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Q2 Review: The Merits of Benchmark Risk

Broad equity indexes were essentially flat in the second quarter; the S&P 500 Index (large caps), the Russell 2000 Index (small caps), and the MSCI EAFE Index (international stocks) all advanced less than 1%.  Through the first half of the year, small cap and international equities were up modestly (5-6%), while the S&P 500 increased only 1.2% (including dividends).  Technology stocks fared somewhat better, with the Nasdaq Composite rising 2% in Q2 and 5.9% YTD.

A modest recovery in oil prices (which hit a 6-year low during the first quarter) helped the Bloomberg Commodity Index advance 4.7% during Q2.  However, this resurgence was short-lived, as crude prices surrendered most of these gains in the first weeks of July.  Despite a reduction in the number of active oil drilling rigs in the U.S., shale producers continue to improve the efficiency of existing wells, leading overall U.S. production to increase, even with prices down 50% from their peak.

Crude Oil vs. CHK

Of course, higher production only exacerbates the current supply/demand imbalance. Another longer term concern for oil traders is the recently-signed nuclear accord between the U.S. and Iran, which will lift restrictions on the sale of Iranian oil.  Once the second-largest producer in OPEC, Iran’s oil production has been cut in half following stiff international sanctions which reduced the country’s access to capital (and consequently, the productivity of its wells). Chinese demand (not just for oil, but other commodities as well) is another swing factor; that country’s slowing GDP growth rate is a headwind for prices of many commodities.

Turning to interest rates, the yield curve steepened during Q2, as investors sold off long-dated bonds in anticipation of rising rates:

Yiled Curve

While the broad-based Barclays Aggregate Bond Index declined only 1.7% for the quarter, long term bonds were harder-hit, declining about 6%.  As might be expected, the best-performing fixed income segments in 2015 are the ones least sensitive to rising rates: bank loans (which carry floating interest rates), short-term debt, and high-yield bonds.  However, even these “standout” categories delivered unexciting absolute returns, as indicated in the table below:

Morningstar Table

A steeper yield curve negatively impacted rate-sensitive investments such as Real Estate and Utilities, which were among the worst-performing equity sectors during the quarter. As you may recall from our Q4 review, real estate investment trusts (REITs) were the best-performing domestic equity sector in 2014, which we attributed to last year’s unexpected drop in long-term interest rates.  At the time, we noted that REITs appeared richly valued as a multiple of future cash flows.  Therefore, our preferred vehicle for investing our clients’ real estate allocation is the Third Avenue Real Estate Value Fund (TAREX), an actively-managed fund with a more flexible investment mandate (and one which we believe will be less vulnerable to rising rates).

Unlike most of their peers, the portfolio managers at Third Avenue are not constrained to investing solely in U.S. listed REITs.  In our view, this is not only pragmatic, but a structural advantage as well.  Because REITs are obliged to pay out 90% of their operating income each year, they have little opportunity to retain and profitably reinvest their earnings in projects which may have attractive long-term returns, but limited near-term income potential.  Moreover, the REIT structure emphasizes current income and attracts a shareholder constituency focused primarily on yield, rather than after-tax total returns.  Ironically, some of TAREX’s most successful investments have been in real estate companies which later converted to a REIT structure, and were subsequently added to capitalization-weighted REIT indexes, at which point their shares attracted investment from traditional REIT funds (particularly passively-managed “index” funds).  Of course, most of the benefit from these “conversion events” accrues to the original shareholders, not the cohort which passively tags along once the company is added to REIT indexes.  The takeaway?  Indexing may have its merits, but in many corners of the market, it still pays to do your homework.

Continuing a recent trend, growth stocks (as classified by Morningstar) outperformed their value counterparts through the first half of 2015.  Several factors may explain this performance spread.  First, merger activity typically rises during a bull market, when companies are flush with cash but have fewer attractive opportunities to reinvest it.  Second, cross-border tax arbitrage and ultra-low borrowing costs conspire to make mergers and acquisitions an appealing method to manufacture EPS growth.  Third, aggressive share repurchase programs (sometimes instigated by “activist” investors focused exclusively on maximizing short-term trading profits) push up stock prices by reducing the public share count, or “float.”

Finally, as mentioned in our Q4 commentary, most equity indexes are market capitalization weighted, and therefore have an implicit growth/momentum bias: as companies in the index trade at higher multiples (decreasing their “margin of safety” from the standpoint of a value investor) they exhibit a proportionately larger influence over the movement of the index itself.  Therefore, as passive investment vehicles gain favor, more investor dollars are allocated–often unwittingly–to the very same growth stocks which have already experienced the greatest price appreciation. This recent article in the Wall Street Journal points out that half of the gain in the NASDAQ year-to-date through July 24 came from just 6 stocks ( Amazon.com Inc., Google Inc., Apple Inc., Facebook Inc., Netflix Inc. and Gilead Sciences Inc.)

Many of these factors are at work in the pronounced outperformance of healthcare stocks, which are now the best-performing equity sector tracked by Morningstar–not just in 2015, but for trailing 1, 3, 5, and 10 year periods as well.  Collectively, a subset of healthcare stocks categorized as “biotechs” are trading at the most extreme valuations.  The Nasdaq Biotechnology Index (up 44% in 2015 and nearly 400% over the past 5 years) contains 150 companies with an aggregate market capitalization of more than $1 trillion, roughly 50x the reported net income of these constituent companies.  Perhaps more astounding, approximately 70% of the companies in this index did not even report a profit in the last year!  It’s enough to leave the citizens of Graham and Doddsville scratching their heads.


