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.
During the second quarter of 2012, we began raising the cash level in our accounts to take advantage of the rally in the equity markets from last year's low and to weed out some individual companies which were not performing up to expectations. 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 equity strategy outperformed the S&P 500 Index by over 1.0% in a down market, significantly contributing to the year-to-date relative performance in the overall account. Several factors were noteworthy during the quarter: in health care and industrials, each of our stock holdings exhibited better performance than their respective sectors; 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, in the same month, one of our technology holdings, Ariba, received a premium bid (all cash) of 20% to be acquired by SAP. Within our equity portfolios, our international exposure remains underweighted relative to the static benchmark. As represented by the MSCI All Country World ex US index, international equities declined more than 7% during the quarter compared to the 2.8% fall in the domestic S&P 500 index. However, two of our consumer stocks with significant international exposure, Anheuser-Busch Inbev and Fomento Economico gained more than 10% on the prospect of stronger earnings. (See Model Performance Chart)
Our trading activity has increased this year, and during the quarter we sold positions where we had heightened reservations with regard to the earnings outlook, quality, or corporate governance. These included Broadcom and Martin Marietta Materials. JP Morgan was sold following the disclosure of a surprising trading loss, which the company underestimated, in its securities portfolio. We also sold our relatively small position in the PowerShares India Portfolio and consolidated a portion of the proceeds into the iShares MSCI Emerging Markets Index Fund.
Though five new equities were added to the portfolios during the second quarter, we did not utilize all the cash raised from the aforementioned sales and any trimming of other stocks. This leaves us with a greater reserve to capture valuation opportunities. Equities added during the quarter included:
FEMSA is a well-managed conglomerate that controls two of the most successful consumer businesses in Latin America, Coca-Cola FEMSA and the Oxxo convenience store chain. It also holds an equity investment in Heineken. Oxxo and Coke FEMSA both enjoy significant entry barriers, hold very large market shares, provide attractive returns on capital while growing rapidly, and are relatively steady businesses. Ample growth opportunities remain for both Coke FEMSA and Oxxo in expansion of the brands in current markets, as well as expansion into new markets - throughout Latin America and potentially beyond.
An unparalleled collection of entertainment and media assets, iconic brands, and a highly regarded management team differentiates Walt Disney from most competitors. Long-term growth should be driven by its Media Networks (ESPN) and Parks businesses, which have greater visibility due to long-term contract signings and a strong capital investment program. As its capital spending programs slow in 2012 and beyond, Disney's cash flow per share is forecasted to grow, providing significant balance sheet flexibility to make future acquisitions, increase international investment, continue to enhance and update current theme parks, expand the cruise ship portfolio, and return a greater portion of free cash to shareholders.
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.
CVS is well positioned in both its retail business and its Pharmacy Benefit Manager (PBM), Caremark. The company continues to bring new changes to retail, such as a store clustering strategy and further development of its ExtraCare program, which is increasing customer adherence. Other exciting growth opportunities include doubling the number of MinuteClinics by 2016, which is transforming the ease of care for patients, and leveraging the integration between Caremark, CVS Retail, and MinuteClinics to enhance the choices available to consumers within the CVS umbrella.
Huntington Bancshares is headquartered in Columbus, OH, with branches primarily in the Midwest. The Huntington National Bank was founded in 1866 and is a large player in Ohio and Michigan. Huntington is refreshing its branch and ATM network, adding new markets (auto lending in New England), hiring commercial bankers (all markets), expanding hours (now the market leader in OH), opening new branches (Giant Eagle relationship), and most importantly growing loans (especially C&I and auto). The stock fits nicely into one of our investment themes, emphasizing service providers to a rejuvenated U.S. manufacturing economy aided by new sources of growth in the production of oil and natural gas.
(See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)