4th Quarter 2012
The actions of central banks and central governments once again dramatically affected financial markets throughout 2012. The year began with a rally fueled by the Long-Term Refinancing Operation (LTRO) carried out by the European Central Bank (ECB) and ended amid concern about the “fiscal cliff” in the United States. Meanwhile, the U.S. Federal Reserve continued to experiment with new forms of monetary policy. Against this backdrop, global economic growth slowed and U.S. corporate profit growth continued to decelerate. Markets seemed to focus more on the liquidity provided by central banks than on the moderating economic and earnings outlook. In our opinion, there continues to be a divergence between the stock market and corporate fundamentals.
For the year, the Fund delivered solid absolute returns but lagged both its composite 60 % S&P 500 Index/40% Barclays US Government Credit Index benchmark due primarily to the equity portion of the portfolio. Many of the equity holdings that helped performance in 2011 did not fully participate in the major equity rally sparked by additional central bank monetary stimulus during the first six weeks of 2012. Volatility increased during the spring and summer as growth concerns resurfaced in Europe, the United States, and China. The stock market gave back some of its early gains during this period, and the Fund delivered solid relative performance. As summer ended, both the Fed and the ECB provided additional support for financial markets and the portfolio participated fully in the ensuing rally. Equity markets subsequently sold off during the fourth quarter, as investors feared the potential destabilization from the “fiscal cliff” as well as a potentially significant increase in taxes on dividends, the latter of which affected several of the portfolio’s higher-yielding, dividend-paying stocks. The Fund’s sizeable position in Corporate bonds mostly aided performance during the year.
Fourth Quarter Laggards
The Fund posted a small loss and trailed its benchmark during the fourth quarter, again driven by the stock portfolio. Stocks within the Healthcare and Industrials sectors weighed on relative performance. Pharmacy benefit manager Express Scripts fell after management issued guidance for 2013 that was below analyst estimates. Still, the company expects that ongoing positive trends in the business, including reduced drug purchase costs, increased generic usage, and greater productivity associated with its recent merger with Medco will offset the weak business environment and the impact of elevated unemployment. Although General Electric enjoyed strong gains earlier in the year, the stock declined during the quarter as most other industrial stocks rose. We ultimately trimmed the position to reflect more moderate earnings growth than we had previously expected despite the stock trading at reasonable valuation levels.
Other notable stock detractors included Bed, Bath & Beyond, Occidental Petroleum, and Wells Fargo. Several of the Fund’s holdings within Consumer Discretionary gained more than the benchmark sector return, but Bed, Bath & Beyond declined more than 11% on further fallout from last quarter’s weak earnings guidance. Occidental continued to lag the Energy sector and we reduced the position as rising costs and capital spending have tempered investor enthusiasm for the company's better than average volume growth. Wells Fargo was flat as most financials rose. We remain positive, and increased the Fund’s stake in the stock, due to our view that expense cuts, strong mortgage volumes, and an improving housing market would provide catalysts for better results for the company.
Relative performance benefited primarily from solid stock selection in Technology and Consumer Staples during the quarter. An underweight position in Apple relative to the Russell 1000 Growth Index driven in part by our risk controls limiting the absolute size of any one position in the portfolio, aided returns as Apple declined nearly 20%. We had also reduced the Apple position early in the quarter after the company reported earnings below expectations. Margin pressure from the release of several new or updated products and the departure of a senior executive was also cause for concern. We eventually added back to the position twice as the stock declined significantly to a compelling valuation with confirming data of increasing product build activity and lower component costs heading into 2013.
Juniper Networks and Visa also contributed positively to performance during the period. IP network provider Juniper reported solid third quarter results, and we added to the portfolio’s position on evidence that North American carrier spending is picking up, new products are gaining traction, and sequential growth in backlog and product deferred revenue.
Unilever and Costco were the standout holdings within Consumer Staples. Unilever rose following the company’s better than expected third quarter trading update. Although a number of companies have made it clear that Emerging Market growth rates have slowed, Unilever did not report a slowdown—implying that the company is benefiting from market share gains. Costco outperformed the sector as the company reported strong same store sales comparisons and benefitted from an increase in membership fee income.
New Holdings: Biogen and Johnson Controls
We established new positions in Biogen, Johnson Controls, and retained and increased the position in Kraft Foods spin-off Mondelez International. Biotech firm Biogen has a diverse product portfolio of multiple sclerosis treatments as well as new products in development. The company has an oral multiple sclerosis (MS) treatment that has been accepted for review by the FDA and is expected to launch in the U.S. during the first half of 2013.
We think Johnson Controls, a manufacturer of automotive systems and building controls, stands to benefit from energy efficiency and clean energy trends. A recent shortfall in execution led to a decline in the stock price that provided an opportunity to add the name to the portfolio at an attractive valuation. The company has a long record of delivering consistent returns and growth. Mondelez, the former global snacks component of Kraft, is the more growth-driven of the two entities. We think earnings momentum is likely to accelerate into 2013, while the foreign currency backdrop has improved. In addition, initial 2013 guidance was likely conservative due to the very early stage at which it was provided following the split from Kraft. The company is also likely to be awarded $1 to $1.5 billion in proceeds from arbitration proceedings with Starbucks.
