4th Quarter Review: American (equities) First

U.S. equity markets pushed broadly higher in Q4 and for calendar 2016, boosted by investor optimism that President-elect Trump’s administration will usher in a wave of business-friendly initiatives including reduced government regulation and lower corporate tax rates. For the first time in 17 years, all three headline domestic indexes (Dow 30, S&P 500, and Nasdaq), finished the year at simultaneous record highs. In a reversal from last year, the strongest returns in 2016 came from Small Cap and Value stocks, as summarized in this heat map of US fund category returns from Morningstar:

Overall, it was a good quarter as our average client’s asset allocation portfolio posted broad-based positive returns despite that only 3 out of our 12 asset classes rose (your own portfolio results may differ – please refer to your Quarterly Portfolio Review Report). Our investment selection outperformed on average in 9 out of these 12 categories during the quarter, and 8 out of 12 during 2016. The new year is off to a good start as well. The table below shows how a model 60/40 balanced (i.e. made up of stocks and bonds) portfolio is allocated, and for each asset category, the benchmark returns:

Much of the gains in US stocks came in the final seven weeks of the year. Investors bet that smaller companies will be the biggest beneficiaries of President Trump’s policy proposals, since they are more directly levered to the U.S. economy, less impacted by potential trade barriers, and stand to benefit the most from a reduction in the statutory corporate income tax rate. With the exception of the very largest growth stocks (which led the market from 2014-15), U.S. equities delivered strong positive returns in 2016. Value stocks in particular reversed a long period of under-performance, paced by a rebound in the energy sector (spot oil and natural gas prices rose 45% and 63%, respectively) as well as strong performance from financials (which stand to benefit the most from rising interest rates). History shows that value’s out-performance should continue for at least a couple of years.

The rebound in commodity prices was generally a positive tailwind for emerging markets equities, countered somewhat by a stronger dollar as higher U.S. interest rates attracted capital from overseas. Still, the MSCI Emerging Markets index delivered a solid 8.6% return for the full year, in U.S. dollar terms. International Developed Markets were relatively flat, hindered by slow growth in Europe, uncertainty over the timing of “Brexit,” and weakness in local currencies (Euro, Pound). The MSCI EAFE index managed only a 1.5% return for the year, in U.S. dollar terms.

Looking at the bond market, an investor might assume that 2016 was a rather sleepy year, with the Barclay’s Aggregate Bond index rising just 2.6%, and the yield on the 10 year U.S. Treasury finishing the year a mere 21 basis points above where it began. However, this veneer of tranquility masked large shifts in sentiment throughout the year. In January and February, a stock market selloff tied to declining oil prices and slowing growth in China brought high-grade government bonds into favor. In late June, the surprise Brexit vote created additional market dislocation, with U.S. government debt once again seen as a global haven. By early July, the yield on the 10 year U.S. Treasury bond reached a record low of 1.37%, and longer-dated bonds were among the market’s best performing asset classes (Morningstar’s Long Term Government Bond category was up 13% through the first half of 2016).

However, following Donald Trump’s surprise electoral victory, investors began to price in substantially higher interest rates. The President-elect campaigned on a set of policy proposals which are likely to increase the federal budget deficit during a period of relatively full employment—potentially leading to higher inflation. Tacitly acknowledging this, the U.S. Federal Reserve not only raised short-term interest rates by 25 basis points in December, but also signaled a more aggressive stance toward further rate increases in 2017 (the Fed now predicts three rates increases next year, rather than two). Notwithstanding stellar returns in the first half, long-term government bonds were pummeled in the fourth quarter—down nearly 12% (per Morningstar, the quarter’s worst-performing bond category, by a wide margin), which nearly wiped out their strong first half return.

Taking a broader view, the best performing bond categories in 2016 were those with high levels of credit risk, and low to moderate levels of interest rate risk. Bank loans and high yield debt fit this criteria well. Each benefitted from a resurgence in commodity prices, which bolstered the credit profile of financially distressed energy producers. Moreover, each of these categories were less negatively impacted by rising rates in the fourth quarter (thanks to high coupon payments in the case of junk bonds, and floating rate coupons in the case of bank loans). Morningstar’s High Yield Bond category returned over 13% in 2016, as contracting credit spreads on junk debt more than compensated for the adverse impact of rising rates.

Finally, emerging market debt was another bright spot in 2016, as surging commodity prices improved the credit profile of sovereign issuers whose economies are oriented toward the production and export of natural resources.

While long-term bonds were hurt the most in the wake of U.S. elections, municipal debt also fared poorly. President-elect Trump campaigned on a pledge to dramatically reduce both personal and corporate income tax rates. All else being equal, lower marginal tax rates diminish the utility of the tax-free interest generated by municipal debt, and reduce the incentive for investors to hold it. The average national municipal bond fund declined about 3.5% in Q4, erasing substantially all the return from the first three quarters of the year.

For the most part, the fixed income allocations in Bristlecone’s client accounts experienced less price volatility than the sub-sectors described above. This is because we have a philosophical aversion to assuming significant credit risk with the portion of our client portfolios earmarked for “Income & Capital Preservation.” Moreover, since we’ve long expected interest rates to eventually normalize at a higher level, we’ve been unwilling to take significant interest rate risk, either. A bond allocation characterized by high grade credits with short-to-medium term duration makes for a boring, yet stable ballast to the portfolio.

