In our Q1 2015 letter to clients, we present our views on stocks and bonds in addition to the goings on in our portfolios. Below is a link to a PDF version of our Q1 letter.
Happy New Year! We are pleased to share with you our overview of investments as well as other exciting news for our firm.
We welcome Theresa O’Donnell to our team as our Client Services Manager, where she will be assuming some of the responsibilities previously managed by Cheyne. She comes to us from US Trust where she was working with their wealth management clients on their investment, trust and banking needs. You can reach Theresa at 800.685.7884 or firstname.lastname@example.org. We are also excited to share that Cheyne has been promoted to Associate Portfolio Manager where he will continue his analytical work on both stocks and bonds.
In today’s busy world we want to make sure that as your trusted investment partners, we are sharing with you relevant and important investment and wealth planning information. We invite you to take a moment to review our blog linked to our website www.nwic.net where we discuss topics of interest in the capital markets and others areas we believe may be important to you. You can also follow us on Twitter where we tweet links to our blog as well as other informative articles. Follow us on Twitter by searching for @NWInvestment. We also invite you to follow us on our LinkedIn company page where we post articles of interest. Finally, please know that we are a here for you and we are always just a phone call or email away.
Stocks wrapped up one of the best years in quite some time, as various market indices were up anywhere from the high-20% to high-30% range, depending on how one slices up the stock market. While final numbers won’t be in for a few months, it looks like earnings growth for the S&P 500 will be in the 10% range. Our calculation tells us that the price-to-earnings ratio (P/E, a simple but very common valuation metric) rose during the year (earnings went up, but prices went up even more). In fact, at the start of 2013, the trailing 12 month P/E was 14.7 and rose to 17.2 by the first days of 2014 (source: S&P 500 operating earnings). To us, that seems slightly on the high side given the current macro-economic environment and based on our fundamental, company by company, research process. As we look at companies to buy for inclusion in client portfolios, we see a lot of fairly-valued, and even over-valued stocks. Bargains are fewer and farther between than they have been in some time.
That said, it is not time to press the panic button, in our view. The economy appears to be strengthening, stubborn unemployment may be coming down slightly, and inflation is still benign. A big key is the continuation and pace of the Federal Reserve tapering its bond purchases as this will most likely push interest rates higher. All else held equal, higher interest rates create a headwind for stock prices. However, the various moving pieces of the economy as a whole, and the specific results of individual companies, result in complex outcomes. So, we continue to own a portfolio of stocks that we think offer good potential, and are searching for additional stocks to own but are finding the list of suitable candidates to be shorter than normal.
NW Equity Income
Equity Income stocks – stocks that pay above average dividends – continued to be in favor with investors looking for income. With bond yields at low levels throughout the year, many investors were willing to take the additional risk of owning a stock and capturing a dividend yield that might be three to four times what the bond market was offering.
In corporate news, 3M announced a 35% dividend increase and also raised the amount it expects to spend on share buybacks from 2013-2017 to between $17 billion and $22 billion. Also, Sysco Foods announced it is purchasing rival US Foods in the fourth quarter. There were many more news items, but these are a couple of the more noteworthy.
For the year, you may recall we trimmed back a number of consumer stocks as they grew to be large positions and towards the expensive side of things. This would include companies such as Sherwin Williams and Home Depot. Also, we completely sold our position in Exelon subsequent to management’s decision to reduce its dividend. Potash was our most recent purchase in this portfolio.
Looking back to the beginning of 2013, recall that AbbVie was spun out of Abbott Labs on January 1st. Abbott has done well without the pharmaceutical business, and in fact, will be increasing its dividend 57% in 2014.
NW Blue Chip Growth
Large multinational firms, which populate the Blue Chip Growth portfolios, performed well during the year and the fourth quarter, and our picks as a whole were slightly better than the market. Trading activity was fairly muted throughout 2013 in this portfolio to our advantage. Some of the laggards from an industry standpoint were utilities and REITs, both of which are generally viewed as income vehicles. We avoided both areas (having sold our REIT position early in the year).
