With this first-quarter letter we have included some changes to our discussion of portfolio performance and added some other information which we hope will be of interest to you.
1. Looking Ahead
2. U.S. Recovery
At this moment a growing list of positive economic indicators points toward a gradually improving domestic economy. U.S. corporations continue to generate solid revenue growth while maintaining high profit margins in a low interest rate/low inflation environment. The Federal Reserve continues to telegraph its goal of keeping interest rates low until the end of 2014. Certain aspects of your portfolio asset allocation and individual security selection are based upon this Federal Reserve strategy. Their strategy is great for those who want or need to borrow money, but it has been brutal for those who need cash flow from their investment portfolios because interest earned on “safe” short-to-intermediate term debt is below the inflation rate.
One very frustrating trend is the ongoing slow recovery in the job market. While there is no question that jobs are being added, today’s economy is well off the pace of job recovery from all previous post World War II recessions. Many reasons are given, but in a recent editorial opinion piece in the Wall Street Journal, New York City Mayor Mike Bloomberg summarized the problem this way:
“Nearly every CEO and business leader I speak with says virtually the same thing: they’re hesitant to make major investment decisions until they know how Washington intends to grapple with its huge deficits. That uncertainty is a major drag on job creation because the price of uncertainty for business is paralysis.”
One other major economic event bears mentioning here. The housing market appears to have bottomed and should, from this point forward, begin to provide a tail wind for the recovery. Home affordability has never been better! In a few states around the country, bidding wars have recently erupted for foreclosed homes which have come back on the market. A recovery in housing has always been regarded as a key component for accelerating GDP growth and it appears that the country will soon begin to benefit from a reinvigorated housing sector.
On balance, the U.S. economy continues on its path of slow recovery for at least the next two quarters. Thereafter things may get considerably more dicey if there is no progress on deficit reduction and effective growth stimulation. The expiration of the Bush temporary tax cuts is projected to reduce economic growth in 2013 by anywhere from 1-2½%, an event which may cause considerable stock market grief.
3. Europe
Meet Mario Draghi, central banker of the century!
In his relatively short tenure as President of the European Central Bank (ECB), Draghi is credited with pulling the euro zone out of an imminent financial death spiral. You may recall our previous observation that Europe is in the midst of three crises, being: a banking liquidity crisis, a sovereign debt crisis and a longer-term demographic crisis.
Mr. Draghi has solved the immediate banking liquidity crisis by providing collateralized, three-year, 1% interest loans to every European bank simply for the asking. In December 2011, and again in February 2012, an estimated 800 banks borrowed in excess of 1.2 trillion euros to: rollover some of their own maturing debt; loan money to cash-strapped European governments; and hopefully, loan money to private borrowers. The private borrower part hasn’t worked out too well yet because virtually all of Europe is grappling with austerity moves which are sending most countries (Germany excepted) into recession this year. Business’ reluctance to borrow is widespread.
These recent ECB actions have been (in our opinion) the single most significant factor behind the first quarter’s pleasant stock market advance. The good times however now appear to already be running out of steam as austerity measures are precipitating increasingly severe recessions across Europe. The economic situation in Greece is so deplorable that some believe the country is approaching a humanitarian crisis. This is the situation in spite of a negotiated Greek default in which private investors lost anywhere from 50-70% of the value of their Greek bonds. In spite of this default, the ratio of Greek debt to GDP barely budged (160% before the default, and estimated to rise to 168% in 2013) because of the country’s massive borrowing needs as it spirals deeper into depression. With a general election coming in May, and a growing austerity backlash, the odds are increasing for 1) a change in government leadership that may be less amenable to previously agreed upon austerity moves, 2) a second (and perhaps final) default and 3) a departure from the euro zone.
By the time of Greece’s actual default in February, Europe’s banks had prepared for the hit to their balance sheets. No panic ensued. Such is not the situation currently with Spain however. That country is now in the cross hairs for a rapidly worsening downward economic spiral. Spain’s unemployment rate is reported to be at 24%. Among young people under the age of 25, unemployment is greater than 50%. Their real estate market is imploding, with property prices still 20-30% above a calculated equilibrium level, according to our economic consultants. Spain’s banks had been aggressive lenders to real estate owners and speculators during the real estate boom of 2008-9, and as a result, the banks are now facing massive write downs of mortgage debt. Finally, there is the austerity pledge to the ECB which is exacerbating the country’s economic woes.
