfolio of assets levered to growing domestic hydrocarbon production and industry leading positions in all three business segments, Phillips 66 stands to be a substantial beneficiary of several of the most promising domestic energy trends (increasing domestic production, low natural gas prices, and the transportation, processing and storage of hydrocarbons across the country). Phillips' U.S. refining assets are situated near major delivery points of crude oil production from Canada and the interior U.S., as well as major refining hubs in the Gulf coast.
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