FOURTH QUARTER 2013
The Economic and Political Climate
The rate of real GDP growth in the major developed economies continues to improve. In the U.S., the pace accelerated during the second half of the year, with growth rates of 4.1% and 3.2% respectively in the third and fourth quarters. Federal budget cuts from sequestration should be less of a drag in 2014. Business confidence has improved in Japan and manufacturing activity in Europe, as measured by the Markit Economics survey, hit a 31-month high in December 2013. We believe this will offset what appears to be a marked deceleration in gains from emerging markets, such as India, China, and Brazil. In all, global real GDP growth is capable of reaching a 2.5%-3.5% rate in 2014 compared to 2.0%-2.5% this year.
Investment Performance and Asset Allocation
It was an exceptionally strong year for U.S. stocks in 2013, as the S&P 500 returned 32.4% and all ten S&P sectors posted returns of greater than 10.0%. The S&P significantly outperformed international markets as represented by the MSCI All Country World ex US index, which gained about half as much at 15.8%. Bond returns were mostly negative in 2013, with double-digit declines for longer term U.S. treasuries. Indeed, the difference in return between U.S. stocks (S&P 500) and certain bonds (20+year U.S. treasuries) was as wide as it has been since the 1930s.
The valuation of U.S. stocks compared to company earnings, sales or book value is now at or above historical averages. We do not see the excessive, bubble valuations of 1999-2000. However, in light of the U.S. stock market appreciating some 50% during 2012-2013, we began rebalancing our stock (equity) allocations towards the end of 2013 to reduce our overweight position relative to target ranges. While the long term outlook for equities is still favorable, it has become more difficult to find bargains.
For calendar year 2013, all of the composites outperformed the static benchmarks, with the portfolios continuing to benefit from an overweight position in domestic stocks. The fourth quarter contributed disproportionately to the year's return. Among individual stocks, there were many strong performers, some returning between 50.0% and 90.0% for the full year (Adobe Systems, CVS Caremark, Google, Hexcel, McKesson, SVB Financial Group and Walt Disney). The return in the bond portion of the accounts was well below that of stocks. However, performance was favorable versus the benchmark due to lower duration, or average maturity, in a time of rising interest rates. Over the course of the year, the interest rate on the 10-year Treasury note climbed by more than 1.0% to approximately 3.0%. (See Model Performance Chart)
Significant Portfolio Changes
Phillips 66 exhibited strong appreciation since our initial purchase, driven by unusually wide price differences, or spreads, between domestically priced West Texas Intermediate oil (WTI) and internationally priced Brent oil. This pricing difference has provided domestically focused refineries, especially those with access to lower-priced WTI (or heavy Canadian) crude, a significant advantage over international or U.S. coastal refineries that tend to process more Brent-based oil. The refining business is quite cyclical and we felt that these wider spreads and current level of profitability would be unsustainable. Following a large gain in the stock price, we decided to sell our position in Phillips 66.
We also sold Target. In recent years, Target's most significant undertaking has been its foray into Canada. The company's aggressive goals for new store profitability and productivity have fallen significantly short of expectations and Canadian consumers have been slow to embrace Target's value proposition, leading to heavy discounts and promotional activity that will continue to pressure profitability for the next few quarters. Following its third straight earnings disappointment, based primarily on its Canadian operations, there is now significant uncertainty whether the strategy to expand and grow market share profitably in Canada will be successful. Subsequent to our sale, Target reported that it had suffered a breach of their credit and debit card customer data.
One new position purchased
Headquartered in Switzerland, UBS AG provides financial services to private, corporate, and institutional clients, including wealth management, asset management and investment banking services. UBS suffered from the recent financial crisis, posting multi-million dollar losses in 2007, 2008, and 2009. Corporate actions resulted in significant litigation, regulatory scrutiny, client and advisor defections, and the suspension and then elimination of dividends from 2008 to 2010. Since the crisis, there has been nearly 100% turnover of senior management. The board of directors and company management have moved aggressively to reposition. In late 2012, UBS committed to significantly shifting its business mix by exiting several areas of fixed income trading and shrinking their investment banking operation ahead of burdensome new funding requirements for those businesses. This transition should reduce earnings volatility, increase return on capital, and support a higher valuation. (See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)