Fourth Quarter 2011
Year in Review
With economic data that was slow to improve, political gridlock in Washington, and problems piling up in the eurozone, news headlines overpowered fundamentals as the key stock market driver, and made for a volatile and challenging 2011.
On the policy front, the debate over raising the U.S. debt ceiling reflected the inability of Washington to act in a timely and concise fashion. While last minute negotiations eventually led to a resolution, Standard and Poor’s rating agency still decided to downgrade U.S. Treasury debt from top-notch AAA. Perhaps the most telling part of the saga, however, was the reaction in financial markets.
Treasurys rallied following the S&P downgrade, sending yields on the 10-year bond below 2 percent, raising questions about the relevance of credit ratings in today’s markets and reflecting investors’ mounting fears and concerns. From an economic perspective, the political gridlock surrounding the debt ceiling, as well as other issues such as the extension of unemployment benefits, limited policy visibility throughout the year and fostered additional market volatility.
Another, more pronounced, source of uncertainty in the markets in 2011 was the eurozone sovereign debt crisis. A lack of fiscal cohesion within the European Monetary Union, as well as fears of financial contagion, continued to snowball, and for the bulk of year, policy failed to keep up with financial markets. Coordinated central bank action from the Federal Reserve, European Central Bank and others to cut the overnight dollar swap rate provided a short-term liquidity boost, but the optimism faded quickly. By late in the year, many market observers agreed that the only way to stem the crisis was massive bond market intervention by the ECB.
Unfortunately, such monetary easing directly conflicts with both the politics and the policies of the ECB, and the central bank’s participation in the secondary market was limited. What did arise, however, was a roundabout form of intervention. Through interest rate cuts and unlimited three-year loans to European banks, the ECB was able to pump liquidity into the banking system. The ECB balance sheet grew by more than 550 billion euros ($700 billion) in the last quarter of the 2011 from the loans, to 2.7 trillion euros. Although this temporarily quelled fears, the crisis is still far from over.
Late in the year, China also began talk of more monetary easing, in a move to counter the weaker demand from the U.S. and Europe for its exports. With baseline GDP growth of 8 percent, Chinese policymakers are looking to stabilize the country’s growth trajectory while keeping inflation in check. Targeted cuts in bank reserve requirements should provide the liquidity needed to keep growth rates at acceptable levels.
Towards year-end, U.S. economic data began to improve with unemployment claims dropping and leading indicators improving. The official unemployment rate ended the year at 8.5 percent, the lowest level since early 2009. However, even with some positive economic readings, there were many structural factors working against the economy. Further, major events such as the Japanese earthquake and floods in Thailand have had an effect on the global supply chain, and continue to cause ripples in markets around the world.
With only the beginnings of a recovery evident in economic readings, we believe a third round of quantitative easing will eventually become necessary for the U.S. economy to get out of its doldrums, especially in the labor and housing markets. With the additional major headwinds of the eurozone crisis still unsolved, we expect financial markets to continue to take their cues from the headlines. A news-driven market tends to be volatile, but it should also favor the type of best-in-class companies that we strive to identify.
Going further, monetary easing from the developed world and rising demand from the developing world should push resource prices (including precious metals) higher. As such, we remain invested in companies that we believe will benefit – either directly or indirectly – from these rising prices.
Growth Portfolio
As oil prices were setting a new average yearly high in 2011, we made some changes to our energy investments throughout the year. In exploration and production companies, we continue to look for real production growth, often investing in smaller companies with stronger production and reserve profiles. This reflects our long-term view of rising resource prices, where companies that can meaningfully grow production with rising selling prices will outperform larger integrated energy companies whose reserve growth struggles to meet their depletion rates. We also look for niche service providers in the energy sector, whose dominance in drilling or extraction services mean their businesses will see exponential growth in demand as energy prices rise. Our latest additions in energy were Master Limited Partnerships, whose oil and gas pipelines generate fee revenue that is less volatile than other companies within the sector. These MLPs will participate in rising demand for energy (via greater volumes), but because of their high income streams should be relatively insulated from the inevitable volatility in the overall stock market.
