First Quarter 2012

First Quarter 2012

Review and Outlook
 
Markets made significant gains in the first quarter of the year, making up for lost ground on the back of last year’s volatility. With the S&P 500 booking a gain of just over 12 percent in the quarter, financial markets have embraced a greater degree of confidence in the economy. Unlike last year, market action in 2012 has again begun to reflect fundamentals, rather than a volatile news flow and large degree of headline risk.
 
In the United States, economic fundamentals have continued to improve. Unemployment, which ended the quarter at 8.3 percent, has continued its decline at a modest pace. While a portion of this improvement reflects declining participation rates as the workforce shrinks due to demographic changes and discouraged workers, we do see things looking up overall. Various gauges of consumer sentiment and leading economic indicators have continued to advance as well, suggesting the recovery has gained a more solid footing.
 
The all-important housing market has shown some positive signs as well. Lower mortgage rates, thanks to the Federal Reserve’s Operation Twist, have helped housing affordability reach record levels. A turnaround in housing – and the pricing data suggests the market is bottoming – could provide tremendous momentum for the broader economy, via homebuilding and construction as well as lending in financial services. 
 
The crisis in the euro zone subsided somewhat following the Greek bailout in early March. Aiding in this was the European Central Bank’s Long-Term Refinancing Operation, which injected liquidity into the European banking system, leading to a reduction in sovereign yields to more manageable levels. In addition, policymakers took steps toward expanding available bailout funds to further address the crisis. While the crisis will not come to a true end until structural reforms are embraced, the policy steps taken thus far did lessen the weight of the crisis on the U.S. stock market during the quarter. Time will tell whether the Europeans can come together for a lasting solution while still maintaining their currency union.
 
Meanwhile, we continue to see resource prices as a potential threat to the global economy. Supply constraints in the oil market have already begun to take a toll, with higher oil and gasoline prices affecting consumer spending and corporate profit margins. Geopolitical tensions, particularly the situation in Iran, threaten to exacerbate gains in oil prices in the short-term. Meanwhile, Saudi Arabia, the world’s largest oil exporter, appears incapable of fulfilling its traditional role as swing producer by meaningfully increasing production.
 
In this country, hydraulic fracturing, or fracking, has led to an eight-year high in domestic crude oil production and record natural gas output. Natural gas prices have dropped to their low levels in more than a decade as a result. Some advocates of the new technology have gone so far as to suggest fracking could lead the U.S. to energy independence. We disagree with this assessment.
 
The data suggests fracking requires much greater quantities of water than estimates allow for. Moreover, some leading fracking companies are cash flow negative after adjusting for the effects of asset sales, despite their huge production gains. At the end of the day, the lackluster economics of fracking mean that the technology will not change the underlying issue of resource scarcity and could even be dangerous in that it will delay America’s investment in renewable energies.
 
Against the backdrop of the improving, but still feeble economic recovery, the introduction of additional monetary stimulus remains a distinct possibility. If the recovery in the labor market begins to slow, or other areas of the economy show pronounced signs of weakness, we expect the Federal Reserve to initiate a third round of asset purchases, or QE3. With a weak recovery and rising resource prices, the economy is walking a thin line between inflation and deflation. Given the choice between the two, policymakers will likely favor labor market improvements over price stability and allow for inflation as the lesser of two evils.
 

Growth Portfolio
Despite lower volatility and improving market sentiment, the materials sector showed signs of continued strain in the first quarter. Namely, the divergence between precious and base metals and the shares of companies that mine them, a trend, which began last year, continued through the early part of 2012. Mining increasingly scarce materials requires huge amounts of capital, and the decoupling of mining shares from the underlying metals reflects the risk that the financing necessary for developing new operations will not be accessible. Additionally, as materials become scarcer, the threat of foreign countries nationalizing their natural resources could harm multi-national mining companies. Accordingly, we have repositioned the investments in our Growth Portfolio in this sector, emphasizing the underlying metals while paring back on the mining company stocks. 
 
In an effort to diversify our energy holdings, we made several other changes to the portfolio during the quarter. Volatility in equity prices for drillers and oilfield service companies led us to expand our pipeline exposure through holdings of Master Limited Partnerships, which we view as attractively valued. The companies’ fee-based revenues provide less volatile earnings streams than others within the energy sector. They also participate in the upside of energy demand through increased volumes of natural gas and oil flowing through their pipelines.
 
Related to energy and materials, we expect to provide the portfolio with further exposure to rising resource demand via our new positions in select industrial stocks. Whether via mining equipment, engineering skills or transportation services, these selections have dominant franchises in their respective industries and meet our key criteria of high quality and attractive valuations.
 
We increased our exposure to the financial sector throughout the quarter, as we expect improving fundamentals in the housing market to benefit select mortgage lenders. The lower long-term interest rates that resulted from Operation Twist brought mortgage rates to record-low levels. And against the backdrop of slimmer inventories and lower prices, we believe the housing market is nearing a turnaround. With the weight that housing carries in these lenders’ loan portfolios, even a modest uptick could boost profitability. Additionally, with the amount of credit they provide to the economy, in our expectations, these banks would be considered “too big to fail” in the event that the economic recovery seriously falters.
Our barbell approach to consumer exposure, focused on both ends of the income spectrum, has proven successful. Going forward, we expect the fundamentals of income inequality and a widening wealth gap to continue. On the low end, cost-cutting retailers allow consumers strained by rising food and energy prices to meet their basic needs. High-end consumers, meanwhile, have been key beneficiaries of the economic recovery and asset price gains, and their spending, via both luxury goods and value-added financial services, continues to grow.
 