Elsewhere, we increased the size of current positions in Oracle and Qualcomm. Oracle again reported solid results with upside from new license sales, total revenue, profit margins, and earnings, as better software sales once again offset weak hardware sales. We added to the position on modest price weakness as we expect improving sales force productivity following strong new sales hires last year, anticipation of less drag from foreign currency exchange, and further aggressive share repurchases. We think wireless chip maker Qualcomm’s aggressive push to 4G LTE and leading-edge 28nm is starting to pay off with share gains, rising average selling prices, and increasing production—all driving upward revisions to estimates.
Sold—Kraft Foods, Amazon, and Omnicom
Three stocks were sold outright from the portfolio—Kraft Foods Group, Amazon.com, and advertising firm Omnicom Group. After its split with the faster growing Mondelez business, we don’t think Kraft’s remaining North American grocery segment is likely to sustain the 10% or more earnings growth over the next 10 years that our process requires. We eliminated Amazon as the stock traded at a 20% premium to our estimated present value.
Omnicom is losing many of the catalysts we first outlined when we re-established the portfolio’s position in early 2011. The Olympics and elections have passed, while global economic growth continues to moderate and is at risk from an adverse shock. Amid the political and economic uncertainty, customers are reducing discretionary advertising and marketing spending, leading to a moderation in organic revenue growth at the firm.
We also trimmed Ebay and Visa as both stocks traded near our estimate of present value, and reduced the Fund’s stake in Google and Stryker on company concerns. Google reported disappointing third quarter results that raised concerns about its desktop-to-mobile advertising transition and the strategic value of the Motorola acquisition. Ongoing leadership changes at Stryker and our lack of conviction in the company's ability to generate double-digit earnings growth next year led to the reduction in that stock. Recent hospital surveys have shown deterioration in capital expenditures, increased negotiation pressure on device prices from group purchasing organizations (GPOs), and a continued lack of recovery in utilization.
In 2013, we think the bond market is likely to experience an environment similar to that of 2012. We expect range-bound yields for US Treasury bonds as slow economic growth and central bank measures to suppress interest rates continues. We expect outperformance of corporate bonds, with investors seeking incremental yield in a low interest rate environment. The Federal Reserve announced that it would continue its program of purchasing $40 billion per month of mortgage backed securities and an additional $45 billion per month of longer-term Treasury securities.
We think this will be an important source of demand, keeping interest rates at low levels. Investors’ search for high-quality, income-generating assets we believe will result in a further reduction in the yield differential between Corporate and Treasury bonds, allowing Corporate bonds to deliver relatively good returns. We are maintaining a duration (a measure of interest-rate sensitivity) position in the portfolio that is shorter than the benchmark bond index given
the unfavorable risk/reward profile of bonds at absolute low interest rate levels, while favoring high quality, intermediate maturity Corporate bonds.
Stocks mostly marked time during the fourth quarter of 2012 after having recovered nicely during the third quarter from their second quarter declines. Overall, though, equities still showed strong year-to-date returns even though global economic growth weakened during the year and U.S. earnings growth slowed thanks to a highly accommodative Federal Reserve that helped to boost the values of financial assets such as stocks and corporate bonds. We believe the market may continue to consolidate its gains amid sluggish global economic growth and weakened U.S. earnings growth. At the same time, earnings expectations for 2013 seem too high.
Now nearly four years into a recovery, the current market environment is a study in contrasts. Housing appears to have bottomed as corporate profit margins appear to be peaking. Consumers have worked to restore balance to their finances, while much heavy lifting remains to repair our country’s fiscal situation. Chinese growth appears to be stabilizing while the European Union remains mired in recession. We think these offsetting factors will continue to create market volatility as we progress through 2013. More importantly, we think valuations for quality growth stocks remain attractive. In an environment in which earnings growth may be scarce and less predictable than perhaps the market is anticipating, we think the Fund is well positioned to deliver positive and more-differentiated returns relative to the benchmark in the year ahead.
Montag & Caldwell Investment Counsel
As of December 31, 2012, Express Scripts comprised 1.82% of the portfolio's assets, General Electric – 2.22%, Bed, Bath & Beyond – 0.87%, Occidental Petroleum – 1.19%, Wells Fargo – 1.92%, Apple – 2.41%, Juniper Networks – 1.46%, Visa – 1.80%, Unilever – 1.32%, Costco – 1.84%, Biogen – 0.62%, Johnson Controls – 0.30%, Mondelez International – 2.06%, Kraft Foods Group – 0.00%, Oracle – 2.05%, Qualcomm – 2.61%, eBay – 1.34%, Google – 1.28%, and Stryker – 1.36%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its dividends.
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