Every quarter brings a host of corporate news items, a few of which we highlight. Oracle continued to be active on the acquisition front, announcing that it is purchasing Corente, a cloud-based services company. This continues Oracle’s activity to expand its presence as more and more activity is moving to the cloud. Microsoft announced in Q4 that it was increasing its dividend 22% over the prior quarter. As growth has slowed somewhat for Microsoft over the last few years, it has been fairly diligent in returning cash to shareholders via growing its dividend payout. Automatic Data Processing, or ADP, increased its dividend by 10%, marking the 39th consecutive year it has raised its dividend.
NW Smaller Companies
Our Smaller Companies portfolio performed well in the year. This portfolio has a mix of small- and mid- cap stocks in it, which turned out to be the best performing areas of the stock market this year.
Shortly after December 31st, we did sell all of our Janus Capital Group holdings after a decent run-up in the stock in 2013. Part of our thesis was that Janus needs to merge with a larger asset management firm, but that seems unlikely since they inked a deal with Dai-ichi Life Insurance Co Ltd in 2012 which includes a 15-20% stake in Janus for Dai-ichi.
In reviewing the year, the two most significant transactions of the year were the purchase of Navigant Consulting (NCI) in Q2 and our continuing sale of CoStar Group (CSGP); a solid company, but a stock price which leaves little margin of safety.
Many people have said, “I’m so thankful 2013 is over. I couldn’t wait to see it go.” While not all of you may agree with that statement, we can be thankful that several events in 2013 didn’t occur. For instance, we avoided multiple sovereign debt crises/cliffs, sidestepped a double dip recession, and avoided a complete destabilization of the Middle East. We do live in interesting times.
If we contemplate the effects of these and other world events on the performance of the average investment portfolio, we see that while the connections may not be obvious, they are pronounced. For instance, just the idea of ending quantitative easing (QE) in September was enough to send interest rates higher, bond prices down, and stocks into a correction. However, now that tapering of QE has begun, we can forget about trying to predict its beginning and start concerning ourselves with what a more normal Fed policy holds. What do we mean by “normal”? For starters, no QE, in any of its iterations, and open market policy that more closely adheres to the historical target levels of inflation and unemployment. The road to a life without QE will be varied and long; the government does nothing quickly. As we approach this long awaited environment, a few comments regarding our portfolio management style seem timely.
For several years our bond portfolios have been managed to a few main tenants. First, manage portfolios to a target duration. Second, insist on high credit quality. Third, seek opportunities in corporate debt.
Currently, the NW Intermediate Fixed Income strategy target duration is lower than its benchmark, the Barclays Intermediate Government Credit index, which stands around 3.75. The lower your duration the less your bond price will change as interest rates change. This is one of the main reasons NWIC is keeping duration low. The other reason is that we believe longer maturity bonds do not provide a favorable tradeoff between risk and return.
Another characteristic we look for in bonds is high credit quality. Many investors are tempted to reach for yield by lowering the acceptable credit standards for inclusion into the portfolio. This can be very dangerous. It’s not that high yield bonds are inherently bad. The question is, are you being compensated for the risk you are assuming? If you buy a junk bond yielding 5%, what have you gained? Sure you received a few more percentage points of return over the life of the security, but what is the probability that bond will default? Well, based on data from Moody’s spanning the period 1970-2010, over 20% of bonds beginning the year rated “Ba” (the highest speculative, or junk, category) defaulted after 15 years. Call us old fashioned but, we are generally unwilling to take that kind of risk with the safest part of your investment portfolio.
Our last bond management guideline is to manage corporate debt exposure. Corporate debt can be an enticing place to put your bond money due to typically higher yields than government debt, but the risks are greater. Our exposure at any given time limits our risk while still providing an increase to overall portfolio performance. As interest rate rise, these higher yielding and typically shorter maturity securities will play an important role in your portfolios performance.
