1st Quarter 2012
Moderately better than anticipated economic results combined with additional monetary stimulus in both the United States and Europe fueled a major rally in equity markets during the first quarter of 2012. The broad market S&P 500 Index gained more than 12% during the period, powered by a rebound in banking stocks in the Financials sector and strong gains by Apple and Qualcomm within Technology. Thus far, the stock market in 2012 has been predominately led by last year’s weaker performers, and not the higher quality issues that outperformed in 2011. Consumer Discretionary stocks gained more than the market during the quarter, while Energy was among the notable laggard among the major sectors.
Yields on Treasury bonds increased during the quarter, and we believe they are likely to remain range-bound at higher levels into the second quarter. Interest-rates have been drifting higher as liquidity conditions improved following the European Central Bank’s extension of three-year loans to European banks. As a result, investors have been enticed to seek higher returns in riskier assets, selling Treasury bonds as a source of funds. Indeed, Corporate bonds significantly outperformed during the period, and we expect they will continue to perform better than Treasury bonds as investors seek incremental yield in a low interest-rate environment.
The Fund trailed its composite 60% S&P 500 Index/40% Barclays US Government Credit Index benchmark during the quarter as the portfolio’s quality-equities bias was not rewarded as it was in 2011. An underweight stake in Technology, particularly in Apple, served as a drag on relative performance. Although a top-10 holding in the portfolio that we increased early in the quarter following the company's outstanding fiscal first quarter earnings report, Apple appreciated considerably leading us to trim the stock twice. Also within Technology, Google declined during the period, detracting from performance. The company announced several planned changes to its core web search product and appropriation of user data for socialization and targeting of ads across sites, leading us to substantially reduce the portfolio’s position.
Elsewhere, a substantial overweight allocation to the more-defensive Consumer Staples sector negatively affected performance as that area lagged the market. Lackluster stock selection within Consumer Discretionary, with exception of TJX Companies, also weighed on returns. Finally, the Fund did not own any stocks in the rebounding Financials sector. The sector’s small representation in the benchmark, however, resulted in only a modest drag to performance.
An underweight position in Energy and solid stock selection within Industrials and Materials benefited relative performance. Engineering and construction firm Fluor delivered steady gains from the beginning of the years through its late-February earnings report. Chemical materials company Monsanto jumped sharply follwing its earnings report in early January in outperforming the overall sector. Within Healthcare, Medco Health Solutions rose strongly as it became clear that the company’s announced merger with Express Scripts would gain approval.
We established four new stock positions in the portfolio during the quarter, two in Technology and two in Consumer Discretionary. We think enterprise storage company EMC will benefit from increased spending on storage due to incremental growth from mobile data access, the move to private, public and hybrid cloud architectures, and rapid growth of unstructured data from sources such as social networking. eBay is the operator of the world's largest online marketplace and leader in online payments via its PayPal subsidiary. We see the company benefiting from the continued robust growth of online commerce and PayPal's proliferation, both online and at point-of-sale and mobile spaces.
The new additions within Consumer Discretionary were Amazon.com and casino resort operator Las Vegas Sands. We purchased Amazon after a significant pullback in the stock. Although profit margins are under pressure in the near- to intermediate-term due to the company’s heavy investments in international fulfillment capacity and technology infrastructure, cost leverage is on the horizon with increasing third-party sales, in-market penetration of new international markets, and the continued migration to digital consumption of media products. We think the company has ample opportunity for expansion into international markets and continues to benefit from rapid growth in existing markets. Las Vegas Sands generates approximately 90% of its revenue and profit from the fast growing Asian and Emerging Markets. The company has strong earnings momentum, as the productivity of recent property openings continues and free cash-flow should improve as capital expenditures taper off.
Notable increases to current positions during the quarter included Costco, General Electric, and Oracle. We added to the portfolio’s position in Costco after the stock pulled back about 10% from a recent high due to investor concern surrounding tougher comparisons for gasoline sales and currency issues from foreign expansion, as well as the company’s focus on price competitiveness. We believe the price investment is a proactive way to drive traffic and loyalty, and not a response to competitive weakness. In addition, the company’s ample cash balance allows it the flexibility to increase share repurchases, and a recent membership fee increase offsets some of the currency issues and the lesser top-line benefit from gasoline sales.