In the materials sector, liquidity concerns stemming from the European crisis had a two-pronged effect. Firstly, liquidity pressures in financial markets led to some losses in precious metals prices, as investors sold gold to cover other positions. Secondly, concerns of a liquidity crunch in the real economy led to a significant divergence between precious and industrial metals prices and the stocks of companies that mine them. Higher selling prices typically translate into strong revenue growth and share price appreciation for these mining companies. However, the high upfront cost of developing mining projects dragged down these stocks on fears the companies would not be able to obtain the necessary financing to grow production.
We continue to embrace a barbell approach to consumer and retail exposure, as we look to capitalize on the growing income and wealth inequality in the U.S. The powerful trend of cost consciousness has helped low-end retailers grow their sales and market share, beating out their higher-priced, mid-level competitors. At the other end the spectrum, luxury retailers have remained relatively resilient in the face of this conservative spending trend.
As corporations are still flush with cash and governments hesitant to cut defense budgets, we continue to like the cyber security sector. Growing online threats from around the globe will ensure companies and governments continue to increase their spending on network security. We added positions in leading cyber security firms that we believe are poised to meet this increasing demand. Moreover, spending has continued to keep pace, although largely on the back of the consumer, in information technology overall. We’ve added positions in leading tech franchises whose stable businesses, and in some cases dividend payments, make them attractive long-term investments. With a lack of “game changing” innovations coming from the sector, we expect these industry behemoths to maintain their tremendous market share and dominance in their respective lines of business.
Seeking shelter from the European financial storm and many still-dubious U.S. bank balance sheets, we largely steered clear of American financials during the year in favor of more conservatively managed Canadian banks. Canada’s healthy resource sector provides demand for loans, and these healthier Canadian lenders are also able to pick up distressed assets from south of the border to grow their commercial banking businesses. Considering where government stimulus will likely be directed, we continue to look for companies in this sector that are poised to benefit from a recovery – whether it be housing or consumer-related.
Healthcare, often used as a portfolio stabilizer, is a sector that offered us some outsized gains in the latter part of the year. Our holdings are largely focused on “cost-cutters,” which should be winners regardless of which political party eventually wins out in the healthcare reform debate. A couple holdings in the sector rewarded our patience, as we trusted our tried-and-true fundamental analysis above what we saw as an overreaction by market participants.
As a portfolio hedge against downside risk from the eurozone crisis, we maintained a position in zero coupon bonds throughout the latter portion of the year. These instruments make no interest payments, and as a result trade at a deep discount to face value and are more responsive to changes in interest rates. In the case of a serious market event, U.S. Treasurys will serve as the ultimate safe haven for investors, and these zero coupon bonds are a leveraged hedge that will outperform interest-bearing Treasurys. Of course, gold bullion remains a trusted hedge as well, and you can read more about the Midas metal below.
Income and Growth Portfolio
Fourth quarter 2011 was a strong one for many dividend-paying stocks, the accent mark to a third consecutive year of robust returns. Other high-payout stocks, however, continued to lose ground, as many investors remained gravely worried about a reprise of 2008.
The good news heading into 2012 is the odds of a universal calamity still appear remote. The macro environment is unsettled as ever. But at this point, only the very weakest companies have been unable to take advantage of the lowest corporate borrowing rates in decades. The rest have slashed interest costs, eliminated near-term refinancing risk and raised funds for low-risk growth. As a result, they’re prepared should credit conditions suddenly worsen.
Moreover, managements across the board are keeping it conservative when it comes to financial and operating plans in anticipation that soft economic conditions will persist. That strategy’s kept U.S. unemployment stubbornly high. But it also means businesses are hunkered down if things slow again.
That’s a far different state of financial and operating readiness than prior to the 2008 crash. And while stocks are certain to be volatile if, for example, the euro falls apart, it certainly puts dividends in far better shape to weather a crisis – which we feel is the key to ultimate recovery.
Unfortunately, just as some companies stumbled in the soft economy and uncertain credit market of 2011, so will others in 2012. As a result, some dividend-paying stocks will continue to outperform, while others are slammed. Aside from companies that have really collapsed, perceived risk to dividends is still the difference maker. During 2011, for example, pipeline stocks became revered as safe havens and were bid up accordingly. Those gains became explosive when takeover bids were announced for several sector companies. Utilities and water stocks enjoyed similar high status, as did a handful of companies in other industries.
In contrast, stocks perceived to be vulnerable to potential global economic weakness generally had a hard time of it. The vast majority remained healthy as businesses, maintaining and even increasing dividends. But their stocks nonetheless lost ground, as investors viewed them as at risk in a dangerous environment.
