FOURTH QUARTER 2012
The Economic Climate
The fourth quarter of 2012 registered subdued performance from the securities markets, caused by the uncertain outcome over discussions in Washington to resolve our so-called "fiscal cliff." Both businesses and consumers appear to have deferred spending. Hurricane Sandy also dampened the resolve to spend.
On January 2, 2013, President Obama signed into law "The American Taxpayer Relief Act of 2012," which also provided some relief for the capital markets. Since the beginning of the year, U.S. stocks have appreciated about 5%, while the interest rate on U.S. treasuries has nudged up slightly.
There are five parts to the fiscal cliff, only two of which are now complete. The completed steps include the extension of the tax cuts enacted by former President Bush for all individuals earning less than $400,000 and households earning less than $450,000. For incomes above these levels, the marginal tax rate will rise to 39.6% from 35.0%. Payroll taxes for employees will also rise to 6.2% from 4.2%. Emergency unemployment insurance benefits were extended for another twelve months. Other parts of the cliff, yet to be agreed upon, include automatic spending cuts or sequestration (deferred to March 1, 2013), a decision to raise the ceiling on the $16.4 trillion of U.S. treasury debt outstanding (recently suspended until May 18, 2013) and a bill from Congress authorizing the U.S. government to spend in the current fiscal year. The leading credit rating agencies will be looking to see if legislation to address these remaining issues holds the prospect of reducing the budget deficit to a level which could stabilize the ratio of government debt/GDP. The prospective revenues raised in the completed tax package could shrink the deficit from approximately 7% of GDP to 5%, but more is needed. Hence, the uncertainty for investors is not yet over; some combination of additional tax increases and spending cuts is required. If a credible program is not passed, the rating agencies could take immediate action.
The revenue-raising measures taken in the taxpayer relief package could dampen U.S. real GDP growth by 1.0-1.5% in 2013. If taxes had been raised for those below the top rates, GDP forecasts could have been slashed by another 1.0%. Hence, markets were relieved that some clarity was provided and the economy was not bludgeoned by the full impact of the cliff, which some had estimated as 4.0% of GDP.
If one looks through the fiscal cliff, it is possible to discern some incipient signs of recovery, lending conviction to the assumption that the U.S. economy will still grow by 2.0% or so in 2013. The World Bank issued their forecast on January 15, 2013 that the global economy will expand by 2.4% in 2013 compared with 2.3% in 2012, including a 5.5% gain in the emerging markets.
Signs of improvement across the globe include:
- Expectations for 2013 Eurozone GDP growth have fallen during the course of the past twelve months to virtually flat, with some of the smaller countries still mired in recession and high unemployment. Car sales, as measured by auto registrations, dropped 8% in 2012, climaxed by a sharper fall of 16% in December. However, the prospect of stabilization across the 17-country territory has improved markedly with the drop in interest rates in troubled countries, such as Ireland, Greece, Spain, and Italy. For example, new two-year Spanish notes were recently issued for under 2.50% compared to 3.28% for a similar maturity issued in October 2012. On January 23, 2013 Portugal’s 10-year bond yield fell to the lowest level since September 2010 (Financial Times, 1/24/2013).
- Through most of last year, investors were also concerned about a slowing pace of GDP growth in China, compared to the prior trend of 10%. Indeed, it appears that an aging workforce, rising employment costs, and the need to address social policy issues will depress future growth. However, exports increased 14% in December, the fastest pace in seven months. Fourth quarter GDP growth accelerated to 7.9% over last year, compared to a 7.4% gain in the prior quarter.
- In the U.S., household wealth is recovering along with the lift in home prices; the most recent reading from the 20-city S&P/Case- Shiller home price index was 4.3% above the previous 12-month period, accelerating from the 3.0% gain in the prior month. Light vehicle unit sales rose 13% above last December to 15.3 million, continuing a trajectory towards the previous December highs of 16.5-17.5 million units sold in 2002-2006. State and local governments, which account for just over 10% of GDP, are expected to increase payrolls in 2013, according to Moody’s Analytics Inc. (Bloomberg News, January 8, 2013). According to The Fiscal Survey of States (Fall 2012) published by the National Association of State Budget Officers and the National Governors Association, "Fiscal 2013 will likely be a turning point for state tax collections with general fund revenues projected to surpass prerecession levels for the first time since the onset of the recession."
Our working assumption for investment strategy is that economic and market conditions will be viewed as improving in 2013, resulting in less trepidation for investors. Short-term, we expect continued volatility as the outstanding fiscal cliff issues - primarily spending cuts - are debated. However, looking beyond this immediate challenge, economic conditions in Europe are bottoming, reaccelerating in China, and holding to steady - albeit modest - gains in the U.S.