These are several of the important criteria we look for when buying fixed income securities and we continue to manage bonds as the safest part of your investment portfolio. As 2014 unfolds we are sure to see the gradual withdrawal of Fed stimulus and with it a less constrained level of interest rates.
We thank you for the trust you have placed in Northwest. Alleviating the responsibility that comes with managing wealth is what we do. Numerous studies show that the individual investor’s emotions take over when it comes to managing their own money and thus they underperform the markets.* We would be more than happy to have an initial meeting with anyone you know that is looking for assistance in the management of their wealth.
Should you have any questions or would like to set up a quarterly portfolio review meeting, please do not hesitate to contact us at 800.685.7884.
Before we discuss investments, we have a few other topics to cover. A transition in life is typically accompanied by a long “to-do” list. Occasionally some of the details don’t make your list and thus are never addressed. Don’t let changing your beneficiaries be one of the tasks that gets overlooked! At the time of death the current beneficiary on your account will be the one to receive the proceeds of your IRA or Trust even if it’s no longer your intent to have that person as the beneficiary. For your IRA accounts, you can either contact your custodian to get a Change of Beneficiary form, or contact us and we will send you the form.
We want to connect with you. Many of you know we have a blog linked to our web site (www.nwic.net ) where we discuss topics of interest in the capital markets and other areas of client interest. We are also on Twitter, where we tweet links to our blog comments in addition to other information you will find valuable. If you are on Twitter, please search for @NWInvestment and follow us so you can stay up to date. Finally, if you are a LinkedIn user, you can connect with our company page.
Stocks continue to have an exemplary year, as the S&P 500 was up 13.8% through June 30th. The long run annual average for stocks hovers around 10% (depending on exactly what you look at), so this is shaping up to be a rewarding year. There are concerns on the horizon, however, and that has led us to allow a bit more cash to build up in client accounts than normally would be there. Perhaps the most significant factor is the interest rate environment – please read the “Fixed Income” section of this letter below for more details. In addition, most foreign economies are growing very slowly, if at all, and earnings gains for businesses here at home look to be somewhat muted in the second half of the year.
All in all, we are somewhat cautious right now. We spend our days sifting through a variety of informational sources looking for good investments. Those good investments are elusive currently. There are certainly a lot of well-run, growing, healthy businesses listed on the stock exchange – the problem is valuation. We are looking for a margin of safety, and the pickings are slim in that regard.
Most of you will be aware that we sold the majority of our REIT position in the second quarter in our Model portfolios. We have felt for a while that valuations in this space were stretched. Where once yields well above 6% were commonplace in this asset class, the yield on the REIT ETF fell below 3% earlier this year. That was not an attractive risk-return tradeoff in our view. Proceeds have gone to small cap stocks and preferred stocks. If you have a custom allocation (i.e., not one of our Models), we will need a signed change of allocation form if you want to follow our recommendation.
NW Equity Income
The current yield on the Equity Income Portfolio stands at about 2.9% weighted by position size, which is just about the lowest it’s been in the history of this portfolio. Primarily, this is a function of a run-up in stock prices. With income in short supply for investors, many who would ordinarily purchase bonds for income have instead purchased dividend-paying stocks. The cautionary note here is that the risk of stocks compared to bonds is apples to oranges. A given stock may have an attractive yield of, say, 4%, but if that stock falls in price by 20%, that is real pain to the investor. A bond may only yield 1% (or whatever) in this environment, but the kinds of bonds we purchase are very unlikely to have a significant price decline like a stock.
Note that many clients have holdings that were purchased over the last several years and their yield based on their cost could well be between 4%-5%.
NW Blue Chip Growth
While our buy/sell activity was fairly muted in Q2 in Blue Chip Portfolios, there were a fair number of holdings who announced dividend increases. Examples include Oracle, which doubled its dividend to $0.12/share, PepsiCo which increased its dividend 6% as it continued with a long string of increases, and Johnson & Johnson, which pushed its dividend up another 8.2%.
