3rd Quarter 2012 SMA Commentary
Despite a strong opening to the period in July and August, the strategy ultimately finished the third quarter trailing its Russell 1000 Value Index benchmark after a tough September. Fears concerning Europe, in an ominously and eerily similar situation to the same period a year ago, were the portfolio’s main undoing. Notwithstanding the setback, the strategy remains ahead of the index for the year-to-date through the end of September.
Holdings in six out of 10 sectors in the portfolio underperformed their respective benchmark sector and/or the overall benchmark during the quarter. Overall, sector allocation was positive while stock selection was negative. In essence, it appears we were in most of the right places but had a mismatch in the timing with stocks held in the portfolio.
The sectors with the lowest level of contribution to performance were Consumer Discretionary, Materials, and Consumer Staples. Each of these sectors outperformed the broader index, and the portfolio was overweight all three, thus it was stock selection that hurt relative performance. The portfolio’s retail holdings in Consumer Discretionary had less than stellar relative performance as more cyclical domestic areas such as homebuilders and autos garnered market attention. Holdings in metals and specialty chemicals hurt performance within Materials. Too much of an emphasis on global exposure appeared to be the culprit in Consumer Staples as the market embraced more domestic oriented companies.
The best performing areas for the portfolio were Technology, Energy, and Healthcare. Four out of five stocks in Technology outperformed. The portfolio’s three refining stocks generated sector- and benchmark-beating performance as that group was clearly favored within the Energy sector. Similar to Technology, four out of five Healthcare holdings outperformed, with one device-maker up more than 29% during the period.
We decreased the portfolio’s stake in Energy and Technology during the quarter. We sold one holding in the Energy sector because of valuation, while other energy stocks were eliminated due to sector adjustments and/or valuation/fundamental issues. A communications equipment provider was the notable sale within Technology.
Much of the proceeds from these sales went towards boosting the portfolio’s exposure to the Healthcare, Consumer Discretionary, and Industrials sectors. New positions were initiated after first being identified as a value creating opportunity followed up with fundamental analysis to vet out its potential as a portfolio holding.
The strategy has now underperformed for two consecutive quarters, though it still maintains a lead over its benchmark for the year-to-date. Although we have a strong belief in the market’s ability to discern value over long periods, in the short run we are less confident. We have never considered ourselves omniscient. We actually are quite candid about what we cannot do, which many investors have come to know from our often repeated dictum that, “We cannot predict the timing, duration or magnitude of outperformance. All we can do is position ourselves to where we believe we can achieve it.”
As we look at the fourth quarter and beyond, we think about the economy and the market in a similar fashion. Uncertainties persist in terms of who will win the US presidential election and what will be the winner’s potential as well as real effectiveness in influencing this economy. Another important issue is how Europe decides upon the best direction, plans, and procedures for their collective union and future. Not far behind is what will be the real growth in China and other developing markets, the likely accelerant, or not, for global growth.
All of these are real issues that will have real, unknowable outcomes in the short-term. Long-term, some of these issues may have less impact than the current attention given them. Our approach to these issues is not to foolishly attempt to predict outcomes that are inherently unpredictable, but to direct our energy and attention to a more certain activity—investing. We have a portfolio of companies that sum up where we see the market is likely to direct capital. We call these stocks value creating opportunities because we believe in their potential to surpass investor expectations.
We think that the strategy’s holdings are positioned collectively to do well regardless of macroeconomic outcomes. Why? We do not buy companies based on themes. Instead, we focus on purchasing companies at a discount to what we believe their fundamentals should bear, not what the market is currently willing to pay for them. We are investors in companies whose current fundamental prowess and potential, in our opinion, are woefully underappreciated by the market.
Regardless of the outcomes of the presidential election, European Union (or dis-Union), or China and the other Emerging Markets, we continue to seek out the companies that we believe should merit the market’s attention and capital. As investors, there really is nothing else for us to do.
Randell A. Cain, CFA