Portugal, Belgium and Ireland also remain mired in worsening economic recessions which make the austerity measures each are implementing all the more painful.
Putting it all together, virtually all of Europe, with the exception of Germany, is an economic mess. Simply stated, there are no good or painless solutions to Europe’s economic woes. Too much has been promised for too long to local populations, and financial markets are now demanding that benefits be clawed back. Lately, a growing general voter backlash against further austerity is casting doubt on the ability of politicians to continue the actions needed to restore competitiveness and fiscal health to many of these countries. Suffice it to say that Europe has the potential to remain a source of significant market instability for years to come.
4. Putting It All Together
We became bullish on our domestic stock market, and to a lesser degree, globally, immediately after the beginning of 2012 based upon improving domestic economic reports and Mr. Draghi’s first round of easy money for Europe’s banks. At that time we started increasing client stock market exposure towards benchmark weightings.
We have previously stated that the current mix of economic factors in the U.S., being: low inflation; low interest rates; a slow but steady recovery; high corporate profitability and reasonable stock market valuations, have combined to create a near-perfect formula for strong stock market performance. Unfortunately the global economy continues to be dogged by spreading economic crisis across Europe and the potential for a debilitating oil price spike out of the Middle East. Thus our overall enthusiasm for the stock market is tempered by events outside the U.S. to the point that we are uncomfortable raising the risk level of client portfolios above benchmark asset class weightings. Finally, we are mindful of the fact that by forcefully holding down short- and intermediate-term interest rates, the Federal Reserve is compelling investors to take on risk in order to earn returns above today’s inflation rate. This means that in spite of significant risk, stocks, and more particularly, stocks with a good history of rising dividends, are today’s most attractive investment alternatives for those seeking income and/or capital gains.
Of course we may modify our thinking at anytime in response to significant changes in economic or geopolitical conditions.
5. Performance Analysis
Index Returns: 1st Qtr. 2012
U.S. Treasury Bill return 0.0%
MSCI All World Stock Index 12.0%
U.S. Investment Grade Bond Index 2.1%
Broad Based Commodity Index 0.9%
CPI (12 months) 2.7%
Benchmark Discussion
Last quarter we began comparing each asset class component of client portfolio performance against a specific asset class benchmark index which we believe to be generally illustrative of our style of portfolio management. Every benchmark index is comprised of a specific group of securities in an unmanaged portfolio while your portfolio only owns a very small sample of securities which, as a portfolio, is generally indicative of the structure of that index. Based upon our economic and securities research we will typically make investment choices for you that vary from the overall composition of each benchmark index in an attempt to either reduce portfolio risk or enhance portfolio return, or both.
Equities Performance
Generally speaking, stock markets around the world generated comparable total returns (capital gains plus dividends) during the first quarter of 2012. Thus there was no particular advantage or disadvantage to domestic versus international securities. A look inside the MSCI All World Index reveals that the financial and technology sectors were the two best performing segments of global markets. SIMI’s portfolio holdings underperformed in these two sectors for the reasons discussed below.
In the financial sector the largest financial stocks in the MSCI Index are the major international banks which have been at the forefront of the recent financial industry meltdown. We are referring here to banks such as Bank of America, Citigroup, Wells Fargo and JP Morgan Chase, whose overall financial risk levels are well above what we deem prudent for all but the most risk tolerant investors. With the improving tone of global financial markets during the first quarter, these bank stocks have vastly outperformed the overall financial sector. As a result, the absence of any of these securities in client accounts has been a contributor to our market underperformance relative to the global stock index during the first quarter.
MSCI’s technology sector outperformed our tech portfolio holdings because, with the exception of Apple, most of the top performing companies in the index were very small, and generally not the type of stocks we would purchase for client accounts.
Our largest outperformance relative to the index was in the healthcare sector where many pharmaceutical and health benefit providers out performed both the healthcare sector and the global index.
