4th Quarter 2013
The U.S. equity market continued its meaningful move higher during the December quarter of 2013. The broad market S&P 500 Index gained more than 10% for the quarter, and more than 32% for the full year. Multiple rounds of Federal Reserve intervention have fueled a significant rise in stocks the past few years. This past year was the fifth consecutive year of gains for the U.S. equity market. This period, however, has seen sharp gains with little volatility. The major exceptions were during the summers of 2010 and 2011, when the Federal Reserve attempted to end its unprecedented experiment with quantitative easing. There were also several periods when more-speculative issues benefitted substantially from the liquidity provided by Central Banks. During the late spring and summer of 2013, smaller, more cyclical issues significantly outpaced the overall market as larger, more-consistent growth companies lagged. We don’t think either of these trends can last as the Federal Reserve attempts to end its experimental involvement in U.S. capital markets.
The Fund modestly outperformed its composite 60% S&P 500 Index/40% Barclays US Government Credit Index benchmark during the quarter, but lagged for the full year. Equity overweight positions in Healthcare and Financials aided returns during the quarter, as did solid stock-picking from both those areas as well as from the Consumer Discretionary and Industrials sectors. In fixed-income, the Fund’s bias toward high quality Corporate bonds boosted returns as US Treasuries continued to feel the full impact from rising interest rates since the middle of the year.
Allergan, Gilead Sciences, and Biogen Idec were the standout performers within Healthcare. Although we had trimmed the portfolio’s position in specialty pharmaceutical company Allergan early in the quarter due to uncertainty surrounding generic competition for Restasis, we added back to the position and the stock rebounded following news that the U.S. Patent and Trademark Office allowed three new patent applications covering the drug. If the patents are granted, growth in near-term earnings is more assured, and the patents would give the company more time to diversify away from this key product. We had boosted the position in Gilead several times during the quarter in anticipation of approval of the company’s in-development treatment for Hepatitis C. The company did receive an approval in Europe that was broader in scope than anticipated, leading the shares to rise accordingly.
Asset manager Franklin Resources and trust bank State Street led the way among the portfolio’s Financials holdings, while General Electric was the top Industrials holding. We increased the position in GE following the company's third quarter earnings report, which demonstrated improving industrial operating margins and continued industrial order and backlog growth. With management execution improving and additional catalysts in the near term, we anticipated that the stock could outperform by closing the valuation gap with its peers. The stock had performed in line with the broad market year-to-date, but had lagged other industrials, before surging during the fourth quarter.
Detracting from performance was the Fund’s underweight position and weak stock selection in Technology, along with an overweight stake in struggling Consumer Staples. EMC and eBay were the notable laggards in Technology. The government shutdown in October negatively affected EMC, leading us to trim the position. Although EMC should continue to benefit from sales of refreshed and new products over the coming several quarters, recent conference calls with other company Chief Information Officers indicate that firms are seeking to reduce infrastructure capital spending by shifting purchasing to cloud providers. We further reduced the position following the company’s third quarter earnings disappointment.
We took advantage of the lagging performance in eBay to increase the position as the stock was attractively valued and after Channel Advisor, which helps retailers manage their online strategies, reported their clients’ same store sales on eBay were up about 30% over the Black Friday weekend. This sales strength gives us confidence that eBay should continue to grow at least in line with e-commerce. Elsewhere, small positions in F5 Networks and Teradata were eliminated as both stocks languished due to investor concerns about deceleration in revenue growth and macroeconomic pressures.
Many Staples stocks lagged the performance of the benchmark as investors favored cyclical issues. Philip Morris International, Costco, and Pepsico were some of the Fund’s weaker performers in the group during the quarter. We trimmed Philip Morris after the company issued 2014 guidance below expectations due to increased investment behind the company's reduced risk product platform and ongoing uncertainty surrounding pricing in Japan and the Philippines.
Buys and Sells
The Fund established new positions in McKesson and Ralph Lauren during the quarter. A leading pharmaceutical and medical-surgical supply distributor, we think McKesson’s recently announced the acquisition of Celesio will be accretive to earnings in the first year, and the combined company will be well positioned to meet the increasingly global nature of the pharmaceutical supply chain. We believe apparel and accessories designer Ralph Lauren has an unusual breadth of brand appeal across genders, categories and price points. It should benefit from international expansion as its business is underpenetrated relative to other luxury brands and its online channel is less than 10% of sales currently, providing another opportunity for continued growth.
We increased the portfolio’s overall stake in Financials to 9% of assets after adding to two holdings during the quarter. We established a position in Franklin Resources during the third quarter, but still thought the valuation of the stock overly discounted the risk of outflows from their fixed-income products. Although rising interest rates may result in outflows from the company’s municipal and global fixed-income products, we have confidence that the company’s broad equity product line-up and global distribution network will help offset those possible outflows. We think State Street should see an improvement in revenue growth and benefits from cost savings and share repurchases. Recently rising equity markets and a steepening yield curve increased our confidence that the company could deliver double-digit earnings growth in 2014.
Other notable sales during the quarter not previously mentioned included French pharmaceutical company Sanofi and energy services firm Cameron International. We lost confidence in Sanofi management's ability to execute given disappointing earnings and guidance the last two quarters. Cameron reported a disappointing quarter. The company continues to struggle with converting record subsea backlogs without cost over-runs and supply chain issues, and new problems have emerged. Its Valve & Measurement business, heretofore quite strong, experienced a slowdown in revenues and some pricing pressure. Increased research and development spending in their joint venture with Schlumberger (OneSubsea) is also likely to dampen margin expansion in 2014.
The outlook for the stock market is generally favorable. A moderate but synchronized global economic recovery and accommodative Central Bank policies throughout the developed world should be supportive of higher share prices. Given fair to full stock market valuations, largely euphoric investor sentiment, and the lack of any meaningful stock market correction in quite some time, however, we do expect a pick-up in stock market volatility during the first half of 2014. This expectation assumes that the Federal Reserve will follow through with its plan to wind down its bond-buying program (quantitative easing, or QE). We believe the added liquidity to financial markets from QE boosted stock prices and reduced investors’ sensitivity to risk. Continued reductions in the size of this program will reduce a major stimulus to higher stock prices, likely increase investor perception of risk, and probably be the catalyst to increased volatility in the new year.
In fixed-income, we expect bond yields to increase as several economic data points have indicated sustained growth and the Federal Reserve reduces its QE program. A reduction in bond purchases will begin the process of removing an important source of demand from the bond market, biasing longer-term interest rates higher despite the Fed’s plan to keep short-term interest rates low for a considerable period. We expect that the yield differential, or spread, between Corporate and Treasury bonds will continue to narrow as investors seek incremental yield and spreads remain above pre-financial crisis levels. In accordance with this outlook, we continue to favor high quality Corporate bonds, and maintained a duration (sensitivity to changes in interest rates) in the fixed-income portion of the portfolio shorter (i.e. less sensitive) than the benchmark index in order to mitigate the impact of rising yields.
Montag & Caldwell Investment Counsel
As of December 31, 2013, Allergan comprised 2.10% of the portfolio's assets, Gilead Sciences – 2.29%, Biogen Idec – 2.16%, Franklin Resources – 0.73%, State Street – 1.68%, General Electric – 2.24%, EMC – 0.43%, eBay – 1.81%, Phillip Morris International – 1.17%, Costco – 1.11%, Pepsico – 1.96%, McKesson – 1.02%, and Ralph Lauren – 1.33%.
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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