3rd Quarter 2013
The Federal Reserve’s ongoing experiment with bond purchases (quantitative easing) continues to drive equity and fixed-income markets. Despite the Fed’s waffling about the timing of its tapering of bond purchases, it has encouraged risk taking through its liquidity programs, and U.S. equity markets have responded. The Fed announced in May its intention to reduce and eventually end purchases of bonds, but by June they were making efforts to give themselves greater flexibility with the timing and duration of tapering the program. At their September meeting, they decided to defer tapering for the time being.
The Fed’s May announcement affected financial markets around the world. U.S. interest rates shot higher and the currencies of many faster growing developing countries declined significantly. This combination had a short- term detrimental impact on many multinational consumer companies and other firms with global footprints and attractive dividend yields. These interest rate and currency moves affected the relative attractiveness of multinational companies’ dividends at the margin, the value of their earnings in faster growing developing economies when translated back into US dollars, and the price of their products in local currencies. Although the Fed quickly distanced itself from its May announcement and eventually decided to defer tapering, interest rates remained well above their lows of early May.
The Federal Reserve’s surprise decision to postpone the reduction of its bond buying program led to a rally in the bond market in September, allowing it to post positive returns for the third quarter. While yields could head lower in the short term due to disruption from the federal government shut-down and ongoing debt ceiling negotiations, we anticipate that yields will head higher once these issues are resolved since the economy should continue to grow at a moderate pace.
Meanwhile, the U.S. economy continued its slow steady growth and equity markets staged a significant rally after the Fed deferred tapering. Within the rally, there was a marked rotation. Higher-quality, consistent growth companies in both the Consumer Staples and Healthcare sectors lagged for the reasons outlined above, while smaller, more-cyclical issues benefited significantly from the ongoing liquidity provided by the Fed. Although the Fund posted solid gains for the quarter, its tilt toward higher-quality equities weighed on performance as it trailed its composite 60% S&P 500 Index/40% Barclays US Government Credit Index.
Overweight positions in Consumer Staples and stock selection within Healthcare hurt relative performance, but the absence of Apple (which is no longer in the portfolio and is the largest position in the benchmark) was significant after value investor Carl Icahn announced an ownership position in the company—driving its stock higher. Also within Technology, Google was weak due to margin compression caused by investments in You Tube, Android, Motorola, and Google Play. We added to the position as we expect earnings to accelerate in the second half and think that the investment expenditures are solidifying Google’s platform for digital advertising growth over the long term.
Abbott Laboratories and Sanofi drove the weakness in Healthcare on concerns about exposure to the slowing and volatile growth of Emerging Markets. Although we anticipated accelerating second half earnings growth for Abbott, we reversed course later in the quarter and trimmed the portfolio’s position, recognizing the impact of adverse currency movements and exposure to Emerging Markets on the company’s earnings outlook. Sanofi lagged owing to Emerging Markets pressure as well as a disappointing second quarter earnings report. The earnings shortfall was caused by a write-down of generics inventory in Brazil and weakness in the Animal Health division. Elsewhere, the portfolio’s holdings in Industrials and Energy, the top performing sector during the quarter, also lagged their peers.
Performance was aided by solid stock selection within Consumer Discretionary, despite an underweight stake in the sector, with strong gains from Starbucks, Johnson Controls, Nike, and TJX Companies. We had increased the portfolio’s position in Johnson Controls early in the quarter given our expectation that the company would continue to benefit from its cost savings program, as well as solid U.S. auto sales and a stabilization in European auto sales.
Despite the overall weakness in Consumer Staples and Healthcare, both sectors had individual winners that helped relative performance. Kraft Foods spinoff Mondelez rose more than the Staples sector, while Biogen and Amerisource Bergen were among the Fund’s top performing stocks.
Buys and Sells
The Fund established five new positions during the quarter, including two new tech names. Application delivery provider F5 Networks is a major player in one of the fastest growing sub-segments within data networking, particularly after Cisco exited the market. Enterprise data provider Teradata is a beneficiary of increasing data creation/storage and the accelerating adoption of business intelligence analytics.
Within Consumer Discretionary, we purchased Priceline.com, a leading travel service company. The firm has low exposure to air transactions and a heavy skew to faster growing international markets. European, Asian Pacific, and Latin American countries continue to migrate to online hotel bookings, and the company's acquisition of KAYAK Software brings a diversified stream of advertising revenue and allows direct competition with other meta-search providers.
Biotech firm Gilead Sciences and asset manager Franklin Resources rounded out the new purchases. The acquisition of Pharmasset in 2012 accelerated Gilead's timeline to develop the first all-oral Hepatitis C treatment as the company remains focused on the development of small molecule drugs for the treatment of infectious diseases. Franklin offers a balanced mix of equity, fixed-income, and hybrid products combined with a strong performance history and substantial distribution network.