Fixed Income Performance
During the first quarter, fixed income markets were primarily impacted by a modest rise in interest rates, most notably in bond maturities greater than 7 years. This quick spike in interest rates during March coincided with the view that economic recovery in the U.S. might accelerate over the balance of the year, which in turn might lead to higher inflation rates, given the Fed’s continuing easy money policy. Bond prices decline in a rising rate environment. SIMI’s fixed income securities are predominantly shorter term-to-maturity investments, meaning that rising interest rates will have limited impact on their values. We have been wed to this shorter-term maturity policy for quite some time as a defensive measure to counter the negative consequences of rising interest rates when that situation actually occurs.
Second, we initiated a position in a mortgage-backed securities fund during the quarter which experienced a price decline subsequent to our purchase. We anticipate this fund will generate positive returns going forward given the Fed’s stance on keeping interest rates low through 2014. That fund purchase had a small negative impact on your fixed income return.
Other Performance
The single largest investment in the commodities portion of client portfolios continues to be gold related. While the price of gold increased by 6.7% during the first quarter, this gain masks gold’s decline from its peak of $1900/oz set during September 2011. It’s perplexing to see the price of gold languish during the past six months in the face of negative real interest rates in the US and Europe, massive government reflation efforts, and substantial bullion purchases made by developing countries. Regardless of shorter-term price action, we maintain our belief that government economic policies in the developed world will fuel continuing increases in the price of gold over time.
6. Stock Talk
We are trying out a new section for the quarterly letter – it’s a brief discussion of the goings on of one company whose shares are widely owned in client portfolios. It is our intention to feature a different company in this section of the report in each future quarterly letter.
Illumina, Inc.
Illumina (www.illumnia.com) is recognized as one of the world’s preeminent companies in the field of gene sequencing, a process used for examining the functioning and – and malfunctioning – of the human body at the genetic level. The company’s products and technologies accelerate genetic analysis research and its application, paving the way for the molecular medicine industry at the individual patient level. Illumina’s rapidly evolving gene sequencing machinery allows medical practitioners to customize an individual’s medical treatment regimen based on analysis of the patient’s genetic code rather than having to rely on treating disease in a more generic fashion.
The stocks of many gene-sequencing firms literally collapsed last summer when the conventional wisdom regarding the future growth rates for this young industry abruptly shifted from positive to negative. The fear it seems, is that expected government budget cutbacks in future years will sharply reduce the cash available for purchasing gene sequencing machines for research purposes at major medical colleges and research centers around the U.S. Illumina notes in a recent quarterly report for example, that approximately one-third of its total revenue is derived, either directly or indirectly, from funding provided by the U.S. National Institute of Health. Illumina saw the price of its shares decline by 64% to a low of approximately $27 in mid December 2011 from a closing high of $76 on July 8, 2020. (Prior to this price decline we had determined that Ilumina’s stock price was too rich from a valuation perspective.)
What has been overlooked in this incomplete market analysis is the fact that the cost of purchasing these machines, the cost of providing gene sequencing services, and the amount of time needed to process the actual analysis have all declined precipitously over the past few years, thereby increasing the potential customer base over the long term from a few hundred end-user research-type institutions to many thousands, perhaps tens of thousands, of smaller end users such as individual medical practices around the world. The cost to sequence an entire human genome has declined from $1 million only 3-4 years ago to $10,000 in 2011 and $1,000 this year. We have now entered the dawn of the new age of personalized medicine. Today’s DNA sequencing market is likened to where the PC market was in 1981 or the mobile phone industry was in 1990.
Companies like Medco Health Systems have begun testing patients for genetic variations to analyze why they respond differently to different treatments. Medco believes genetic testing will increase the percentage of people who can successfully use lower cost generic drugs. Through genetic testing patients can be pre-screened to determine which ones will experience positive results from particular drugs. Industry estimates are that, as a society, we presently spend approximately $60 billion on drugs that don’t work.
DNA decoders have declined in price to as little as $1,000. As a result, the science of personalized medicine, known as pharmacogenomics, is expected to grow from around $4 billion currently to a potential $100 billion market over the next several years. Low cost genetic sequencing is expected to be transformative to other industries as well, including agriculture, nanotechnology and alternative fuels.
As always we look forward to discussing with you any thoughts or questions you may have regarding the contents of this letter.
Sincerely,
Sheffield Investment Management, Inc.