Large Cap Value

The median Large Cap Value account in the second quarter under-performed slightly  (net of fees but including the reinvestment of dividends) the gain of about 0.3% for the S&P 500 Index (dividend reinvested as well).  The best performing holdings during the quarter were Agco Corp (AGCO, +19%) and Bank of America (BAC, +10%). The biggest laggards were Apollo Education Group (APOL, -32%) and Chesapeake Energy (CHK, -21%).

Shares of AGCO received a boost when one of their principal competitors (Lindsay Corp, LNN) announced better-than-expected earnings near the end of June.  This likely motivated many AGCO short-sellers to cover their positions by repurchasing shares in advance of AGCO’s own earnings release, scheduled for late July (as a point of reference, ~17% of AGCO shares were sold short on 6/30/15, equal to 14 days of average daily trading volume in the stock).  Meanwhile, BAC stands to benefit not just from a probable rise in interest rates (which would boost the average net interest margin on their loan portfolio) but also from an abatement of litigation charges relating to legacy mortgage portfolios inherited from Countrywide Financial.  Additionally, an improving housing market means that BAC has been able to whittle down their pipeline of loans in foreclosure, reducing the administrative costs of managing this portfolio.  Finally, a greater emphasis on mobile banking has allowed the firm to trim the number and average size of their branches, further reducing costs and improving profitability.

APOL, a for-profit education company most frequently identified with their flagship University of Phoenix brand, continues to struggle with declining enrollments in the US in the wake of more stringent regulatory guidelines seeking to limit the burden of student loan debt on recent graduates.  While the magnitude of enrollment declines is certainly disappointing, we are encouraged by the firm’s ability to quickly adjust costs: APOL has remained solidly profitable during a multi-year period when total enrollments declined at least 50% from their peak.  It also owns a growing international education business with schools in South America and India. Moreover, APOL carries no debt and has over $700MM of cash on its balance sheet (equal to one half of the current market capitalization).  In short, we believe that APOL has the financial strength to weather the current downturn. We also believe that the current stock price merely reflects the value of cash on the company’s balance sheet and of the international assets, and could be worth considerably more should US enrollment trends stabilize.

Chesapeake Energy (CHK) has seen its stock price stumble along with the price of crude oil, both having declined more than 50% in the past year:

Crude Oil vs. CHK (2)

Unlike Apollo, Chesapeake carries quite a bit of debt, and needs to spend billions of dollars annually in order to fund the development of new wells and increase its production of oil and natural gas.  Servicing this debt and funding the company’s capital expenditure budget is no easy feat when the price of the company’s principal product declines 50% in one year (in recognition of this, CHK recently suspended its dividend, which will conserve $240 million per year).  CHK is a classic example of “asset rich but cash poor.”  While its ongoing liquidity needs are not ideal, CHK has repeatedly demonstrated the ability to monetize its extensive drilling acreage on favorable terms, when funding shortfalls require it.  The core of our investment thesis on CHK is that the present value of the firm’s natural gas assets in the ground–which will take decades to develop and extract–far exceeds the value of their near-term cash flow based on $50/barrel oil.

Aside from trades designed to harvest unrealized losses on certain tax lots of CHK and the Bank of America Class A warrants, we made only one other across-the-board trade for the LCV portfolio in Q2, which was to divest our remaining position in Walgreens Boots Alliance (WBA) in early April.  We originally purchased this company at the onset of the financial crisis in September 2008 (a mere two weeks after Lehman Brothers filed for bankruptcy).  Back then it was known simply as “Walgreens,” and generated about $59 billion in annual sales, mostly within the U.S.  Following the completion of a two-step merger with Switzerland-based Alliance Boots in late 2014, WBA now has a global retail footprint and is the world’s largest purchaser of prescription drugs.  Management estimates that 2016 sales will be in the range of $126 to $130 billion, and that the combined company will be able to cut about $1 billion of annual costs by that point.  Given the complexity of merging two large companies whose retail footprints did not previously overlap, we were somewhat skeptical of these projections.  However, the stock price appeared to be giving full credit (and then some) for these “projected” results.  Judging that the stock’s price greatly exceeded our estimate of the company’s value, we elected to sell this investment and bide our time for more attractive opportunities.

As an ironic aside, we note that soon after completion of the merger (and a re-listing on the Nasdaq exchange) WBA was added to the Nasdaq 100 index in mid-March (just a few weeks prior to our sale)–at which point it immediately became one of the top 15 positions in that index by weight (and surely attracted new purchases from numerous passively-managed index funds, which have collectively seen record inflows over the past year at the expense of actively-managed funds).  What are we to make of an investment environment where the best-performing stocks represent companies without actual earnings?  Where fundamental analysis is no longer considered a prerequisite for investment success?  Where stocks are added to an index at times for completely arbitrary reasons and their shares attract billions of dollars in new investment as a result?  We think we’ve seen this movie before, and it definitely raises some warning flags…

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.