Large Cap Value Update
Our average Large Cap Value stock portfolio exceeded the S&P 500’s 3.8% return in Q4, yet slightly lagged the index’s full year return of 12% (Again, please refer to your Quarterly Portfolio Review Report for actual results). The portfolio’s 4th quarter performance was anchored by a significant weighting to financial stocks, including Bank of America Class A Warrants (+115%), Bank of America (+42%) and Wells Fargo (+25%). We had long considered Bank of America to be one of the most undervalued stocks in the portfolio (in fact, the stock has traded at a significant discount to book value since the financial crisis), so it was gratifying to see Mr. Market finally come around to our way of thinking.

As we covered in a prior commentary, Bank of America’s tremendous latent earnings potential was overshadowed for several years by legacy legal settlements and restructuring charges—costs which are now almost entirely in the rear-view mirror. For perspective, a recent New York Times pieceoffered a tally of the total fines and legal settlements paid by each of the largest banks since the financial crisis. Bank of America was first on the list, having paid a total of $71 billion in 24 settlements! The next-highest tally (belonging to JP Morgan Chase) amounted to less than half of that figure.

On the other side of the ledger, the biggest laggards in Q4 were Dynegy (-32%), Medtronic (-17%) and Johnson Controls (-11%). Both Medtronic and Johnson Controls declined after reporting disappointing earnings for Q3 and modestly lowering earnings guidance for 2017. As an independent power producer, Dynegy continues to struggle with slumping electricity demand, exposure to volatile fuel prices, and a significant debt burden. Nevertheless, the company expects to generate positive free cash flow in 2017 and beyond, and has significantly expanded its generating capacity in the last few years by acquiring assets for a fraction of the price (measured in dollars per kilowatt) at which new gas-fired power plants can be constructed. In the long-run, we believe this will be value-accretive to the firm’s shareholders, particularly if management can execute on their plans to pay down the debt from these acquisitions in a timely manner.

With the S&P 500 index finishing the year at a record high, and average valuation (as measured by the Shiller P/E ratio) well-above its long-term average, we found fewer new investment opportunities for the LCV portfolio during 2016. After beginning the year with about 12% of the portfolio in cash, we were net sellers for much of the year, driving the cash balance as high as 17% by the end of Q3. Fortunately, we were able to put some of this excess cash to work in the fourth quarter. First, we added to our position in Graham Holdings (GHC), which had decreased as a weight within the portfolio after a series of divestitures and spinoffs from the conglomerate formerly known as the Washington Post Company. At this point, the two main businesses remaining under the GHC umbrella are a collection of local television stations, and a test preparation business (Kaplan Education). However, the company has a number of other potentially valuable assets including a portfolio of emerging internet and healthcare businesses, a significant pension surplus (which could perhaps be monetized via an acquisition of a company with an under-funded pension plan), and a significant cash balance (equal to roughly 1/3 of the current market capitalization). CEO Donald Graham has proven himself an able and shareholder-friendly steward of capital, with a long-term view of value creation which nicely overlaps our own.

In early November, we increased the weights of two existing positions, which were among the worst-performers year-to-date: Aggreko (ARGKF) and QVC Group (QVCA). Aggreko, a British-based global provider of temporary power solutions, has seen revenue growth stall the past few years due to a decline in commodity prices, which cut demand from their mining and energy customers. Compounding the company’s weak operating performance, our investment performance also suffered from a weak British currency, which declined 38% vs. the U.S. dollar during our ownership period. We believe both factors are likely to normalize over time, and therefore were comfortable increasing our stake in a company with low debt and commanding market share, in a business which we expect has a long runway of secular growth.

QVC Group, which operates the namesake multi-channel specialty retail business (and owns a 40% stake in rival Home Shopping Network, as well) is one of several spinoffs we’ve received from an original investment in Liberty Media Company many years ago. Founded in 1986, QVC carved out a successful niche marketing discretionary products to well-to-do middle-aged homeowners (mostly women) via cable infomercials, and was an early adopter of e-commerce, launching a web shopping portal in 1996. This niche has proven remarkably resilient in an era when many “brick-and-mortar” retailers are losing ground to Amazon.com. To get a sense of how swiftly consumer shopping habits have shifted, consider this telling infographic from the Visual Capitalist blog, which points to the steady erosion of sales at “big box” and department stores over the last decade. The worst performing retailer on that list (Sears) was the subject of a recent investigative report from Business Insider, which characterized the firm’s struggles as a “death spiral” and predicted that it could be forced to declare bankruptcy within two years.

Against this dour retailing backdrop, QVC’s U.S. sales showed signs of slowing in their second-quarter earnings release, leading many investors to fear that competition from Amazon and/or declining cable viewership from “cord cutters” was taking a toll. The stock dropped 18% following that August earnings report. While a certain amount of apprehension is understandable, this seemed an overreaction to us. QVC already holds many advantages of an e-commerce retailer (in fact, it is the 10th largest e-commerce retailer in the U.S.), yet it also boasts some unique strengths: an infomercial format which encourages impulse purchases, exclusive vendor inventory, and a very loyal customer base which purchases about 24 items per year, on average. The strength of this business model is apparent in QVC’s profit margins, which are much higher than most retail peers (and more than twice as high as Amazon’s):

Thanks to QVC’s higher margins and low capital intensity, the firm generates copious amounts of free cash flow (nearly 10% of its market capitalization, over the past 12 months), which it utilizes to aggressively repurchase shares (total share count has declined 19% over the past 5 years). This is a formula for tax-efficient, long-term wealth compounding which Liberty Media chairman John C. Malone has mastered over a long and distinguished investing career. We are happy that Mr. Market once again offered our clients an attractive entry point to compound wealth alongside him.

As we look forward to 2017 and beyond, we feel confident that our clients’ portfolios are positioned to benefit from the underlying trends in capital markets that we anticipate: rising rates and high valuations (in the US) should, if history is any guide, favor value strategies and alternative asset classes. 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.

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.