Total Return - Third Quarter 2012

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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 percent 15 months ago. Though second quarter growth was only 1.3%, preliminary third quarter GDP returned to the 2 percent 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.

Investment Performance

While all of the models underperformed their respective static benchmarks during the third quarter, all were ahead year-to-date through September 30th and over the last 12 months. Both the stock and bond portfolios performed better than their respective market comparisons during the nine to twelve month periods; an overweight allocation to stocks relative to bonds had a positive impact in accounts holding both asset classes. 

For the third quarter, fixed income performance was positively 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. Portfolio performance benefitted from stock selection in the Energy sector as oil and natural gas prices increased during the quarter. The portfolios' two largest equity positions, Apple and General Electric, appreciated almost 15.0% and 10.0% respectively. The portfolios' international equity underweight position relative to the static benchmark was a modest drag as international equities outperformed the U.S. equity market (on a year-to-date basis, international returns have trailed). Stock selection in Health Care and Technology also detracted from third quarter returns. (See Model Performance Chart)

Portfolio Changes

During the quarter, we sold two companies that are in the process of being acquired.  Cooper Industries 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. In August, the remaining position in Ariba, which was acquired by SAP, was also sold. The largest portion of the position was sold during the second quarter; however, we held a portion until the capital gains on the position became long-term for tax purposes.

Apache was also sold in an effort to replace a low conviction name in favor of those we feel have a greater potential for growth. The stock has lagged the Energy sector over the last year (although it has been a strong performer over our entire holding period), largely due to concerns surrounding its significant exposure in Egypt that we do not think will subside in the near future. The proceeds from the sale were used to increase the position in Schlumberger.

A number of new names were added during the quarter.

O'Reilly Automotive is one of the largest specialty retailers of automotive aftermarket parts in the United States, serving both do-it-yourself and professional service provider markets. The aftermarket parts business is highly fragmented, allowing the largest competitors to operate the industry as an oligopoly, gaining market share and consolidating the industry by overtaking smaller mom-and-pop stores. The countercyclical nature of the auto parts industry provides some level of protection should the economy weaken materially (consumers would be more likely to make repairs to their existing cars, as opposed to buying a new car). We initiated our purchase after the stock had corrected 18% from its recent high.

Clean Harbors is the largest hazardous waste disposal company in North America. Its breadth of business segments include emergency response services, where the company generated $220 million in revenue from its vital role in cleaning up the BP oil spill, high pressure and chemical cleaning, and hazardous incinerator capabilities. The company
has experienced significant growth within its energy services and industrial services divisions, and has an impeccable safety record. In 2008, Clean Harbors generated no revenue from oil and gas production or exploration. In 2011, these areas represented 25% of their business. Through acquisitions and internal growth, the company is well positioned to participate in the growth of the North American energy business which will also enhance cross-selling opportunities to its legacy business. 

Cytec Industries, a specialty chemical and materials company, is currently undergoing a significant portfolio restructuring through the sale of a Coatings Resins business which the company purchased in 2004. The proceeds of the sale will be partially used to purchase a small composites firm, Umeco, with the remainder available for a significant share buyback, special dividend or additional small acquisitions in the composite space. After the sale, the new Cytec will be largely comprised of growth businesses, including  Composites and a business that focuses on mining chemicals and phosphine gas for semiconductor and LED manufacturing. The result will be a less cyclical, higher return company with 66% of revenues coming from a strong composite business. 

Bed Bath & Beyond, Inc. is a chain of retail stores that sells a wide assortment of domestic merchandise. The company and its subsidiaries operate under the names Bed Bath & Beyond, Christmas Tree Shops, Harmon and Harmon Face Values, and buybuy BABY. The company sells a wide variety of domestic merchandise and home furnishings. The domestic merchandise includes categories such as bed linens and related items, bath items, and kitchen textiles. The home furnishings include categories such as kitchen and tabletop items, fine tabletop, basic housewares, general home furnishings, consumables, and certain juvenile products. It also sells food, giftware, health and beauty care items, and infant and toddler merchandise. Bed Bath & Beyond has a pristine balance sheet with zero debt and over $1 billion in cash. The company should benefit from the recovery trends developing across the housing market. 

Phillips 66 was spun-off from Conoco-Phillips and began trading independently on May 1, 2012. 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.  

Founded in 1925 and headquartered in Dallas, Dean Foods is the country's largest producer of branded conventional milk.  Holding greater importance, Dean owns the #1 organic milk brand (Horizon Organic), #1 nondairy (soy, vegetable, etc.) milk brands (Silk in the U.S., Alpro in Europe), and the #2 coffee creamer business (International Delight and Land O’ Lakes); these brands (WhiteWave-Alpro division) are being monetized through the impending IPO and spin-off into WhiteWave Foods. We believe Dean Foods will unlock substantial value for shareholders as the market is likely to assign a premium multiple to the faster growing WhiteWave, on par with other organic/fresh grocery and premium/high growth consumer product companies. Furthermore, Dean may use the proceeds from the announced sale of its Morningstar business to reduce debt.
(See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)

Model Performance (as of 9/30/2012)
Model Performance
Top 10 Equity Holdings (as of 9/30/2012)
Top 10 Equity Holdings
Equity Sector Diversification Versus the S&P 500 Index (as of 9/30/2012)
Equity Sector Diversification


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