FOURTH QUARTER 2011
The Economic Climate
It is hard to imagine a worse series of events for investors than those that grabbed the headlines in 2011. Unrest throughout the Middle East and North Africa pushed oil prices above $114 per barrel by April. Coupled with the March tsunami in Japan, these events fomented worries of another global recession, beginning in the debt burdened countries of Southern Europe. Interest rates in Greece, Portugal, and Italy jumped to intolerable levels for refinancing their debt. Investors became skittish. According to a November 18, 2011 report by Oppenheimer, the average daily price change for U.S. stocks, as measured by the S&P 500 index, exceeded 1.5% from July to mid-November. That measure of volatility is more than twice the long-term average. The superior growth rates of emerging markets were also implicated, as these are dependent upon European banks for financing and European consumers for their exports. In addition to the tangential effects of a disintegrating Europe, whose markets account for some 30% of U.S. corporate sales, the U.S. had its own set of problems, from speculation regarding municipal bond defaults to the downgrade of our Sovereign debt rating by the Standard and Poor’s rating service.
As we begin 2012, expectations for economic growth have been reset at much lower levels, reducing the impact of any negative news on securities prices. As measured by a Bloomberg survey, the consensus expectation of U.S. real GDP growth in 2012 has fallen to 2.3% from 3.2% over the past twelve months. The comparable reading for Europe is negative 0.2%, down sharply from the year-ago expectation of 1.8%. According to a Wall Street Journal survey published on January 12, 2012, 48 of 50 participating economists predicted that Europe has either already entered a recession or soon will. Even Germany, perhaps the healthiest of the group with an unemployment rate of only 5.5%, suffered a GDP contraction in 4Q 2011 from 3Q at a 1.0% annual rate.
Against this reduced set of expectations, recent developments appear somewhat more balanced. The U.S. unemployment rate has gradually inched down to 8.3% from over 10.0% in 2009. January marked the seventh consecutive month of net job gains in excess of 100,000. Auto sales continued to climb, rising 9% in December. Total vehicle sales approached 13 million units for 2011, still well below the 16-17 million level reached before the 2008 recession. The U.S. consumer confidence index published by the University of Michigan hit an eight month high in January 2012. (Another confidence index published by the Conference Board actually dropped in January from December.) Recent earnings reports from industrial companies, such as Caterpillar and UPS, contained some signs of optimism about the continuation of a modest U.S. recovery.
Policy changes in Europe have the potential to soothe investor psychology, notwithstanding the likelihood of recession in 2012. Political leadership has rotated in Greece, Portugal, Spain and Italy. The European Central Bank has taken steps to augment liquidity by committing over $600 billion to a program offering three-year loans to banks at the low rate of 1.0%. The European Commission is subjecting the fiscal budgets of member countries to closer scrutiny with penalties for insufficient deficit reduction. Refinancing costs have just begun to subside in Spain and Italy, but still remain at dangerous levels in Portugal and Greece.
A complete turnaround in Europe will take time. The Greek government and bondholders, as represented by the Institute of International Finance, have only recently agreed on interest rate terms for an exchange of debt. On January 13, 2012, S&P downgraded the triple A status of France and Austria, though this was widely anticipated. Concerns remain about the willingness of some European governments to fully implement deficit reduction targets drafted in a new fiscal treaty.
Our strategy outlook for 2012 presumes that the economic and political risks – though very real – are largely reflected in current valuations. The P/E ratio on U.S. stocks is about 13x trailing earnings, below the longer-term average of 15-16x. Relative to the prospective return on bonds, equities are particularly appealing. The current yield on 10-year Treasury bonds is under 2.0%, no higher than the expected rate of inflation. The January 9, 2012 issue of the Wall Street Journal contained a chart that depicted a 30-year return for treasury bonds of 11.03% compared to 10.98% for stocks. The thirty years ending 2011 was the first such time period where treasury bonds bested stocks since the 1950s. Ironically, municipal bonds were one of the top performing asset classes in 2011, reporting a return of 10%. During the course of 2012, we will be looking for opportunities to increase exposure to international stocks that, as a group, collapsed 10%-20% during 2011.
While corporate balance sheets are generally healthy, profit margins are approaching the 2007 peak and may come under pressure if the global economy continues to slow. Other risks to the outlook include another spike in oil prices due to an Iranian crisis or other acts that gnaw at tension in the Middle East, and the possibility of a political stalemate in the U.S. or Europe as officials squabble over deficit reduction proposals. Oil demand in the developed countries is relatively weak (U.S. demand dropped 1.6% in 2011). However, over 10% of China’s oil imports and 5% of overall consumption derive from Iran, making the implementation of broad sanctions a thorny issue.
After a dismal September, U. S. equities bounced back to gain 11.8% for the fourth quarter. Our equity strategy yielded results that were almost as strong. Foreign markets appreciated less than half as much. Our bond investments benefitted from the addition of a high yielding exchange-traded fund.