Cost savings are also a focus of many of our investments in the healthcare arena. Despite the ongoing debate about ObamaCare and regardless of which side of the aisle wins out, reducing healthcare costs are necessary for the longevity of this country. We hold a collection of companies that are helping to save healthcare dollars, whether it be from streamlining operations with healthcare IT, winners from the proliferation of prescriptions (especially generics), or targeted pharmaceuticals that are combating this country’s most debilitating ailments. Our healthcare holdings not only boast some “safety” qualities given relatively inelastic demand, we believe they can also deliver double-digit earnings growth.
 
A collection of what we view as technology leaders helped drive portfolio performance to the upside as well. Ranging from consumer products to IT services/outsourcing and cyber-security, we have an assortment of companies that have carved out their respective niches in a still strong sector. With deep pockets, these dominant companies are not only garnering the lion’s share of the revenues in their respective sub-industries, but they are outspending their rivals in R&D as well, which will help to maintain their competitive moats going forward.
 
As always, we remain vigilant by maintaining a defensive and well-hedged portfolio. Tail risks from Europe as well as domestic policy persist, and we believe positions in gold and zero coupon bonds provide necessary hedges against inflation and a deflationary accident. Our portfolio also contains several high-quality companies which we believe are best equipped to ride out a volatile economic environment. Of course should the economy improve in a meaningful way we will take the necessary steps to scale back the hedges in the portfolio.  
 
Income and Growth Portfolio
First quarter 2012 was generally positive for dividend-paying stocks, following the hopeful pattern that emerged in the fourth quarter of 2011. The single-biggest positive remains corporate borrowing rates, which are still near their lowest point since the 1950s. The biggest negative are on-going economic and credit pressures from Europe, and the risk they’ll wash over to these shores.
 
The 35 percent decline in North American natural gas prices since the beginning of the year has had a dramatic impact on several dividend-paying sectors, some positive some negative. Electric utilities have been able to pass lower fuel costs along to customers, making it easier to earn a return on investment in infrastructure.
At the other end of the spectrum, producers of natural gas that inadequately hedged output or that have failed to move toward producing oil and gas liquids have seen their profits plunge and dividends become at risk. Pipeline companies are protected by long-term contracts. Profit, however, has gone out of the gas storage business, as mild weather has led to full capacity and little turnover. Cheap gas is also a threat to propane distributors, which compete with it. And because wholesale electricity prices are pegged to natural gas, companies that generate and sell power also face lower earnings this year.
 
We’ve yet to see the full impact of the gas price drop on affected companies and their dividends. First-quarter earnings will provide important clues to how companies are faring and we’ll react accordingly. Until then, we’ve limited our exposure to the companies most dependent on gas prices.
 
Similarly, we remain very cautious about debt leverage. Even as some companies are issuing 70-year debt, others are being forced to borrow at rates high enough to hit earnings hard, particularly in Europe. Companies with sizeable refinancing needs are at risk, should tight European credit conditions spread to these shores. So are companies that are reaching a tap out point on credit lines.
 
Another risk to the market is, as we get closer to November, election rhetoric is certain to heat up on both sides. That will increase fear for the future, which will only be further inflamed by any negative news on the economy and global markets. Another uncertainty is emerging Asia, which appears set to grow robustly this year, but at a slower pace this year than in the recent past. Then there’s the pressure of resource nationalism, as countries like Argentina get more comfortable about trampling on rights of foreign investors.
 
As dividend investors, the important thing to remember about all of these risks is they only matter if they impact the companies you own. That’s why our focus continues to be on individual stocks, rather than the grand themes that dominate the investment press.
 
One thing we should not have to worry about in coming months is a negative reaction from rising interest rates. We may indeed see a higher rate on the 10-year Treasury bond, which has to be one of the worst bargains in the history of world markets at just 1.96 percent. But as we’ve seen repeatedly in recent years, dividend-paying stocks follow prospects for the economy, not so-called benchmark interest rates.
 
So long as we focus on healthy and growing dividend paying companies – trading at good prices – we believe 2012 should be another successful year, following the three before it.

Peak Resources and Energy Portfolio
Our Peak Resources and Energy Portfolio remains leveraged to the long-term trends of resource scarcity and the rising demands of an industrializing emerging world. While the long-term strategic outlook for this portfolio did not meaningfully change in the last quarter, we did make several adjustments to better address our objectives in the face of an ever-evolving market.

In the energy sector, we remain skeptical of the benefits of hydraulic fracturing, as mentioned above in our market outlook. We believe fracking requires much greater quantities of water than estimates currently allow for, which ultimately will drive up costs and drive down estimates of recoverable energy resources. With this in mind, we added positions in smaller energy exploration and production companies, whose healthier reserve positions should allow for considerably higher production growth than the large integrated oil companies will generate.

In the materials sector, we exited two mining positions on mounting political concerns. Both base metals and rare earths are critical for the development of renewable energy infrastructures. And as policymakers around the world come to this realization, deposits of these critical resources come under the growing threat of nationalization. We also see higher mining taxes and the potential for outright bans on exporting critical resources as likely milestones ahead in a resource-scarce world, threatening many mining companies’ businesses. To lower risk, when possible, at this time we prefer owning the underlying metals and resources as opposed to the companies that mine them.

However, at the same time we believe that there is significant underlying value in the shares of many of the miners, including junior gold miners who possess enviable deposits and could become attractive takeover targets. Our investments in the sector now are devoted to the stocks that belong to the select group of mining companies that should be able to meaningfully grow production in response to rising demand.