So long as a European credit event or sluggish U.S. economic growth is a risk, such perception will rule the market. We, however, remain convinced that diversification and balance are a far more prudent income investing strategy than attempting to predict 2012’s hot and cold sectors.
Our focus is always on selecting dividend-paying companies backed by strong underlying businesses in a range of industries. Our goal is to buy and hold them to collect a rising stream of dividends, which in turn will push share prices higher over time. And so long as our companies accomplish this, we’re willing to ride out the volatility that’s inevitable in a market with as much near-term uncertainty as this one.
We’ll continue to hold a healthy portion of natural resources stocks against potential inflation and weakness in the U.S. dollar – but also for their ability to grow as businesses, as Asian demand for their wares continues to rise. And we’ll hold selected bond investments for reliable income, as well as for protection from stock market declines.
Diversifying and balancing among individual stocks protects you against the risk of a meltdown at a particular company. We believe that’s critical in an environment when even the strongest dividend paying stock can stumble. Doing the same between sectors and investment types carries the same benefit when larger disasters strike.
We’ve built a solid long-term record on this strategy. And despite some severe ups and downs, our Income and Growth strategy had another solid year in 2011. We hope to deliver strong results again in 2012.
Peak Resources and Energy Portfolio
Despite only modest growth in the United States and the European Union, an area that represents approximately half of Gross World Product, many important commodities reached their highest average yearly prices in 2011. Notable among these were oil and copper, production for both of which appears to be on a plateau.
But supply is just one part of the equation. Continued strong demand for resources from many emerging economies (with China front and center) is another major driver behind these gains.
Political events such as the revolution in Libya, which took that country’s petroleum exports off the market for several months, also affected resource markets. In the case of oil, even a release from the U.S. strategic petroleum reserve only provided temporary relief from rising prices.
While it surrendered much of its earlier gains by year’s end, gold notched its eleventh consecutive annual advance, climbing nearly 10 percent and solidifying its position as an alternative to paper currencies. The metal’s weakness toward the end of the year was most likely due to gold representing liquidity at a time when liquidity was decidedly lacking in Europe. Eager to raise cash, institutional and individual investors alike were forced into selling the one liquid asset left.
This selling pressure abated once the European Central Bank introduced a three-year refinancing program aimed at providing the banking sector with liquidity. But while this program helped the EU’s ailing banks, it does not address the sovereign debt crisis. In a world characterized by growth headwinds thanks to high commodity prices, high debt levels and the total lack of any real growth initiatives, the issue has to be first and foremost avoiding a depression.
Eventually, we expect the Europeans to realize that they need to buy themselves time. And they can do that – just as the U.S. in the midst of the 2008-09 financial crisis – by aggressively buying bonds. We believe that anything short of robust quantitative easing on the continent is likely to be doomed to failure, with extremely negative consequences for global growth. The choice is either the printing press or what is likely to be a devastating depression.
Here at home, even though the economy is showing signs of improving, the Federal Reserve has expressed its willingness to take additional steps to help spur growth if need be. Likewise, with its inflation cooling, China has once again let up on the monetary brakes. And while that nation’s economy may not expand at a double digit rate this year, it is nevertheless likely to experience the kind of growth we in the West would find enviable.
With further monetary easing expected in 2012, and the issue of resource scarcity very much still present, the case for investing in commodities, including precious metals remains strong. And if the EU can resolve its debt crisis, the call on resources should accelerate.
We made only minor adjustments to our holdings in the fourth quarter, putting more emphasis on high-dividend paying partnerships and major oil and gas exploration and production companies demonstrating superior reserve growth.
Gold (via an exchange-traded fund) remains our largest single holding. Gold miners, which dramatically underperformed the metal last year and as a group are trading at attractive valuations not seen in years, also continue to play a spotlight role in the portfolio. Silver offers the potential for even stronger gains than gold thanks to the metal’s use in industrial applications, including solar power. We have maintained a hearty weighting in both silver and silver mining stocks.
While we expect the Europeans to take the necessary steps to settle their crisis, holders of Greek bonds have remained reluctant to take a greater haircut on their bonds and Athens has not gone far enough in getting its finances in order. Absent a 130 billion euro loan from its euro zone partners, Greece is faced with bankruptcy in March. We are therefore holding a modest stake in zero coupon Treasury bonds as a hedge against a deflationary accident.