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1st Quarter 2015 Review: Growth beats Value, International beats Domestic, and Small Cap beats Large Cap

Despite some domestic economic headwinds, Euro-zone tension following January Greek elections, and expectations that the US Federal Reserve (the ‘Fed’) is ready to start raising short-term rates, the US stock market as measured by the S&P 500 managed to eke out a small 1% gain during this year’s first quarter.

In the US, economic headwinds included bad weather on the East Coast, a strong dollar, and a labor dispute in West Coast ports that interrupted exports. The unemployment picture continues to improve and wages appear to finally be picking up. Europe is still barely growing at all and China’s growth continues to moderate. These contrasts in economic fortunes, combined with the Fed’s more hawkish stance, appear to be the reasons behind the US dollar’s relative strength, a trend which is not helping US companies that sell their products or services overseas.

According to Morningstar, Large Capitalization (‘Cap’) Growth funds outpaced their value competitors (up 3.5% vs. 0.2%); Small Cap Growth funds advanced 5.8%, also beating their value peers (up 2.3%). Foreign markets were up 3.8% (MSCI Ex US index) despite the currency headwinds, with Japan one of the better performers. European markets were buoyed by the European Central Bank’s bond buying program. Again, foreign growth funds outpaced value.

On the bond side, Fed concerns have not yet led to higher interest rates. The opposite actually happened as rates declined during the 1st quarter: the yield on the benchmark 10 Year US Treasury bond fell from 2.1% to 1.9%. Funds investing in US Treasuries and bonds with long maturities outperformed. Tax-free and so-called ‘junk’ bond funds were also up slightly, while currency exposure dragged down returns for foreign bond funds.

Our review would not be complete without mentioning that Energy (and most commodities), Utilities, and Financial Services were the worst performing sectors within the US stock market during the quarter, as they all experienced declines. The best performing stocks were in Health Care, Consumer Cyclical (particularly Real Estate), and Technology. Not surprisingly, looking at cyclically adjusted price-to-earnings ratios (a measure of stock valuation that corrects for swings in profitability), the most expensive sectors were consumer cyclical (39.1x), Health Care (31.5x), and Technology (28.8x). The cheapest were Energy (13.8x), Financials (16.8x), and Utilities (20.9x). These numbers compare to the S&P 500’s average multiple of 27x at the end of the quarter.

Reflecting this wide range of sector performance, our average client portfolio was up moderately during the quarter. Investment categories that performed best matched those previously mentioned, i.e. International and Small Cap funds. The best performer was the Wasatch Small Cap Growth fund (WAAEX). The laggards were in the commodities and natural resources sectors with both the iPath Dow Jones Commodity Index fund (DJP) and the RS Global Natural Resources fund (RSNRX) declining in mid- single digits. All bond funds were up slightly, performing more or less as expected depending on the type of fixed income securities they held. No investments were bought or sold across the board; only rebalancing based on individual circumstances took place.

Does the mix of stocks vs. bonds matter over the long run?
For the greater part of the past 25 years, it has been close to a religious dogma that investing in stocks pays off over the long run despite the risks. Looking at our own clients’ portfolios over the past 10 or 15 years makes you wonder: there was little difference in average annual performance between portfolios that started heavily weighted in equities and those more invested in bonds. Yet, the more aggressive portfolios experienced some dramatic, once in a generation, drop in values during the financial crisis: by November 2008, the S&P 500 had suffered a 45% price decline from its prior high! In contrast, over the past 15 years, the biggest declines in intermediate, high-quality bond prices were in the 3% to 5% range.

The relative homogeneity between different mixes of stocks and bonds is explained by i) historically low equity returns, and ii) historically high bond returns. An aggressive investor who would have been invested 100% in an equity index fund such as the Vanguard 500 Index fund would have seen his portfolio grow by about 8% a year over the past 10 years, and by about 4% annually for the past 15 years. A very conservative investor who, over the same time periods, would have been invested entirely in bonds through the Vanguard Total Bond Market fund would have earned respectively about 4.8% and 5.4% annually. This performance from bonds was partially derived from the income received but also by a relentless decline in yields (when interest rates decline, bond prices increase). Combining stocks and bonds in varying proportions produced blended returns that were very similar, because the difference in performance between the two was small relative to prior periods in history.