Many companies also continued to repurchase their shares. Both of these actions serve to return excess funds, which are not needed to reinvest back into the business, to investors.
NW Smaller Companies
We added one new holding to the Smaller Companies portfolio during the quarter: Navigant Consulting (NCI). NCI, a specialty consulting firm, provides dispute, investigative, economic, operational, risk management, and financial and regulatory advisory solutions to companies, legal counsel, and governmental agencies facing the challenges of uncertainty, risk, distress, and significant change in the United States, the United Kingdom, and internationally. NCI has shown increasing profitability over the last few years, has a good balance sheet, and offers good potential returns to shareholders.
In other news, Advent Software, a current portfolio holding, announced it would pay a special $9 per share dividend out of cash on hand as well as utilizing its debt facilities. This move to reward shareholders was announced in Q2 and should be received into client accounts on July 9.
The second quarter of 2013 started innocently enough with the interest rate on the 10 year US Treasury note at 1.87%. In fact, yields actually continued to move lower through April, reaching a low of 1.66% by May 1. However, some pieces of good economic news with respect to personal spending, consumer confidence, jobless claims, and inflation started a push on interest rates gradually upward through mid June to 2.2% as the markets saw an improving economy that might someday be able to stand on its own two feet.
However attractive the concept of a healthy economy that is self-sustaining might be, the fixed income markets weren’t quite ready for the same assessment from the head of the Fed, Dr. Ben Bernanke. On June 19 he had the audacity to suggest that at some day in the future the Fed would not need to feed the US economy $85 billion each month. Mind you, he said that day was not now, and he added that rather than taking away $85 billion/month he might just reduce it somewhat. Nonetheless, within 5 days interest rates on the 10 year jumped to 2.6% and pundits predicted higher & higher rates and an imminent bond market meltdown. Thankfully, we are not in the business of entertainment – we manage your money as your fiduciary – so some perspective is in order.
In the business entertainment world (you know that Cramer and CNBC are in the entertainment business, right?), the 10 year US treasury bond is an important rate for a range of things and is closely followed. Many residential mortgage rates are set based upon the 10 year, and general corporate borrowing can be affected by its level, too. So, as a barometer of the cost of money, the 10 year has its place. And, if you owned the 10 year treasury as rates have increased the price of that bond has gone down. The 10 year treasury on May 1 had the market price of $103.33 (and a yield of 1.63%), and by the end of June its value had dropped to $96.17 for a 6.9% drop in the span of just 60 days!
Contrast that with changes on the price of the 3 year US treasury. Today we manage our Intermediate Fixed Income bond portfolios to have short maturities (on average) that are much closer to 3 years. The graph below shows how these two different bonds behaved during the May and June periods of this year.
The white line is the price of the 10 year treasury (what Jim Cramer & Rick Santelli scream about), while the orange line (3 year treasury) is much closer to what Northwest bond portfolios are designed to do. Both bonds were lower in price during the time period; only one of them makes for good entertainment. Rest assured, we seek to invest our clients’ bond portfolios for low volatility and safety – not entertainment value.
We thank you for the trust you have placed in Northwest. Alleviating the financial burden that comes with managing wealth is what we do. Numerous studies show that the individual investor’s emotions take over when it comes to managing their own money and thus they underperform the markets.* We would be more than happy to have an initial meeting with anyone you know that is feeling burdened by the sudden responsibility of managing their wealth.
Should you have any questions or would like to set up a quarterly portfolio review meeting, please do not hesitate to contact us at 800.685.7884.
