With the benefit of a month’s hindsight, market fallout from the Brexit campaign appears surprisingly short-lived, particularly in the U.S. Following a brief selloff in the few days following the June 23rdvote, the S&P 500 rallied over 8% in the next few weeks, hitting a fresh all-time high by early July. European equities, while still modestly negative for the year, also regained much of the ground lost after the Brexit vote. Neither a terrorist attack in Nice nor an attempted coup in Turkey did much to slow the rebound.
In fact, aside from a few funds with significant exposure to European stocks, every other asset class in our client portfolios appreciated during the second quarter. The best performing funds were in the commodities and natural resources sectors, which benefitted from a strong rebound in energy prices. Oil prices increased 30% during the quarter, while natural gas rallied 48%. These two commodities were key drivers in the performance of the Bloomberg Commodity Index, which advanced 12.8% in Q2 and finished the first half of the year up 13.3%.
Among domestic equities, small and mid-cap stocks led the pack, advancing 2-4% in the quarter, according to Morningstar. Among large caps, value stocks continued their recent outperformance, slightly outpacing the 2.5% quarterly return on the more growth-oriented S&P 500 Index. While the MSCI EAFE Index (a proxy for developed market equities outside the U.S.) was down 1.2% for the quarter, most of that drag was attributable to Europe and the U.K.; Japanese stocks advanced nearly 3%. Performance of emerging market equities was also generally positive, led by high single digit returns in India and Latin America.
More interesting than equity markets, however, are some unprecedented developments in global bond markets, and the ripple effects they are having across a variety of yield-oriented assets. To fully understand, it may help to review some mechanics of monetary policy. Interest rates are effectively the “price” of money. In normal times, central banks like the U.S. Federal Reserve engage in the purchase and sale of short-term bonds as a way to target an inter-bank lending rate (i.e. “price”) which appropriately balances the availability of credit with the desire for a stable value in the currency.
During the last financial crisis, with short-term interest rates already hovering near zero, the Fed took extraordinary measures to further expand the availability of credit (and stimulate growth), via three iterations of “Quantitative Easing” (2008-2014). During the QE programs, the Fed purchased bonds from commercial banks with newly-created dollars. These purchases bid up the price (and drove down the yield) on a variety of fixed income securities of longer duration. In the process, the yield curve flattened considerably, and the Fed’s balance sheet expanded from $800 billion to $4.3 trillion.
Theoretically, an influx of cash from QE gives banks fresh capital to lend, while a drop in long-term interest rates (particularly on mortgages and corporate debt) stimulates demand from potential borrowers. Taken together, these factors should accelerate economic growth, eventually putting inflationary pressure on the economy. Even though U.S. GDP growth since 2009 has been slower than the long-term trend, by late 2014 the Fed felt sufficiently confident in the economic recovery that it wrapped up QE3 and made plans to beginning increasing interest rates in 2015.
Meanwhile, other central banks followed the same playbook. The Bank of Japan’s (BOJ) experiments with QE had predated even those of the U.S. Fed, but they gained renewed momentum following the election of Prime Minister Shinzo Abe in December 2012. The European Central Bank (ECB) dramatically expanded QE beginning in January 2015. In March of this year, the ECB broadened the bond buying authorization to include even some highly rated corporate debt, an unprecedented step which appears to have substantially lowered the borrowing costs for the most creditworthy firms (in April, Unilever issued a 4 year bond yielding 0.08%). Earlier this month, Merrill Lynch estimated that $13 trillion in global debt (about 2/3rd of it issued in Japan) traded at prices which implied a negative yield to maturity (the proportion represented in the orange area of the graphic below).
During times of economic distress, and particularly when stocks crash, high quality bonds typically offer uncorrelated returns to equities (often, they move in different directions, since bonds are perceived as a safe haven to the volatility of stocks). Thus far in 2016, we have witnessed a more intuitive relationship, as stocks and bonds rallied together. Since equities as a whole discount future companies’ earnings far in the future, the normal relationship is that when rates go down, stock (and bond) prices go up.
The Barclays Aggregate Bond Index rose 2.2% in Q2, and 5.3% YTD. The S&P 500 Index advanced 2.5% in Q2 and 3.8% YTD. By early July, the yield on the 10 year U.S. Treasury hit an all-time low of 1.36%, just as the S&P 500 was setting a new all-time high (side note to homeowners: now might be an opportune time to consider refinancing your mortgage, if you have not done so in the past 12-18 months).
One explanation for these ever lower yields is that the “financial repression” of negative interest rates in Europe and Japan has created a class of income refugees, fanning out across the globe in search of return. This may explain why the top-performing U.S. equity sectors tracked by Morningstar over the past year were: Utilities (+31.5%), Real Estate (+20.3%), and Consumer Defensive (+17.9%), all of which soundly trounced the 4% return on the S&P 500 over the same period. These three sectors traditionally attract more income-oriented investors, who are no doubt discouraged by the competing yields on offer in the fixed income universe.
Another side effect of low interest rates has been a surge in the level of stock buybacks. S&P 500 companies repurchased more than $160 billion of their own shares in first quarter, the second-highest quarterly pace in history (and the highest since 2007). According to the Wall St. Journal, aggregate share count among S&P 500 companies is on track to decline this year for the first time since 2011. Partly, this reflects the cheap cost of debt, which enables companies to finance mergers and acquisitions without issuing new equity shares. Additionally, there may be an element of tax arbitrage: interest on corporate debt is tax-deductible, whereas dividend distributions are generally taxable. Therefore, borrowing at low rates to fund share repurchases is arguably a tax-efficient method of returning capital to shareholders. As the following graphic from Factset shows, buybacks have steadily claimed a larger proportion of the total capital returned to shareholders, since the recovery began in 2009:
Depending on whom you ask, this trend may reflect either myopic financial engineering, or pragmatic caution about future economic growth. First, the cynical perspective: accelerated stock repurchases facilitate a financial alchemy whereby tepid growth in net income morphs into acceptably-higher levels of earnings per share growth (since repurchased shares are typically retired or cancelled, the remaining shareholders are each entitled to a larger slice of the earnings pie).