Should we expect similar results going forward? We do not anticipate the next 10 years resembling the last 10 years. While we certainly do not claim to have the ability to forecast equity markets, bonds have historically produced a narrower range of return outcomes. An investor buying a 10-year US Treasury bond today and holding it to maturity, will receive an annual return of less than 2%. Although rising rates will eventually lead to higher yields in the future, it’s difficult to see how the broad bond market could possibly deliver returns like those of the previous 10 or 15 years.

So while it is tempting to expect a repeat of 7% annualized returns from a balanced portfolio, it’s unlikely to happen in our opinion. That doesn’t necessarily mean that investors should take more risk and throw their bond allocation away. Besides income, bonds also provide increased stability when paired with stocks within a balanced portfolio. However, this explains our prudence and use of more conservative intermediate-term assumptions when helping our clients plan for retirement. And it means that some investors will need to save more to reach their goals.

Large Cap Value Review
In our Large Cap Value portfolios, we were more active than usual. Part of the reason was that we had waited until the New Year to begin selling some holdings that had unrealized gains, in order to postpone taxes for another year. This was the case with our sale of 3 positions that we received as spinoffs from our holdings of Tyco International (TYC) shares: TE Connectivity (TEL), ADT Corporation, and Pentair (PNR). This does not completely close the chapter on our ownership of Tyco as we still hold a small position.

We also divested our position in Annaly Capital Management (NLY), which we had purchased barely more than a year ago. It is very unusual for us to change our mind about an investment in such a short period of time. As you may recall from our discussion when we originally bought the shares, we expressed some reservations about the complexity of the business (and about management’s compensation). During our ownership, we noticed an increasing use of derivatives, coupled with a change in the mix of securities that the company invested in, which obscured the drivers of economic value. In the end, we decided to place it in what Charlie Munger, Berkshire’s vice chairman, calls the “too complicated pile.”

Rounding out our sales for the quarter, we reduced our position in Medtronics (MDT) based on valuation. The company’s business is performing very well and expectations have risen accordingly. We felt that valuation no longer warranted such a high percentage of our clients’ portfolios

On the buy side, we increased our investment in Aggreko PLC (ARGKF) as the stock price declined about 20% from our original purchase last summer. Reasons behind the decline include the appreciation of the British pound as well as declining economic growth in some of the company’s markets. We do not view these short-term headwinds as a reason to change our thesis, and we continue to like Aggreko’s long-term prospects.

Finally, we initiated a new investment in Valmont Industries (VMI), a company far removed from the social media and assorted biotech stocks making today’s headlines. Valmont is a leading manufacturer of both mechanized irrigation systems and utility poles. Valmont operates in 100 countries, and commands about half of the US market for center-pivot irrigation systems, which use much less water and are less labor-intensive than traditional furrow irrigation. With increasing concerns about water scarcity (see these charts of California Snow Water content), adoption of more efficient mechanized irrigation systems continue to grow in the US and particularly in the developing world.

Along the way, Valmont developed an expertise in galvanized metals and pipes, and through small acquisitions, became one of the leading manufacturers of utility poles used for public infrastructure. We feel that the company enjoys some competitive advantages, and is run by very disciplined and conservative managers. The recent declines in farm income and uncertainty about infrastructure spending gave us an opportunity to buy shares in this company at a discount to our estimated appraisal of its value.

US Natural Gas: Mistake or Opportunity?
As we alluded to in recent commentaries, our Large Cap portfolio has suffered, relative to the broader market, from its direct and indirect exposure to energy prices and particularly natural gas. Companies in your portfolio include some traditional names such as Exxon Mobil and Chesapeake, but also Dynegy and NRG, two power producers whose revenues from selling electricity are indirectly affected by the price of natural gas.

Natural gas production from shale has been the great American success story of the past few years. Production growth has been phenomenal (up 25% since 2009) and the increased supply has weighed dramatically on prices. What has been a boon to consumers, has been the bane of the companies we just mentioned. Not surprisingly, the natural tendency is always to extrapolate recent production growth far into the near future, and the consensus view is for prices to remain low for an extended period of time.