Here at Northwest Investment Counselors, unlike many other investment managers, we maintain a spreadsheet on the S&P 500 which includes key fundamental data on every member of the index to assist us in identify attractive investments for both the Blue Chip Growth and Equity Income strategies. With the second quarter having just ended, we thought we would share some insights. To compile our data, we review every annual SEC 10-K filing for companies in the S&P 500. From this, we develop two of the three factors used in our valuation model; the third factor, sentiment, is compiled from data not contained in 10-K filings. The goal of using this data in our research process is to make sure we are fishing for investment ideas for clients in the most attractive parts of the market based on quality and value. Keep in mind that this is just one of the research tools we use for clients in our disciplined equity investment process.
We split the results into quintiles, or groupings of 100 stocks, with quintile 1 being the most attractive and quintile 5 the least attractive. The first chart below displays the average stock price returns (no dividends) for the value factors (blue bars) we use and the average stock price return for the S&P 500 (red bar) both for the second quarter. The rankings are calculated from data at the beginning of the quarter and then price performance is graphed over the following quarter. We repeat this process every quarter.
There isn’t enough room in this blog post to detail the formulae and all of the data adjustments, but suffice it to say that the value factor represents the price of a stock divided by the income it generates (price/income)–lower being ranked higher. There was a strong value component to what performed well in the second quarter and what did not (See Chart 1. Value Rank). The red bar shows that the average S&P 500 stock return during the second quarter was a little over 3%. Don’t confuse this with the return on the S&P 500 you may read about in the paper as that performance number is weighted by the market capitalization of the members of the S&P 500; it can and generally will be different. The first blue bar shows that the average stock return for the second quarter for the top 100 companies (first quintile) in the S&P 500 ranked according to our value factor at the beginning of the quarter was about 7.5%. The other quintiles either equaled the return of the S&P 500 (second quintile) or fell well short (quintiles four and five). The goal of this factor is to weed out glamour stocks (those that are most expensive) and focus on reasonably priced investment ideas.
Chart 2 below displays the quintile average stock performance for the quality rank (blue bars) compared to the S&P 500 (red bars)–again, the stock performance is for the second quarter for rankings at the beginning of the quarter. Our quality rank, to summarize, captures the ability of a company to efficiently use their capital to generate a return for stockholders. The top three quintiles (300 stocks) all exceeded the S&P 500 average stock return in the second quarter, while the poorest (quintile five) came up well short. The goal of this factor is to weed out poor industries or poorly managed companies.
For the sake of brevity, we will skip the details on the sentiment rank for this blog post. Overall, we equally weight the value, quality, and sentiment ranks to create our Quantitative Value (QV) summary statistic, which is displayed in Chart 3 below by quintile (blue bars) compared to the S&P 500 (red bar). There was a solid relationship between the rank at the beginning of the quarter and the subsequent performance over the second quarter (just what we want to see).
Our Quantitative Value strategy is composed of 50 stocks from the top quintile (top 100) while candidates for inclusion in the Blue Chip Growth and Equity Income strategies receive further scrutiny by our analysts since our target investment horizon is many years for Blue Chip Growth and Equity Income (plus an attractive dividend yield), not just the subsequent quarter.
You thought correctly, but as the Wall St. Journal pointed out today, the world of bond funds is undergoing a disconcerting trend: they are owning more and more stocks instead of bonds. To be sure, this ownership is permitted and disclosed to investors, but inside the black box of bond mutual fund investing, things are changing.
As the WSJ article points out, there are now 352 mutual funds classified as fixed income funds which now hold stocks as part of their portfolios – one notable extreme holding a whopping 49% in dividend-paying stocks! And with interest rates as low as they are and dividends as high as they are, who can blame them? And, really, what could go wrong?
We have not been fans of owing your fixed income investments in a fund form for many reasons, but this is just one more. And in reality, the move by bond funds to own dividend-paying stocks mirrors the same impulse we see in many of our own clients. It is not infrequently that we are counseling clients to stay the course on their fixed income allocation and resist the temptation to buy, say, Intel Corp, for its sexy 3.7% yield.