We continue to advise an overweight position in equities relative to fixed income. While corporate revenue growth flattened during the past two quarters, investor expectations have become more realistic. Hence, Bloomberg has recently reported that of the S&P 500 companies reporting fourth quarter results thus far, over 70% have exceeded expectations for earnings. The investment tracking firm, Factset, estimates the price/earnings ratio on forecasted 12-months earnings to be 13.0x, only marginally above the five-year average of 12.8x. We find this particularly attractive compared to the yield on the 10-year Treasury note of about 2.0%, which is below the yield on many stocks. Furthermore, corporate balance sheets remain healthy. We estimate that dividend payments for the S&P500 companies during the fourth quarter of 2012 were some 15-20% above their former peak.
Investment themes receiving emphasis include: 1) the benefits to U.S. manufacturing, regional banking, and the consumer from lower natural gas prices and our reduced dependence on imported energy; 2) exposure to faster growing emerging markets through global corporate leaders, such as Unilever and Anheuser-Busch Inbev, and exchange-traded funds; and 3) holding a shorter maturity bond portfolio, deemphasizing U.S. treasuries, to guard against a jump in interest rates.
For the year 2012, the return of accounts with a bond component was in line with the static benchmarks. Accounts with an All-Equity objective lagged the benchmark. The sharp recovery in international stocks detracted from performance. Compared to our benchmark, we have maintained an overweight exposure to equities, which lifted the returns in the accounts. Positive contributors also included Baxter International, Merck, Accenture, and Phillips 66.
International stocks ended the year by finishing ahead of the U.S. market, gaining about 6.0% in the final quarter. Our holdings of foreign consumer-related equities, such as Unilever and Anheuser Busch Inbev, contributed positively to performance. We continue to increase our exposure to the international markets. (See Model Performance Chart)
During the quarter, we sold two names, Seadrill and ConocoPhillips. As noted above, Seadrill had performed well, and thus, we decided to realize the gains in the position. The sale of ConocoPhillips reflects our ongoing view that dividend growth could slow going forward.
A number of new names were added during the quarter.
Headquartered in Norwalk, CT, FactSet provides financial information to the investment management and investment banking industries. The company has posted 32 consecutive years of revenue growth, 16 consecutive years of earnings growth, and has consistently increased the dividend since initiation in 2002. FactSet continues to gain share from significantly larger competitors (Thomson Reuters) driven by low cost pricing, expanding functionality, and differentiated, high-touch service model. The company has consistently high margins and ROE, no debt, and a large cash balance (5% of market cap). Client growth, price increases, and regular share repurchases should support low-double-digit earnings growth; dividends should grow in-line with earnings.
Apple Computer is trading at a 10-year low on a forward P/E basis; and is in-line with other large-cap technology companies such as Microsoft, Intel, and IBM, despite the company's stronger market position and end-market exposure. In addition, Apple has significant capacity to increase its dividend going forward (current yield is 2.0% and payout ratio is 24% of FY13 EPS), and with its current dividend amply covered by free cash flow alone, Apple can increase the dividend and still grow its U.S. cash hoard (currently ~$40b), and still not touch it’s ex-U.S. cash of $80B.
Covidien was founded in June 2007 through the Tyco spinoff. It currently operates through three segments, Medical Devices, Medical Supplies, and Pharmaceuticals and plans to spin off the Pharmaceuticals division by June 30, 2013. Over the next five years, we expect the company to generate more than $10B in free cash, over 60% of which it plans to return to shareholders through dividends and buybacks. Covidien recently announced a 16% dividend increase, and plans to increase its payout ratio over the next few years. Covidien has access to their cash with limited repatriation expenses due to its status as an Irish corporation, which creates flexibility in acquisitions and is willing to divest underperforming assets. The company has a robust pipeline, planning to launch 57 new products over the next three years. They also plan to double sales in Emerging Markets by 2016 from 2011 levels.
The health care company Sanofi, was formed through a number of mergers. The current management team has been in place since 2009 and has focused on cost reduction (€2b cost reduction program) and external R&D opportunities. The current team is generally viewed as more transparent and shareholder-friendly than Sanofi's former management. Sanofi's exposure to patent expirations (e.g., Plavix®) is passing in 2012, while remaining core growth platforms in diabetes (Lantus®) and the recently acquired Genzyme portfolio are growing faster and face less competition. Vaccines and Animal Health should continue to post moderate growth, and geographic mix is favorable with Sanofi deriving 30% of sales from emerging markets (mostly outside of China). Earnings growth should resume in 2013 and dividend growth and share repurchase opportunities should follow.
In the fixed income portfolios, we initiated a relatively small position the Federated Emerging Market Debt Fund. It provides a higher current yield (3.78%) and better diversification compared to developed country debt. In many cases, emerging market demographics, growth rates, and balance sheets are superior to developed markets. As such, the credit quality of emerging market debt is projected to improve. (See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)