Like all commodities, oil and natural gas are a case study in economics 101. By nature, lower prices plant the seeds of their eventual recovery. We believe that, in the background, there are already some powerful factors that will bring back higher prices:

  • Gas producers have dramatically cut down investments in new wells;
  • Production rates from shale fields tend to decline much more rapidly than from conventional wells;
  • Demand for natural gas continues to increase slowly but steadily;
  • A significant amount of coal-fired energy plants are being phased out due to environmental regulations and are replaced by more efficient gas-fired plants;
  • Petro-chemicals facilities are being built or expanded to take advantage of lower feed costs (fertilizer, etc.);
  • New natural gas liquefaction plants are coming online next year, opening the door for export of US natural gas (which sits near the bottom of the global cost curve).

To be clear, we do not claim to be able to forecast the timing of a recovery in natural gas prices, but we believe that prices will recover, and probably sooner than most pundits expect it today. In the meantime, we believe that our companies are financially sound: not only will they be able to survive the current down cycle, but they will likely emerge in a stronger competitive position thanks to much lower production costs.

Large Cap Value Performance
Traditionally, upon our track record anniversary at the end of each 1st quarter, we show the Large Cap Value’s portfolio 12-months returns ending March 31, as well as cumulative and annualized returns since inception on April 1st, 2000:

Buffett Table 2015

Performance during the most recent 12-months period was clearly disappointing as the average Large Cap Value account rose by a much smaller percentage than the broader market, following consecutive 12-month periods of outperformance. Although only a handful of our companies faced challenges during the last few months, their performance was poor enough to more than offset the strong operating results from the majority of our holdings.

We discussed the culprits back in January in last year’s 4th quarter commentary: greater exposure to energy-sensitive stocks and to shares of foreign companies at a time of US dollar strength, as well as a high cash position. Despite this recent setback, since the onset of the financial crisis 6 years ago, the Large Cap Value portfolio has compounded annually at about 18% versus 19.7% for the S&P 500 index, a much higher than historical absolute rate of return. Yet, this was not an easy period for value strategies: after underperforming the broader market during the Great Recession (2008), the S&P Value index underperformed again in 2009, 2011, 2013, and 2014. If history is any guide, the pendulum will eventually swing back.

While we make no effort to have our portfolio mirror the S&P 500 index in any way, we still see it as a fair comparison for the universe of stocks from which we are choosing. The key takeaway from the table, in our view, is that we have delivered slightly superior performance, after deducting our fees, over a 15-year period now, encompassing several market cycles. We are, however, displeased by the wide negative divergence between our portfolio’s returns and the index returns during a couple of recent 12-months periods, the result of which is that the portfolio lagged the market over 3, 5, and 10-year.

Future performance is all that should matter to you as well as to us since we invest our families’ assets alongside yours. Although low by historical standards, we continue to draw comfort in the portfolio’s overall discount to intrinsic value. Buying quality, growing businesses, run by competent managers, at a discount to our estimate of their value remain in our minds the key attributes of a process that has the potential to deliver long-term outperformance.

Overall, we remain moderately satisfied with our performance since inception and continually look to improve our processes. And while we have contributed to our clients achieving greater wealth, we are constantly reminded that the biggest role we play in assisting clients meet their financial goals is helping them establish a solid long-term investment plan and overcome strong behavioral weaknesses that regularly undermine most investors’ long-term success.

We appreciate greatly the trust you have shown in Bristlecone’s services.

Disclosure Brochure Offer
Securities laws require Bristlecone to make available every year to clients the latest version of our disclosure brochure (Form ADV Part 2A). This form contains important information about our firm, such as services, business practices, potential conflicts of interest, a summary of our Disaster Recovery Plan, and Privacy Policy.

If you receive your 1st quarter statement by mail, a copy is included for your convenience. If you elected to receive your statements through our online portal, the disclosure brochure is available for download on our website by clicking here, but we’ll be happy to mail you a copy free of charge (call 877-806-4141 or email clientservices @ bristlecone-vp.com)

You may also find additional information about our firm at our website, and through the SEC’s Investment Adviser Public Disclosure system website. We are also required to adopt a code of ethics and provide a copy of which to clients upon request. The current version is available on our website by clicking here or by contacting our firm at the telephone number or email address listed above.

Please contact us immediately if you have had any changes in your investment objectives or financial circumstances. Any changes could impact how we manage your portfolio and will become part of your client file. You should also contact us at any time during the year if your investment goals and/or financial circumstances change. Should you hold equity securities in your portfolio, you might be responsible for the voting of proxies with regard to those investments. We typically do not vote client proxies unless specifically requested.

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. 

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.

 Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.