3rd Quarter 2012 SMA Commentary
Mixed Economic Backdrop
The global economy remained problematic during the quarter, with the economic backdrop mixed at best. With Europe mired in a recession and China clearly slowing, it was only a matter of time before the U.S. was swept into the fray. Although there were clear signs of improvement during the early part of the summer, by the latter half of the third quarter the tone of economic indicators turned less positive as durable goods orders declined, company surveys remained gloomy, payroll growth waned, and the Conference Board’s Leading Economic Index turned negative. At the same time, housing was a clear bright spot, as lower interest rates and increasing affordability have finally helped the market form a bottom.
U.S. firms continued to struggle to overcome the challenging environment. In the last few weeks, a number of bellwether companies lowered their outlooks for 2012 on mounting economic concerns. Earnings growth among companies in the S&P 500 Index has moderated in recent quarters and, according to FactSet Research Systems, the estimated growth rate for third quarter earnings is negative 2.6%. If that estimate is correct, this will be the first year-over-year decline in aggregate earnings since 2009.
The market rally that started in June continued through the end of the third quarter as investors properly anticipated that the weakening economic picture meant further monetary support from the European Central Bank (ECB) and Federal Reserve. At first glance, the rally resembled the quantitative easing (QE)-induced surges of the past few years, but it would be an error to dismiss it as just another “risk-on” rally. Among S&P 500 stocks, the performance of many macro factors during the period was generally consistent with the strong rallies of the last three years, but the differentials were muted. The highest yielding companies in the S&P 500 lagged the lowest yielding companies by only half as much as they did following the launch of QE2 in fourth quarter of 2010. According to Bank of America/Merrill Lynch, low-beta and high-quality stocks trailed as well, but again the gap was not as large as had been seen previously.
Unlike the other QE-induced rallies since 2009, investors generally favored large-cap stocks over mid- and small-caps. Value modestly outperformed growth across all market-caps, though the gap was narrower among large-caps than small-caps. While all 10 economic sectors in the strategy’s Russell 3000 Value Index benchmark posted a positive total return for the quarter, performance was mixed as the list of best and worst performing sectors each included both cyclical and defensive sectors. The best performing sectors were Telecommunications, Consumer Discretionary, and Energy, while Utilities and Technology posted meager results. Due to weakness in the transportation-related industries, Industrials was the third worst performing sector in the benchmark.
Hard Hit Industrials
The strategy underperformed its benchmark during the quarter as seven of 10 sectors had a negative total effect on relative performance. Although both sector allocation and stock selection, primarily in Telecommunications and Materials, detracted from returns it was weak stock selection within Industrials that hurt returns the most. A railroad operator and package delivery service were among the worst performing holdings as slowing economic growth weighed on many firms in the transportation industry.
Despite the woes among transportation stocks, the biggest negative individual performer was a semiconductor stock. Shares were weak following a disappointing earnings release and a larger than anticipated cut in guidance. Although some of the company’s business services groups continued to post strong growth, its core PC business was softer than expected. Shares continued to slide after two of its largest customers offered disappointing results and guidance as well. Results in the industry tend to be cyclical, and we believe the company’s large technology lead, strong balance sheet, and growing dividend continue to make it an attractive investment.
Strong stock selection and an underweight position in the Utilities sector was the biggest positive driver of relative returns during the quarter. A regional utility holding reported earnings above expectations and filed a request for a 15% increase in rates with regulators, boosting the stock. Stock selection in Energy and an overweight position in Consumer Discretionary also contributed positively to results.
The top individual contributor, however, was a drug store chain. A public contract dispute with a benefit manager that locked the company out of its network at the end of 2011 was resolved during the period. As the contract dispute escalated, sales comparisons turned negative and the stock performed poorly. Capitalizing on the market’s negativity, we increased the position throughout the year as we believed the company retained the option to compromise and bring these customers back. The market misjudged this option and the stock rose double-digits following the announced settlement in July. We reinforced our conviction following the announcement by increasing the portfolio’s position.
Looking at valuations at the end of the quarter, our discount-to-value indicator for the top-20 holdings in the portfolio was roughly 89%. Despite a slight decline from the previous quarter, valuations remain an important concern. At the end of June, nearly 16% of the portfolio was trading above 100% of our assessed Absolute Value (AV), versus 13.4% at the end of 2011. After reducing or eliminating nine positions trading above 100% of our AV, the percentage of the portfolio trading at a premium had still increased to more than 20%.
In recent months, we have been asked about the valuation of dividend stocks in general and whether we are concerned. When analyzing the universe of dividend payers we noted that valuations increased sharply as company payout ratios increased above 70%. Investors are often paying a hefty premium for these highest yielding stocks. We believe a total return approach is key to the success of a dividend-focused strategy, which is why this group represents a much smaller portion of the portfolio than it has in the past. We believe stretching for yield, without considering value, is a formula for capital losses.
Since June, the market has largely responded to the whims of central bankers, with little notice to the slowing pace of earnings growth and increasing unease voiced by management teams. As we noted previously, year-over-year earnings growth estimates turned negative for the third quarter and businesses across America are facing the same election and tax uncertainties as investors. Given the Federal Reserve’s diminishing ability to supply a steady drip of supportive headlines to the market, investors and business leaders will likely key off the dysfunctional process in Congress amid what could be a challenging earnings season.
Although tail risk has increased, we continue to expect the U.S. market will deliver an attractive return for 2012. We would not be surprised, however, if September 14 marked the high point for the year. Much of the risk lies at the edge of the fiscal cliff. The market could prove quite volatile around the end of the year as the political process deals with this difficult issue. We wish we could provide a confident assessment of how that will play out, but the upcoming election muddies the water too much.
We would welcome a period of increased volatility or a choppy earnings season during the fourth quarter. Our watch list is full of stocks we would like to buy, but only at the right price. We believe that a patient, value-oriented process is central to long-term success. From a portfolio perspective, we remain focused on companies with growing dividends, healthy balance sheets, attractive valuations, and other characteristics we believe the market will reward in the months ahead, including the ability to thrive in a low growth environment.
River Road Asset Management