We added to GE several times during the quarter, notably after the company’s fourth quarter results and the Federal Reserve’s stress test results. Reported earnings demonstrated improvement in its industrial division margins and strong orders in late-cycle businesses. In addition, while GE was not subject to the Fed’s stress tests, GE Capital ended 2011 with a Tier 1 common equity ratio above the average of the 19 institutions that were subject to the test. The additional cash from GE Capital implies the company has the flexibility to significantly increase its dividend payout ratio, pay a special dividend, and/or repurchase shares.
After trimming Oracle early in the quarter due to diminished relative earnings growth following the company’s fiscal second quarter miss late last year, we added back to the position after its fiscal third quarter earnings report. Business should continue to rebound at the firm as long as enterprise spending remains relatively stable. We think the stock can perform well based on easing seasonal comparisons as it enters its historically strongest quarter of the year, the ramping up of new product cycles for Exa-series and Fusion apps, a significant expansion in its sales force, and a stock price that has lagged the rest of the market over the past six months.
Industrial Sales, Consumer Trims
Two positions were sold during the period. Given its successful quarter Fluor approached our estimate of fair value, prompting us to exit the position as the uncertain economic outlook is unlikely to lead to an expansion in its price/earnings multiple. Also within Industrials, we eliminated Emerson Electric from the portfolio as the company is struggling with both internal execution issues (specifically its Network Power business unit) and mixed-end market trends (particularly in Europe).
We trimmed a number of the portfolio’s consumer-oriented holdings for a variety of fundamental reasons. McDonald’s was reduced due to position size and the expectations that the company will likely experience cost-related headwinds that may cap gains in the stock in the near- to intermediate-term. Nike and TJX were reduced as both stocks had performed well on a relative basis and traded near all-time highs.
Staples stocks Procter & Gamble and PepsiCo were also trimmed. P&G was reduced given the company’s skew towards developed markets and as we continue to wait for a sustained inflection point in operating profit growth. Pepsi was reduced after a boost in the stock following significant management and operational changes. The company’s earlier fourth quarter earnings led to diminished relative earnings growth. Thus, we took advantage of strength in the stock to reduce the position. Finally, we trimmed medical-device maker Stryker on diminished earnings visibility as patients continue to postpone elective orthopedic procedures.
Although broad stock market indices have delivered strong gains thus far in 2012, we expect a more challenging environment for stocks in the period ahead. Global growth has slowed and will likely be sluggish for the remainder of the year. The U.S. economy benefited from an unusually mild winter during the first quarter of 2012 that spurred unexpected growth, with more moderate growth expected for the remainder of the year. Meanwhile, Europe has most likely entered into a recession. With global growth slowing and corporate profit margins at record levels, we believe investors will be disappointed to find that corporate profit expectations for both the intermediate and longer-term periods are generally too high. Lastly, investors will have to contend with significant political uncertainty until U.S. voters determine which candidates are most capable of addressing the United States’ large budget deficit, high national debt, and high unemployment problems.
On the fixed-income side, as economic growth continues at a moderate pace and the Federal Reserve approaches the end of Operation Twist, in which it has been selling short-maturity bonds in favor of longer-maturity bonds, we expect that the yield on 10-Year US Treasury Bonds may drift modestly higher. We believe that further increases will be contained by continued de-leveraging, contributing to below-trend economic growth. The presidential election and uncertainty about the election outcome’s effect on fiscal policies are also likely to contribute to a range-bound environment for Treasury yields. Thus, we continue to maintain a duration (a measure of interest-rate sensitivity) in the bond portfolio that is shorter than the benchmark and favor high-quality, intermediate Corporate bonds.
Montag & Caldwell Investment Counsel
As of March 31, 2012, Apple comprised 2.99% of the portfolio's assets, Qualcomm – 3.00%, Google – 1.37%, TJX Companies – 1.85%, Fluor – 0.00%, Monsanto – 1.80%, Medco Health Solutions – 1.80%, EMC – 0.69%, eBay – 0.61%, Amazon.com – 1.06%, Las Vegas Sands – 0.93%, Costco – 1.97%, General Electric – 1.83%, Oracle – 0.91%, McDonald’s – 2.07%, Nike – 0.85%, Procter & Gamble – 2.08%, PepsiCo – 1.72%, and Stryker – 1.90%.
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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