Investment Strategies ■ Mid Cap Value ■ Performance Commentary
4th Quarter 2011 Mid 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. The Cooke & Bieler Mid Cap Value portfolio fully participated in the rally, but the wild move up punctuated an exhausting year. At first sight, stocks of mid cap companies posted unremarkable performance in 2011, with the Russell Midcap Value benchmark generating a -1.4% return for the twelve-month period. This ostensibly muted point-to-point showing, though, belies the year’s record breaking equity market correlations and an especially volatile second half, with daily price swings for the Russell Midcap Value benchmark the highest they have been since the beginning of 2009. Prices moved violently, in unison and ultimately lower. Not surprisingly, investors paid handsomely for stability in this environment. Consumer Staples and Utilities holdings led the pack in 2011, generating approximately +13% and +20% returns, respectively. The other end of the spectrum was dominated by more economically sensitive issues.
Portfolio Performance & Developments
As you might expect, it was a frustrating year for many managers. According to Lipper, the average mid cap value fund underperformed the Russell Midcap Value Index by a whopping 330 basis points. Against this backdrop, the Cooke & Bieler Mid Cap Value portfolio performed very well, beating the Russell Midcap Value benchmark. Although portfolio holdings were not immune to the market’s volatility, we are confident in the quality of their underlying businesses and that their exposure to long-term business risk remains limited. Looking forward we are more optimistic that equity market correlations will subside, auguring well for Cooke & Bieler’s company-specific focus on quality and value. We are more excited than we have been in some time about the Cooke & Bieler Mid Cap Value portfolio’s prospects.
Stock selection was the driving factor in the portfolio’s 80 basis point outperformance of the Russell Midcap Value benchmark in 2011, somewhat offset by sector allocation decisions. Leaders and laggards came from a diverse cross-section of industries, but the year’s favorable relative performance primarily hinged on outstanding stock picks in the Financials sector tempered by an underweight in Utilities and the disappointing performance of two portfolio holdings.
Within Financials, which saw security selection decisions contribute over 500 basis points to relative performance, the Cooke & Bieler Mid Cap Value portfolio’s insurance holdings stood out. Although some fared better than others, all but one of the portfolio’s insurance names outperformed the Russell Midcap Value benchmark’s insurance allocation. Of particular note, one property and casualty insurer returned +35% for the year and added 75 basis points to the portfolio’s annual performance. The company’s management has excelled at adding value in two ways: disciplined underwriting and the opportunistic entry and exit of business lines. Offsetting this favorable performance, our underweight in Utilities – a space we continue to view as generally overpriced – presented a 210 basis point headwind.
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.
Going forward the Cooke & Bieler Mid Cap Value portfolio continues to be positioned best for balanced economic growth, particularly if that growth is accompanied by rising interest rates. Although sector weightings changed over the past year, the portfolio’s aggregate pro-cyclical bias remains approximately unchanged from the beginning of 2011. More specifically, we reduced the portfolio’s allocation to Financials following the outstanding performance of our insurance holdings and increased the allocation to selected Consumer Discretionary holdings. In total, we added 10 new holdings on the year and made 12 eliminations. Of these, only the elimination of one, which had reached our estimation of fair value, occurred in the fourth quarter. 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 these fundamentals over a full market cycle.
Given this positioning, a hazy economic outlook and the turbulence of equity markets, our high quality, low risk bias should offer protection from volatility. But our primary definition of risk has and always will be that of a long-term investor: the risk of permanent capital impairment. In other words, we seek to minimize the Cooke & Bieler Mid Cap Value portfolio’s exposure to business risk and financial leverage while concentrating on franchises that can compound value over time. In most environments limited price volatility is a favorable consequence of this process, although unprecedentedly high correlations in the market have muted this effect more recently.Market Outlook
We cannot promise lower correlations in 2012, but we will say that we have become more optimistic about the opportunity for achieving separation from the Russell Midcap Value benchmark as well as outsized absolute returns. With earnings having rocketed off their troughs, growth rates are now decelerating for the market as a whole. Analysts have already adjusted their forward estimates for the market, revising 2012 projections down by 3.3% since September. 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 analysis and benefitting Cooke & Bieler’s investment style. 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 Mid 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 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.