We sold the small remaining position in Oracle and eliminated a holding in Unilever during the quarter. The shift to a cloud-based model (fewer capital expenditures, more operating expenses) means less upfront revenue for Oracle and more revenue spread out over time. Thus, we concluded that revenue growth is limited to the low-to-mid single digits absent acquisitions, which will need to be large-scale in order to have an impact—raising the risk profile of the company.
Earnings momentum has failed to come through as expected at Unilever as household products became a greater portion of the total business mix. Although the company has improved margins, recent Emerging Market currency movements are likely to continue to prevent the company from delivering stronger reported earnings growth despite relatively strong fundamentals.
Trims and Adds
We boosted the size of a number of current portfolio positions during the quarter, including Estee Lauder, Pepsico, and Qualcomm. We believe Estee Lauder can continue to generate above-average earnings growth given a strong innovation pipeline, better overall category growth, and its large long-term Emerging Market expansion opportunity. We added to Pepsico twice during the period as we think well-publicized activist shareholder proposals are likely to result in a restructuring or break-up of the company, which should unlock shareholder value.
We initially reduced Qualcomm based on reports of order cuts at Taiwan Semiconductor from Qualcomm and its competitors, reflecting weak high-end smartphone sales. We subsequently added back to the position, however, given increased confidence that declines in average selling prices due to competition at the high end of the smart phone market would be offset by consumers in Emerging Markets shifting from feature phones to smart phones. In addition, the company stands to benefit from higher royalties from China Mobile as the company moves to the LTE standard. We further increased the position after the company announced a new $5 billion share repurchase authorization to replace the nearly completed prior $5 billion program. This announcement strengthens confidence in near-term fundamentals and highlights a growing focus on returning capital to shareholders.
Notable reductions occurred in positions in Accenture, Visa, and Monsanto. We trimmed Accenture as the stock remained resilient despite earnings disappointments the past two quarters. With its price/earnings multiple at more than 16x, we don’t think the stock is likely to offer much near-term upside until there is a positive inflection in consulting demand. The stock of Visa is likely to be range bound while the Federal Reserve appeals a Federal judge's ruling that its interpretation of the Durbin Amendment didn't go far enough in lowering debit fees. The legal process could be drawn out for another 12 - 18 months.
We reduced Monsanto, the Fund’s sole position in the Materials sector, as several headwinds impeded its valuation, including the break-up of the potash cartel, a correction in corn and soybean prices, and concerns over speculation in farmland prices. A smaller position seemed warranted despite strong company fundamentals.
Given the near-term uncertainty regarding gridlock in Washington and the timing of a reduction in the Fed’s bond buying program, we have been maintaining a neutral duration (sensitivity to interest rates) position relative to the fixed-income benchmark in the bond portfolio. Although we anticipate an increase in yields over the intermediate-term, we believe the increases will be contained as economic growth remains subdued and inflation modest. As the low interest rate environment persists, we expect investors will continue to seek out incremental yield. Thus, we continue to favor high quality, intermediate Corporate bonds.
The outlook for the stock market continues to be favorable. The risk of a recession is low, monetary policy is very expansive, market valuations are fair to full though not extreme, and investors are optimistic but not euphoric. The market may be more volatile in the near term, however, as consensus economic and earnings expectations remain too high. While the Federal Reserve’s bond buying program should continue to support the stock market, this added liquidity, as noted above, has both reduced investors’ sensitivity to risk and significantly helped boost bond and stock prices. Consequently, the Fed’s stated intention of eventually winding down that program coupled with the uncertainty as to how and when it will do so could also contribute to increased market volatility.
We believe that the high-quality growth stocks held in the Fund are well positioned for the possibly volatile period ahead. We think they are reasonably valued and offer the potential for more assured earnings growth due to their global diversification and financial strength. We expect economic growth to continue to be more moderate than generally assumed as the developed world deleverages and for the Federal Reserve to keep short term interest rates low for a very long time.
Montag & Caldwell Investment Counsel
As of September 30, 2013, Apple comprised 0.00% of the portfolio's assets, Google – 2.71%, Abbott Laboratories – 1.92%, Sanofi – 1.79%, Starbucks – 1.92%, Johnson Controls – 1.70%, Nike – 2.23%, TJX Companies – 1.70%, Mondelez – 2.05%, Biogen – 2.23%, AmerisoureBergen – 1.43%, F5 Networks – 0.42%, Teradata – 0.43%, Priceline.com – 1.10%, Gilead Sciences – 1.09%, Franklin Resources – 0.48%, Estee Lauder – 2.06%, Pepsico – 1.92%, Qualcomm – 1.82%, Accenture – 0.59%, Visa – 1.52%, and Monsanto – 2.01
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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