Perhaps not coincidentally, EPS growth is one of the most frequently cited metrics in assessing management performance (and in awarding incentive compensation). A skeptic could note that incentive compensation packages are increasingly comprised of stock grants, and that accelerating EPS growth is one of the quickest ways for executives to boost their personal compensation (a doubly-tempting prospect, if they can do so using borrowed money). Moreover, it is important to remember that in the absence of buybacks, share issuance attributable to employee compensation dilutes the ownership of other common shareholders. Such dilution has a non-zero cost, which is imperfectly captured by GAAP accounting, and thus rather opaque to non-professional investors. At some companies, the number of shares repurchased is barely sufficient to neutralize the dilutive impact of stock awards to management and employees!
To be fair, one could also make the case that lingering excess capacity in the economy (ex: slow wage growth despite relatively high levels of employment), is a sign that substantial new investment in plants and equipment is not yet justified by aggregate demand. Pragmatists may concede that returning capital to shareholders via buybacks—even at elevated stock prices—is still more prudent than chasing expensive acquisitions or building unneeded factories. Nevertheless, the temptation for management to prioritize its own short-term interests over the long-term interests of shareholders is a classic example of the agent/owner conflict, and illustrates the critical role of a strong, independent, and ethical board of directors.
Large Cap Value Update
Our average Large Cap Value portfolio outpaced the S&P 500 index during the 2nd quarter bringing the YTD return also ahead of the 3.8% for the S&P (for actual individual performance figures, please refer to your 2nd Quarter Portfolio Review Report). Top-performing positions last quarter were Dynegy (+20%), Pfizer (+19.8%), Novartis (+17%), and Tyco (+16.6%). Laggards were Cemex (-11.9%), Bank of America Warrants (-10.5%), Liberty Ventures (-5.2%) and AGCO Corp (-5%).
In our Q4 2015 commentary, we discussed the drivers of our investments in Dynegy (DYN) and NRG Energy (NRG). A key part of the investment thesis for both companies had to do with the secular shift toward renewable or at least cleaner-burning fuel sources, including natural gas. In fact, there is a high correlation between the prices of natural gas and wholesale electricity, since natural gas now powers about a third of the nation’s electric grid, and is most often the marginal fuel source during periods of peak electricity demand. After a precipitous decline in natural gas prices during 2014-15, new drilling activity was significantly curtailed. This allowed excess supply to work through the market, setting the stage for a rebound in gas prices this spring, which benefitted both DYN and NRG.
Meanwhile, bank profitability faces headwinds from a flattening yield curve (which compresses “net interest margin”—the spread that banks earn on their loans), increased costs from new regulation, and below-average loan growth. These factors have pressured share prices of the largest banks in 2016, including two of our LCV holdings, Bank of America (BAC) and Wells Fargo (WFC). As one measure of investor pessimism, consider that BAC’s stock has now traded at a discount to its book value for nearly 8 consecutive years (currently 60% of book value). Price-to-Book multiples for other large banks have similarly contracted from their pre-financial crisis averages.
Nevertheless, we think management at these firms has responded well to the variables that are within their control (ex: reducing operational costs by shifting more of the business to mobile platforms, and reducing the footprint of physical branch locations). Moreover, the latent profit potential at BAC in particular seems enormous. From 1997-2007, BAC’s non-interest expenses as a percent of total revenues averaged 55%. Over the past 6 years, a variety of restructuring charges, legal settlements, and other one-time events have elevated this figure to an average of 80% of revenues. If BAC had instead averaged even a 60% rate over that period, the cumulative pre-tax profit would have been about $160 billion, rather than the $50 billion actually reported. For a company with a current market capitalization of less than $150 billion, this is a non-trivial difference in earning power!
With the stock market hitting new highs recently, our trading activity in the LCV portfolio was rather subdued. Our only transactions in the quarter were the sale of two long-term holdings. In early May, we sold our remaining stake in Vulcan Materials (VMC), as the stock rallied beyond even an optimistic appraisal of the company’s fair value. Soon thereafter, we eliminated our small position in Cable One (CABO), which we had received as a spinoff from another long-term investment, Graham Holdings (GHC, itself formerly the parent company of The Washington Post, WPO).
Cable One is a niche provider of broadband internet services to rural areas. The business enjoys high profit margins, but is slow-growing and capital-intensive. As part of a conglomerate of disparate businesses within GHC, CABO’s value was obscured. However, as a stand-alone business in a rapidly consolidating industry, the market awarded CABO a much higher valuation post-spinoff (perhaps speculating that it may eventually be acquired by a larger competitor). In our assessment, the sale price offered an attractive premium to valuation levels implied by other recent deals in the industry, particularly given the growing uncertainty of how the media and telecom landscape will evolve. As with our ownership in various Liberty Media spinoffs, our original purchase of WPO in 2008 was predicated on the thesis of a “conglomerate discount.” We judged that the parent company was trading for much less than the sum of its parts. With the sale of CABO, we are incrementally closer to unlocking the value we perceived years ago.
As always, we welcome your comments and feedback, and appreciate your trust in our services.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
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