Investment Strategies ■ All Cap Value ■ Performance Commentary
4th Quarter 2011 All Cap Value Equity Commentary
Market Commentary
Fueled by evidence of an improving U.S. economy, another good earnings season and growing optimism about euro-zone sovereign debt issues, the stock market rallied furiously in October and posted very strong gains for the fourth quarter. Though the rally was all-inclusive, stocks of economically sensitive companies outperformed their more defensive peers considerably. Risk was clearly “on” during the quarter.
The market’s wild year-end move punctuated an exhausting year marked by record-setting volatility. The flattish return posted by major market indices does no justice to the conditions that prevailed most of the year. Prices swung violently and in unison even if they ultimately went nowhere. Not surprisingly, investors paid handsomely for stability in this environment. Utilities, Healthcare, and Consumer Staples holdings led the pack for the Russell 3000 Value Index in 2011, generating returns of approximately 19%, 17% and 13%, respectively. Beset by concerns of spreading euro-zone financial contagion, more stringent regulations, and margin pressures, financials generally were punished with the sector finishing down 16%.Portfolio Performance & Developments
Against this backdrop the Cooke & Bieler All Cap Value portfolio unsurprisingly lagged the Russell 3000 Value benchmark. With the portfolio’s pro-cyclical positioning providing a modest lift, the culprit was stock selection. As stock pickers we never like seeing a negative result but it happens from time to time typically when our investment style is out of favor. Such was generally the case in the fourth quarter. In our quest to avoid permanent capital impairment and manage business risk, we tend to avoid companies with business models that are highly economically sensitive and operationally leveraged. In the “risk-on trade” that prevailed most of the quarter, it was stocks of those kinds of companies that dominated.
As one might expect, the year was frustrating for many managers. According to Lipper, the average multi-cap cap value fund underperformed the Russell 3000 Value Index by 290 basis points. In fact, studies are showing that 2011 will go down as one of the most futile on record for active managers. In this context, the Cooke & Bieler All Cap Value portfolio performed reasonably well, generally matching the Russell 3000 Value benchmark. Our historical pattern of performance in flat markets would suggest outperformance but 2011 was anything but flat. Between tumultuous volatility and unusually high macro driven correlations, it was exceedingly tough out there for bottom-up fundamental stock pickers like us.
Generally, the year broke down into two distinct periods: the first nine months and the last three. During the challenging first period when stocks were down broadly and meaningfully, the Cooke & Bieler All Cap Value portfolio - buttressed by our high quality, low risk investment principles – held up relatively well. Led by particularly good results in most of the worst performing sectors, stock selection was favorable and explained most of the portfolio’s outperformance against the Russell 3000 Value benchmark. The second period relative underperformance discussed above was exactly offsetting.
More specifically, the biggest contributors by far to full year relative performance were stock picking within the Financials sector coupled with our bottom-up based decision to underweight the sector, particularly big bank stocks which struggled mightily. In both cases, our commitment to quality was the determining factor as quality at the individual security level was rewarded handsomely in the beleaguered sector and many commodity-like banks do not meet our investment criteria. Offsetting this favorable performance were the Cooke & Bieler All Cap Value portfolio’s underweight in the surging Utilities sector and a few poorly performing holdings. Regarding Utilities, suffice it to say we believe valuations are more than full and better long-term investment opportunities lie elsewhere.
With respect to the two poorly performing holdings, we think further discussion is warranted. The first, a healthcare company, added to the portfolio last summer, is off to a difficult start. Believing that the company’s manufacturing problems were limited and imminently resolvable, we eagerly took the position. We liked the company’s stability, financial strength, broad offering of drugs, and advantaged competitive position tied to high manufacturing barriers to entry. The company also appeared to be positioned well to expand internationally. At the time, the stock seemed like a bargain. We were wrong. Manufacturing issues were deeper and more involved than we thought and current earnings and near-term prospects have been ravaged as a result. Though we are loath to admit it, some value has been permanently lost. Nevertheless, if problems are resolved over the next 6-12 months as we expect, the company will start down a path towards normalized EPS range. If not, the company is likely to seek a buyer. In either scenario, shareholders benefit.
The second, a consumer staples company, was down considerably due in no small part to concerns about secular issues facing the company. We are sticking with this company as we disagree with the doomsayers who have driven the stock to an unjustifiably low valuation level.
Overall, we believe our process is working well. The vast majority of portfolio companies demonstrated good fundamental progress in 2011 though it did not necessarily translate to share price gains. Additionally, our research pipeline produced sixteen new investment ideas spanning a broad range of industries.
Going forward the Cooke & Bieler All Cap Value portfolio continues to be positioned best for balanced economic growth. The market’s volatility dictated a good bit of activity in 2011 which resulted in some change in sector weightings, but the portfolio’s aggregate modest pro-cyclical bias remains generally intact. More specifically, five securities were eliminated for valuation reasons and replaced by other more attractive Industrial and Tech holdings, as well as several more defensive holdings. As a result, the Cooke & Bieler All Cap Value portfolio became a little less pro-cyclical at the margin. Later during the year, we used extreme weakness in the Financials sector to invest in several uniquely attractive franchises. As is always the case, these decisions were based not on top down sector calls, but on our assessment of individual business fundamentals and the likely performance of those fundamentals over a full market cycle.Market Outlook
Although we cannot promise lower correlations among stock returns in 2012, we know without a doubt that fundamentals ultimately drive stock prices and have become more optimistic about the opportunity for achieving separation from the Russell 3000 Value benchmark as well as outsized absolute returns. With earnings having rocketed off their troughs, growth rates are now decelerating for the market as whole. Analysts have already adjusted their forward estimates for the market, revising 2012 projections down. In this sort of environment investors can no longer rely on a rising tide to perform their heavy lifting. Instead, stock-by-stock performance is likely to diverge, increasing the importance of bottom-up fundamental analysis. Our belief is that Cooke & Bieler’s investment style is particularly advantaged going forward. The prospects for the stocks of our bread and butter, high quality businesses are very positive right now and valuations are attractive. As we enter a period of more measured corporate earnings growth and as equity correlations fall, the returns earned by equity investors should once again approach the returns generated by their underlying portfolio companies. By definition, high quality businesses generate superior returns over time. We believe that the Cooke & Bieler All Cap Value portfolio, which owns these businesses at reduced valuations, is well positioned to capture their returns.
Sources: Factset; Lipper - Wall Street Journal 1/9/12
The material presented represents the manager's assessment of the All Cap Value institutional portfolio and market environment at a specific point in time and should not be relied upon by the reader as research or investment advice regarding any stock.
