3rd Quarter 2012 SMA Commentary
Sluggish Recovery Continues
The U.S. economy continued to record modest growth during the third quarter of 2012, with employment and housing strengthening. The Federal Reserve initiated a third round of quantitative easing by announcing that it would buy up to $40 billion in mortgage-backed securities per month until signs of a substantial recovery is underway in the U.S. Although the euro zone seems to be moving toward a more unified fiscal structure, each pronouncement by an individual country or officials in Brussels threatens to take that movement off its current path.
Against this backdrop, U.S. equities posted solid gains during the period, rebounding from their second quarter lows. The strategy’s S&P MidCap 400 Index benchmark rose more than 5%, slightly behind the broad-market large-cap oriented S&P 500 Index. The portfolio outperformed both during the quarter and closed to roughly in-line with its benchmark for the year-to-date through the end of September.
Among the top performing holdings were media and technology companies. Investors reacted positively to the appointment of a new CEO, the sale of an underperforming asset, and an 8% increase in circulation at one media company. That and another media company both reported increased digital subscribers and revenues, and continued to make progress in monetizing its content delivery through digital and print mediums. A holding that’s a leader in accelerating the delivery of Internet content reported better-than-expected results and gave guidance for a strong second half of the year.
On the negative side, transportation stocks were among the biggest detractors after being among the best performers during the second quarter. The decline was due in part to higher fuel costs. One healthcare holding received new warning letters from the FDA concerning manufacturing issues. The company is addressing these problems and we expect profits to recover once these issues have been resolved. A tech hardware firm reported second quarter results below expectations. The company subsequently announced a significant share repurchase program and a major restructuring plan. With its stock currently trading at book value with an attractive yield, we’re maintaining the position as the restructuring plays out.
Short-term Concerns, Long-term Opportunities
The portfolio is structured and managed to participate in the long-term growth of the companies in which we invest across a variety of market environments. Concerns about the current economic problems in the U.S. and abroad have provided us with the opportunity to initiate or add to positions with strong secular growth that are under pressure due to the weak economic environment. We look for companies that have the ability to weather the current storms and report strong results once conditions improve. Cost cutting, operational restructuring, and balance sheet strengthening are actions that company management teams can implement to improve long-term profitability. Due to the difficult times, the stock prices of many companies have fallen to levels that present long-term investors with great opportunities. We think that three new holdings added to the portfolio during the quarter are examples of such opportunities.
College enrollments are down in the U.S. due to slow economic growth and prolonged high unemployment, negatively affecting for-profit education firms. At a recent purchase, management has taken steps to align costs with enrollment levels, and it continues to expand into international markets (Brazil) where enrollments are stronger and profit margins higher. The company has a strong balance sheet with no debt, and pays a modest dividend. The stock was trading near the low end of its historic valuation range at the time of purchase. We think the long-term prospects for the company are quite positive as it is recognized for its strong brand and reputation, and stands to benefit from improved economic conditions.
Another purchase was an office products company that’s the second largest internet retailer. The company is profitable with a large revenue base, but a recent decline in earnings has prompted management to reorganize operations. Our analysis shows that the stock is trading at all-time low valuations. We think that the ongoing restructuring will lead to an increase in firm profits that will eventually benefit the stock.
A producer of fully assembled seat systems tied to new car production was trading at depressed levels given the economic problems in Europe, including weak new car sales. Since emerging from bankruptcy roughly three years ago, this company has rationalized operations and moved manufacturing to lower cost locations. We expect revenues and profits to improve in the coming years as worldwide demand for automobiles and light trucks increases.
The only position sold outright from the portfolio was a home healthcare provider after it announced that it agreed to be acquired by a German company at a substantial premium. The stock had been a holding in the portfolio for six years, highlighting the benefits of our long-term perspective on owning proven companies. Acquisition targets tend to involve companies perceived as solid businesses trading at attractive prices. Since 1999, the strategy has experienced takeover offers in 26 holdings, a substantial number for a relatively low-turnover portfolio that typically numbers only 40 to 45 holdings. The bursting of the credit bubble has put a damper on merger and acquisition activity in recent years, however. Only two of the takeovers, including this most recent one, have occurred since the credit crisis in 2008. We view the takeover as a sign that the market may once again be recognizing that there are companies with strong, focused business models trading at sizeable discounts.
Economic growth in the U.S. continues to be sluggish, but some important sectors are showing signs of strength—employment and auto sales are increasing and the housing market is improving. The national elections in November may have some impact on tax policies, healthcare reforms, and government spending, however, and the looming “fiscal cliff” may result in government spending cuts beginning in January if Congress does not act before then.
We remain aware of macroeconomic uncertainties and are prepared to take advantage of significant moves in the market if they occur. We will add to holdings with competitive advantages, good management teams, and strong balance sheets when valuations are attractive. Similarly, we will sell stocks when they become fully valued. Overall, we view the portfolio as attractively valued on a price/earnings (P/E) and P/E to growth (PEG ratio) basis as of the end of September, more so than that of the strategy’s S&P 400 benchmark.
Thyra E. Zerhusen, Managing Director and Portfolio Manager
Marie L. Lorden, Co-Portfolio Manager
Mary L. Pierson, Co-Portfolio Manager