Investment Strategies ■ Mid Cap Value ■ Performance Commentary
1st Quarter 2013 Mid Cap Value Equity Commentary
Market Commentary
2012 was a banner year for mid cap investors and, with the Russell Midcap Value Index already posting a 14% return in the first three months of 2013, this year is off to an even stronger start. For context, this rally puts the Russell Midcap Value Index 360 basis points ahead of the S&P 500 in the first quarter. Against this difficult bogey, the Cooke & Bieler Mid Cap Value portfolio lagged its benchmark.
Portfolio Performance & Developments
This modest underperformance is consistent with Cooke & Bieler’s historical pattern of results during very strong up markets – particularly those lacking proportionate fundamental underpinnings. The most meaningful detractors were 1) frictional cash, which has a more pronounced impact during strong up or down periods, and 2) a 20% decline in one holding which has significant exposure to the housing industry. Given the ongoing improvement in the U.S. housing market, expectations for the firm have been moving higher. However, the company has yet to fundamentally deliver on those expectations. We think investors are failing to realize the lag inherent in the business and we have taken the opportunity to add to the position. Partially offsetting these setbacks were strong gains from a holding that we added to in December.
Stepping back from portfolio details, we encouraged our clients to take a balanced view of risk in our first quarter letter last year. We highlighted the massive valuation risk we saw across the fixed income universe and the relative opportunity we saw 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 Midcap Value Index up over 35%, 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.
We find it particularly instructive to revisit this final, somewhat misleading, observation. The ten-year Treasury yielded on average 11.5% in 1980 (vs. 1.9% today). At the time, blue chip companies traded at tremendously discounted valuations despite growth rates (and, importantly, expected growth rates) almost unimaginable among mega-cap names today. One, for instance, traded for less than 9x forward earnings and was growing earnings at rates in the low teens. Another traded at less than 7x forward earnings and was growing at greater than 20%. Both companies had, as they do today, highly stable EBIT streams and above average pricing power. We offer these examples as a cautionary tale. While today’s valuations might be within shouting distance of long-term averages, growth expectations are below average and earnings multiples are still over 1.5 times those prevailing in 1980. And it is hard (impossible?) to argue we will have rates at our back going forward.
So despite an abundance of top down enthusiasm, the equity rally over the past year feels reluctant. Investors are in the ironic position currently of rooting for and rewarding subdued economic growth. Anything better would put at risk the Fed’s artificial backstop. Lacking the buoyancy they’ve exhibited during similarly strong market moves, investors cannot shake the nagging feeling that stocks merely represent their least worst option at the moment. The truth is, absolute returns matter and most bottom-up practitioners will freely 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 – an increase in rates – could prove almost as ruinous to equity investors.
We think mid cap investors especially should be alive to the adverse impact of rising rates. For nearly every annualized period ending 3/31/2013, the Russell Midcap Value Index has outperformed the Russell 1000 Value Index. Furthermore, over the past market cycle more than 20% of that outperformance has derived from Utility and REIT constituents – highly rate sensitive issues. In a rising interest rate environment, these holdings will suffer disproportionately, penalizing the Index and any portfolio designed to minimize tracking error. The Cooke & Bieler Mid Cap Value portfolio remains unexposed to REITs, significantly underweight Utilities and well-positioned to navigate the eventual hazards of a new rate regime. In other words, we feel strongly that the strategy has significantly less exposure to what we see as the large downside drivers embedded in the Russell Midcap Value benchmark.
But as the saying goes, you can’t eat relative returns. And our mandate extends beyond capital preservation. For this reason, we have been active in the Cooke & Bieler Mid Cap Value portfolio, shoring it up, trimming our winners, revisiting our investment theses and seeking out enduring franchises at a discount. We feel good about the strategy should economic recovery stall, inflation escalate and interest rates rise. As we see it, the cheap, long-term compounders we own will insulate you from the potential headwinds of wholesale multiple contraction, having less room to fall and a greater ability to grow their way out of a hole. Importantly, we feel just as good about the Cooke & Bieler Mid Cap Value portfolio’s positioning should economic growth accelerate and rates remain subdued.
We took the opportunity this quarter to add to eight holdings. Their valuations range from compelling to very compelling and we are confident that all 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 Mid Cap Value portfolio, something we can also say about the strategy’s new positions in two companies. Making room for these new positions this quarter, we trimmed eight stocks and eliminated three.
Market Outlook
The net impact of these transactions is a portfolio with better fundamental prospects yet lower appreciation potential than it had three months ago. We continue to identify new ideas, but are proceeding with a higher degree of caution than the current market narrative would advocate. We admit, that narrative is seductive in its simplicity: bonds are expensive, not worth the risk and, although the timing is uncertain, interest rates are likely to rise. We are not blind to this view, simply less convinced that such conditions should have investors scrambling for an indiscriminate allocation to equities. In other words, what’s bad for bonds is not necessarily good for stocks.
With the “great rotation” now bordering on foregone conclusion, investors’ overwhelming bias is toward aggressive valuation and only secondarily on company-specific research. Left with seemingly no alternative, many are impelled to close their eyes and buy. We perhaps have a more nuanced view. Just as easy money inspires overly optimistic behavior, rising interest rates are likely to restore some rational order. While this transition will involve a painful correction for many, our disciplined approach has historically avoided considerable heartache. Buy the compounders. Don’t overpay. Repeat.
Sources: FactSet, Russell, Federal Reserve
The material presented represents the manager's assessment of the Mid 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.
