Investment Strategies ■ Large Cap Value ■ Performance Commentary
1st Quarter 2013 Large Cap Value Equity Commentary
Market Commentary
The U.S. stock market bolted out of the gate, with the Russell 1000 Value Index posting its best first quarter results since 1991. Emboldened by an uneventful sequestration, signs of economic improvement, several high profile buyouts, and ever-accommodative monetary policy, market participants firmly embraced equities. The advance was not only strong, but also broad-based, with returns fairly evenly distributed across economic sectors and industries. Traditionally defensive sectors including Consumer Staples, Healthcare, and Utilities led the charge, differentiating this “risk-off” rally from most other rallies over the past few years.
Portfolio Performance & Developments
The Cooke & Bieler Large Cap Value portfolio performed very well relative to its Russell 1000 Value benchmark and peers. Both sector allocations and stock selection contributed to the favorable results. We would not normally expect to keep up, much less outperform, in such a robust environment. In this instance, however, we are not surprised in the sense that we believed some portion of last year’s underperformance was unwarranted based on company specific fundamentals. Recognizing that stock prices can diverge from underlying fundamentals over shorter periods of time, but that they will ultimately track earnings and cash flows, we would say that outperformance this year is attributable to that self-correcting process.
For instance, among the top performers in the first quarter were a number of stocks that lagged in 2012 despite demonstrating solid fundamental progress throughout the year. Included in this group were a number of names which all were up more than their sector peers and the overall market. We called out a number of these holdings in last quarter’s commentary in the context of head-scratching underperformers. These also seem to be cases of stocks ultimately coming back into line with underlying fundamentals. This very clear pattern in 2013 suggests that our stock picking was not as bad as it appeared last year and also provides positive reinforcement for decisions made last year to stick with many underperforming holdings that resulted in unusually low portfolio turnover.
Regarding the market environment, we have encouraged our clients for some time to take a balanced view of risk. More specifically, we have highlighted the massive valuation risk embedded in the fixed income universe and the relative opportunity in equities. Now, as we enter the second quarter of 2013, equity valuations still present a relative opportunity, albeit to a lesser extent. Indeed, with the S&P 500 Index up over 25% since the beginning of 2012 and the Russell 1000 Value Index up over 30%, the comparative appeal of equities has all but permeated conventional market wisdom. Noted bears are acquiescing by the day. Volatility is at a five year low. And with the S&P 500 breaching new records, the bulls point out that stocks are less expensive now than at any market high since 1980.
But despite this abundance of top down enthusiasm at the moment, the equity rally over the past year feels reluctant. Lacking the buoyancy they have exhibited during similarly strong market moves, investors cannot shake the nagging reality that stocks merely represent their least worst option at the moment. The truth is, absolute returns matter and most bottom-up practitioners will readily admit that the fat pitches of 2009, 2010 and 2011 are anything but obvious these days. Worse, the Damoclean event looming large in the bond market – the specter of higher rates – could prove almost as ruinous to equity investors.
For these reasons, we have been active in the Cooke & Bieler Large Cap Value portfolio this year, shoring it up, trimming winners, revisiting our investment theses and seeking out enduring franchises at a discount. For example, we took the opportunity during the quarter to add to three holdings. Their valuations range from compelling to very compelling and we are confident that all three will expand their earnings power meaningfully over the next three to five years. Our increased stakes in these companies improve both the valuation and quality profile of the Cooke & Bieler Large Cap Value portfolio, something we can also say about the portfolio’s newest position.
The Cooke & Bieler Large Cap Value portfolio’s most recent addition is the leading provider of insurance to primary insurers of catastrophic property damage. They are in the business of underwriting short-tail, low frequency, high severity risks. And they do it particularly well as evidenced by their consistently superior returns on equity (generally in the 15-20% range) and strong earnings growth that is not highly correlated with economic cycles. Importantly, the stock’s attractive ROE results from strong competitive position and unique fee income generation, not from excessive leverage or aggressive management of investment assets as is the case with many insurers. The fact that the stock has compounded its book value per share more than 12% annually over the past decade - a period that includes a financial crisis and heavy cat activity - pretty much says it all.
To make room for these additions, a number of the Cooke & Bieler Large Cap Value portfolio’s positions were trimmed. We also decided to eliminate one name which has failed to show consistent progress toward realizing normal margins - an important aspect of our thesis. While macro weakness has been a factor and cannot be blamed on management, we are 46 months into a recovery and margins have not markedly improved. Our sense is that the business has changed structurally and current margins likely are the new normal.
Market Outlook
The net impact of these transactions is a portfolio with better fundamental prospects. The appreciation potential of many holdings admittedly is more subdued now than it was three months ago, but we still see good value looking at it holistically. We continue to search for new ideas, but are proceeding with a fairly high degree of caution with respect to fundamentals and valuation given the complacency we see creeping into the market. And, given our quality orientation, we feel good about the portfolio should the market environment deteriorate. As we see it, reasonably valued franchises that compound earnings over the long-term guard against the potential headwinds of wholesale multiple contraction, having less room to fall and a greater ability to grow their way out of a hole.
Sources: Bloomberg, Russell
The material presented represents the manager's assessment of the Large 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.
