Another strong December, quarter and year
One year ago we began our report reviewing 2013’s exceptional market returns. We noted that, although commentators had begun to use words such as “bubble” to describe the equity market, the historical record was surprisingly positive for years that followed –Â +30% years. And “surprisingly positive” is how 2014 turned out, although not without its bouts of downside volatility, two of which unsettled investors late in the year.
The Equity and Income Fund earned 4% in the quarter, which contrasts to a 2% gain for the Lipper Balanced Funds Index, the Fund’s performance benchmark. For calendar 2014 the returns for both the Fund and the Lipper Index were 7%. The annualized compound rate of return since the Fund’s inception in 1995 is 11% while the corresponding return to the Lipper Index is 7%.
Oracle (ORCL, Financial), CVS Health (CVS, Financial), UnitedHealth Group (UNH, Financial), TE Connectivity (TEL, Financial) and MasterCard (MA, Financial) Class A were the largest contributors to return in the quarter. The largest detractors were National Oilwell Varco (NOV, Financial), Ultra Petroleum (UPL, Financial), Dover (DOV, Financial), Glencore (GLEN, Financial) and Baker Hughes (BHI, Financial). We doubt that anyone will be surprised to see that energy stocks dominated the detractors list. Detractors from return for the year were General Motors (GM, Financial), Glencore, Diageo (DEO, Financial), Dover and Ultra Petroleum. The largest contributors to annual portfolio return were General Dynamics (GD, Financial) (sold), United Health Group, CVS Health, Union Pacific (UNP) and Oracle.
Loser’s game?
The Financial Times’Â always interesting John Authers used the title above (without the question mark) for an extensive December 21, 2014 article. In this piece he describes how difficult it has been since 2009 for U.S. active managers to beat their benchmarks. He also writes that investors have persistently shifted assets from active managers to passive index funds over this period (which itself tends to exacerbate the relative performance problem). Authers goes on to quote Amin Rajan of UK consultancy Create, who argues, “The more money that goes into passive, the more they (index funds) will become dumb.” Rajan believes that indexing helps to fuel investment bubbles because new money flowing into such funds is automatically allocated to the companies with the highest market value.
We agree with the arguments in this article as far as they go. Our problem with this discussion, however, is that we believe that it mischaracterizes the fundamental investment problem for individual investors. Here is our view. Few investors in mutual funds actually have a need to “beat the market.” To most, the market is an abstraction with which they have little personal connection. Instead, most investors desire that their capital grow in real value over time, produce cash flows that can help them meet their personal lifestyle needs and to do all of this in a manner that does not offend their sensibilities. It may be that one can find investors who simply wish to participate in the broader economy in a manner that index funds represent, and for them the passive approach makes good sense. But others need to have their personal economic requirements met over time, and to that end they need to develop an investment portfolio that marries their own character attributes with their investing goals. And the degree to which they can tolerate volatility is often the most important personal character attribute. Again and again we hear of investors who have not returned to equities since 2009 because of the losses that they suffered in that downturn. If their personal portfolios had been allocated according to their actual risk tolerance, they likely would not have missed out on the rally since then.
As we manage the Equity and Income Fund, we have no explicit goal of beating the market. Rather, our goal is to construct a portfolio that produces income and growth sufficient to meet the needs of the Fund’s investors, and for the pattern of returns to be one which does not overly stress those investors. Ideally this means positive rates of return with low volatility. We do not always succeed, as 2008 amply demonstrated. Of course, to some observers the Equity and Income Fund’s 2008 outcome was successful in that it “outperformed” most similar funds. To actual clients, however, such a relative victory was hollow at best –Â no one can support their lifestyle with such victories. Nevertheless, in the Fund’s 19-year history 2008 stands out as the only significant loss year, and it is our job as portfolio managers to keep it that way.
Investors should also never forget that we invest the Fund according to the tenets of our value investing philosophy. Very simplistically, we look to purchase equities selling cheaply relative to our estimate of their intrinsic value and to build out the portfolio with bonds that enhance income and reduce volatility. Someone who does not find the core idea of value investing compelling may find it hard to stick with the Fund in times when value investing is out of favor.
As we have often written, we believe that the most important consideration for investors is that they attempt to know themselves, especially to understand how they may react under stress because securities markets will often produce significant stress. So we conclude that the true “loser’s game” is not active management per se, but for someone to invest in a manner that is not aligned with who they are.
Transaction activity
One year ago we wrote that stock market strength meant that more of the Fund’s holdings were approaching their sell targets while it was becoming more difficult to identify dominant investing opportunities suitable for the Fund. Accordingly, it should not be surprising that the Fund’s equity allocation shrank in 2014 even though the equity allocation itself had another solid year. In the December quarter, however, we modestly increased the equity allocation as short-term market volatility afforded us opportunities to establish new positions. Perhaps the most striking economic event in the quarter was the major decline in the price of oil. Concomitant with that decline, companies with almost any sort of commodity exposure also suffered substantial share price erosion in the period, and we took advantage of the resulting attractive valuations to establish new positions.
The holding most directly connected to oil’s price decline is Rowan, shares of which we had eliminated from the portfolio only one quarter ago. This offshore driller’s price plummeted during the quarter, affording us the opportunity to repurchase shares at a large discount to its book value. Flowserve also returned to the portfolio as its share price slumped during the oil price collapse. Flowserve manufactures pumps, valves and seals. While we think its original equipment manufacturing business is attractive in its own right, Flowserve’s aftermarket operations comprise almost half of its revenue, which should help to reduce the company’s cyclicality. Flowserve rewarded Equity and Income Fund shareholders in the past, and we believe the time has come again to invest with this company’s strong management team.
In the case of recent portfolio addition WESCO International (WCC), we believe that its share price decline in the quarter far overstated the importance of that company’s energy exposure. WESCO, originally the distribution arm of the old Westinghouse Electric, is still perceived to be a mere distributor, but we believe the company has evolved into a value-added supply chain outsourcer. We had been monitoring the company for some time and took advantage of the quarter’s bouts of volatility to build a position.
Finally, Southern Copper (SCCO) is the most obvious commodity producer of our four new purchases, but rather than oil, it mines the commodity that many forecast to have the best long-term supply/demand fundamentals. Southern owns four low-cost and long-lived copper mines in Mexico and Peru. Unlike energy commodities, which are subject to conservation and alternatives, copper participates more than fully with worldwide economic growth.
We eliminated four holdings for price reasons in the quarter. General Dynamics had one of the longest tenures in the Fund’s history, and the company’s results have justified our investment case. We thank the employees of General Dynamics for their contribution to the Fund’s success, as well as our retired partner and former co-manager Ed Studzinski for initially recommending General Dynamics for the Fund. Laboratory Corporation of America and Varian Medical Systems (VAR) were both purchased during the dark days of the financial crisis, and they met our price objectives during the quarter. Although HNI (HNI) dipped below our buy price on more than one occasion, these opportunities proved to be quite short-lived, and we were never able to accumulate a meaningful position. We look forward to future occasions when we might repurchase shares of these companies at favorable prices.
As always, we thank our fellow shareholders for investing in the Equity and Income Fund and welcome your comments and questions.
Clyde S. McGregor, CFA
Portfolio Manager