The models were positive for the quarter and outperformed a static benchmark consisting of a Lipper Money Market Index, the Barclays Govt./Credit Index, the S&P 500 Index, and the MSCI All Country World (excluding U.S. Index). (Using a static benchmark which contains an international equity component more closely captures the range of opportunities available and any tactical asset allocation decisions.) Our focus on U.S. equities lifted relative return during the quarter compared to this benchmark due to our greater exposure to domestic equities, which outperformed foreign markets.
(See Model Performance Chart)
Significant Portfolio Changes
During the quarter, we sold the Templeton Global Bond Fund from accounts that had a portion invested in bonds. When we established the international bond position last spring, the situation with European banks and the European economy was very different than today. At the time, recession in Europe was not a foregone conclusion and it was expected that the European leadership would ultimately resolve its debt issues. However, as the European debt crisis escalates, it continues to weaken the viability of European banks. Therefore, Europe’s economies are contracting from both austerity measures and retrenching credit. As such, current economic forecasts suggest Europe is in recession or entering one. Given that European banks have been heavy lenders (twice the amount of U.K. and U.S. banks) to the emerging markets, these areas are also vulnerable to reduced credit inflows from European banks. Additionally, Europe has been a large importer of goods from emerging markets leaving them (EM’s) exposed to reduced final demand from the Eurozone. The Templeton Global Bond Fund had significant exposures to a number of countries that are vulnerable to European contraction including Poland (10%), Hungary (5%), Malaysia (10%), and South Korea (15%). Additionally, countries that run large current account deficits and at the same time have large claims owed to international banks within the next 12 months are especially vulnerable. Such countries include Hungary, Poland, South Korea, and Turkey. We took a tax loss in the fund, with the intention to reassess this bond segment at a later date.
We also sold Thermo Fisher Scientific. Twenty-five percent of Thermo’s revenues are reliant upon government and academic funding (largely through the National Institute of Health), and an additional portion of the business has been partially driven by stimulus spending over the last few years. There are recent signs of a slowdown in scientific research spending in the academic end market in anticipation of reduced government funding. We believe this overhang will be persistent over the next few years, and may prove worse than currently expected.
Three new names were added during the quarter.
Qlik Technologies is a fast-growing and innovative data analytics company with a disruptive technology that is rapidly taking market share in the increasingly important area of “Big Data”. Data has been accumulating rapidly for the past decade, and the growth rate is currently accelerating due to the proliferation of social and mobile technology. Qlik estimates that global data storage doubles every 16 months. This results in an increasing need for software to gather information from this data (traditionally called Business Intelligence or BI). Qlik is uniquely positioned to meet the growing demand for data analysis. The company has developed a proprietary analytics technology that puts powerful analytics tools at the fingertips of business users. This technology is quick to implement, easy to use, and comes at a reduced cost compared to traditional BI programs. The result has been both rapid market share gain and market expansion, resulting in a 40%+ organic growth rate the past two years. Holding only 2% of a rapidly growing BI software market, Qlik should see 25%+ growth rates for the foreseeable future. The valuation is reasonable compared to other small and rapidly growing software peers. Further, we believe its opportunity set is larger than most of its peers and its relative competitive positioning is above the average of its premium peer group.
Anheuser-Busch InBev is the largest brewer worldwide with a 20% share of the international beer market. After the transformative deal in 2008 when InBev bought Anheuser Busch, the industry has further consolidated allowing pricing power and scale for the largest brewers which has led to significant margin improvement. The company has leading positions in key emerging markets such as Brazil and China which have supplemented volume growth while the North American market has declined due to high unemployment in young males, high gas prices, and lower consumer confidence. As an enormous generator of free cash flow, management has stated their intention to increase the dividend to be competitive with other consumer staples companies once they hit their leverage target which is expected later in the first half of 2012. Modest margin improvement coupled with increasing consumption in emerging markets, a slow economic recovery in developed markets, and a focus on shareholders, should provide a return that is quite satisfactory.
Headquartered in Pittsburgh, PNC Financial’s retail branch network spans the Mid-Atlantic, Midwest, and Southeast, while its Corporate & Institutional and Residential Mortgage lending divisions are national in scope. PNC acquired a large stake in the asset management firm BlackRock in the mid-1990s, and continues to own a 21% economic interest. Organic growth should be above the historical average in the coming years as the branch footprint overlaps the shale gas regions in Pennsylvania and Ohio. Market share gains are coming from troubled banks in the U.S. and Europe as large corporate borrowers seek stable partners for new borrowing and/or refinancing activity. Credit and capital ratios are strong (PNC performed in the top tier of banks through the last credit cycle) and relationships with regulators are good (the Fed did not require the bank to raise capital in its pending acquisition of RBC’s U.S. branches). (See Top 10 Equity Holdings Chart)
(See Equity Sector Diversification Chart)