The thing about that 3.7% yield, though, is that it comes with some fairly common swings in the price of Intel stock. The chart below shows the last 6 months of Intel prices, and you can see it has gained a welcome 8.3% during that time – AND you got half of that 3.7% dividend, so another 1.85%. Gotta like that, right?
Well, like with any stock, Intel’s 8.3% price growth over the last 6 months wasn’t exactly a straight line. Look at all the red markings: each of those represents a drop of 4% or more over usually a period a week or so. If you bought Intel to earn 3.7% in dividends over a full year, it would be more than a bit disappointing to lose that much (or 2x or 3x) in just a week or two. If you think that the 8.3% overall gain makes that volatility perhaps a bit more palatable, you may be surprised to learn that you were gain-less until the last 9 trading days of the 6 month period.
The point is that even the best dividend-paying stocks are still stocks, and even the lowest-paying bonds are still bonds. We buy bonds for clients to reduce volatility and introduce certainty into a portfolio. Do we like to be able to generate some income along the way? Absolutely. But that’s the gravy, not the sole purpose of your bonds. At NWIC, your bonds really are bonds, and we intend to keep it that way.
An interesting tidbit crossed our desk the other day related to dividends, which is a topic many clients have been interested in with income from bond holdings at fairly meager levels. Morningstar reports that “342 of the S&P 500 companies increased their dividends (in 2011), while only five cut their dividends, leading to a net annual increase in payout of $41.1 billion, a far cry from the $37.3 billion in dividend cuts created by this group in 2009.” The Morningstar author goes on to posit that he expects healthy dividend increases in 2012 as well. In our view, that may well turn out to be the case in 2012. However, President Obama has proposed some pretty hefty increases in taxes on dividends, to the tune of up to 44.8% in the top tax bracket compared to today’s 15% (calculation by the WSJ). That tax increase, if it comes to fruition, may pose a headwind for increased corporate payouts. We know that when tax rates on dividends were cut in the past, dividend payouts went up as corporations recognized a preference for dividends over share buybacks from many in their shareholder base. It seems reasonable to postulate that a dividend tax over 40% could cause the reverse behavior. Stay tuned.
This week, we have some merger and acquisition news to pontificate on with regard to our portfolios. In the Blue Chip Growth portfolio, our long-time holding Ecolab (ECL) announced it had reached an agreement to acquire Nalco Holding Company (NLC) for $8.1 billion in cash (30% of deal) and stock (70% of deal), including the assumption of Nalco’s $2.7 billion in debt. Ecolab sold off after the announcement (not an unusual response to most large acquisitions) and some pundits thought Ecolab was overpaying for a business, Nalco, with inferior business economics. Nalco, by our analysis, has a return on tangible invested capital (ROIC) of about 30%, consistent with Ecolab’s business. Nalco earned about $626 million in adjusted operating earnings in 2010. Ecolab is paying about 13 times operating earnings or about a 20% premium to where the composite S&P 500 is trading. Ecolab, itself, is trading around 13 times operating earnings. While it will be tough for Ecolab to squeeze much more out of Nalco’s 30% ROIC, Ecolab is picking up a good business with its, already, pricey stock. So, in the end, we think the market’s reaction is more about the value of Ecolab than the quality, or price, of the business it is buying.
In the Equity Income portfolio, Carl Icahn first proposed acquiring Clorox (CLX) for $76.50 per share and then upped his unsolicited takeover price to $80.00 per share about a week later. We carry a fair value estimate of about $80 per share currently for a minority position. While we would hate to see a good company like Clorox go from the Equity Income portfolio (good companies trading at reasonable price are difficult to find), we do welcome Icahn pointing out that Clorox was undervalued by the market. A price of $80 would represent a 13x multiple of enterprise value (stock capitalization plus debt) to adjusted operating earnings. We think the Board of Directors should reject $80, but be open to accepting an offer between $95 and $100 per share, or a 20% control premium on top of our estimated value.