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Wedgewood Partners' Second Quarter Letter
Posted by: Holly LaFon (IP Logged)
Date: August 31, 2012 04:06PM
Wedgewood's investment philosophy is imbued with significant, structural advantages relative to more common active Large Cap Growth managers. First, our view on risk is contrary to the typical long-only manager. We define risk, very simply, as the prospect of permanent loss of capital. This is contrary to the traditional approach of measuring and managing risk through the lens of historical price volatility of individual securities. In our view, far too many long-only managers employ excessive portfolio holdings as a means to mitigate price volatility. In their quest to diversify a portfolio of many dozens of stocks, such managers inefficiently diversify away the portfolios' very best ideas and actually increase the potential for capital losses due to the addition of numerous, low-conviction ideas.
As such, we believe that a focused portfolio of twenty or so carefully researched and studied, best-in-class growth companies; invested at compelling valuations as well as prudently diversified, as to minimize like or competitive business models, will serve the Focused investor quite well in both favorable and difficult market environments.
Further, we believe that we should think and act like business owners, which in turn offers the advantage of participating in the "value creation" inherent to the long-term compounding of earnings. The Large Cap Growth space is known to be dauntingly efficient, which is not to say it is perfectly efficient. Specifically, we think that the market often does a poor job of discounting long-term earnings growth, and over a business cycle, stocks often follow, rather than lead, this growth. Acting like business-owners allows us to ignore short-term dislocations in order to take advantage of long-term opportunity.
We have a 20-year history of conducting in-house, proprietary research that utilizes independent research services, company filings, quarterly transcripts, trade publications, sellside research and communication with management. The goal of our process is to identify companies that exhibit five, well-defined characteristics that are necessary for portfolio inclusion. First we look to uncover companies that possess sustainably superior profitability relative to competition. We analyze the effects that a company's suppliers, rivals and customers have on long-term industry profitability and then decide if a company's value chain is unique enough to withstand those pressures. A portfolio holding must also possess the potential to grow profits at a double-digit rate over a full business cycle. Next our portfolio companies must exhibit unique financial strength. Fourth, we look for the equity to trade at compelling valuations, based primarily on historical, relative and absolute price ratios, but also using discounted cash flow models and sum-of-the-parts analysis. Last, we seek to
own companies that derive the vast majority of profitability from sources that are substantially different from the profitability sources of other portfolio holdings. We believe that this is a more thoughtful approach to diversification than simply making the holdings in the portfolio more numerous.
We will sell a holding from the portfolio if it no longer displays the high standards inherent to any of these five characteristics. We will also initiate sells if a position approaches our maximum weighting of 10% based on current prices. The minimum weighting of portfolio holding is 2.5%.
Wedgewood's philosophy and process yields a distinct and sustainable investment edge by producing a portfolio of high-quality holdings that are routinely overweight relative to performance benchmark weightings. As we expect, it is only our best ideas that contribute to performance.
Review and Outlook
The Wedgewood Partners, Inc. Equity Composite ("the Composite") had a poor second quarter generating a negative return of -5.04%. We underperformed our benchmark, the Russell 1000 Growth Index (-4.02%), as well as underperformed the Standard & Poor's 500 Index (-2.75%).
Our view of the investing environment is largely unchanged from our thoughts over the past few quarters. The Great Bull Market of 2009-2012 marches on, but with increasing headwinds – or lack of tailwinds - from a reduction in "QE liquidity" from the Federal Reserve. Our early year expectations that the next leg of the Great Bull Market - which we expected to be characterized by the classic "wall-of-worry," as well as a significant leadership rotation - has come to fruition. Current headlines out of Europe are rotating from Greece to Spain – where an astonishing 57% of Spain's budget is devoted to pensions, unemployment benefits and debt interest payments. Spain's unemployment rate has reached a sobering 24%, and their banking system is woefully undercapitalized. While Eurozone politicians dither, pontificate and point fingers, the markets have long been brutally vigilant in their application of "hard math" high interest rate sovereign debt refinance rates. The once "unthinkable" exit of Greece from the Euro may now be a fait accompli. A full bailout of Spain this summer is at least a 50/50 proposition. France is next… Beggar-thy-debtor nation fiscal policies (pro-money printing press, anti-austerity), not unlike bankruptcy itself, unravel slowly - and then collapse rapidly.
In the U.S., investors are now faced with a weaker economy that is barely growing above stall speed, including a confidence sapping "fiscal cliff" on the near 2013 horizon. "Shadow Leading Economic Indices" have rolled over. The risk premium lows in the U.S. stock market (as high last fall as the brutal bear market lows during 1974) have dissipated with the recent advance in stocks. We also worry that corporate profit margins are unsustainably high, and even a slight reversion to mean historic levels could produce an expectantly high number of earnings disappointments and the attendant increase in stock price volatility throughout the remainder of 2012. Indeed, year-over-year earnings expectations last August for the just ended second quarter for a robust +11% increase have since steadily fallen to -2% decline.
Furthermore, year-over-year earnings growth for the S&P 500 (ex-financials) has flat-lined to zero – the worst period since the collapse of Lehman Brothers.
In the silver-lining department, during this low return environment, the single-digit gains in the Composite have not kept pace with the underlying earnings growth. The portfolios, as currently constructed, offer the prospect of greater than 50% secular earnings growth rates relative to the S&P 500 Index and almost 25% secular earnings growth rates relative to the Russell 1000® Growth Index. Yet the Portfolios come with a 12-month forward P/E valuation at 3% discount to the S&P 500 and a 15% discount to the Russell 1000® Growth Index. Even in this challenging investment environment, we no doubt like such risk/reward odds.
Some of the top Portfolio performers during the quarter were Perrigo (PRGO), Berkshire Hathaway (BRK.A)(BRK.B) 0.25% and Verisk Analytics (VRSK).
Perrigo positively contributed to performance during the quarter after the Company reported a 32% increase in adjusted income from continuing operations and subsequently received FDA approval for five new prescription and over-the-counter (OTC) pharmaceuticals. Over $15 billion in OTC pharmaceuticals will lose patent protection over the next several years and Perrigo, as the largest manufacturer of private-label, OTC pharmaceuticals, will have ample opportunity to provide its value-added services to retailers around the globe. During the quarter, shares of the company traded to valuation levels that were not as attractive as they have been in the past, so we trimmed positions in Perrigo.
Berkshire Hathaway five key non-insurance businesses are all operating at record levels. Housing related business continue to grow, albeit at a snails pace. Warren Buffett continues to report that Berkshire's top-five business units alone are on pace to each set an earnings record in 2012. These fab-five businesses alone will generate +$9 billion, pre-tax. Also, float is set to exceed $70 billion by year-end. We calculate Berkshire's weighted average cost of capital at just 3.25%. The advantages of this cost of capital – at rates lower than most of the world's central banks - accrues enormous structural advantages to Buffett, whom continues to methodically grow Berkshire. Lastly, Buffett's September 2011 announcement of a formal stock buy back policy – Buffett's first ever – ratified our view that the shares of Berkshire were then (and are today) unduly cheap.
Verisk positively contributed to performance during the quarter after the company reported 17.5% year over year growth in diluted adjusted earnings per share. The company continues to leverage its position as the largest provider of actuarial data and analytical services to property and casualty insurers. Verisk operates as a niche player in the information delivery sub-industry. There are no rivals in this sub-industry with offerings that are as comprehensive as Verisk's portfolio, so the company encounters very little competition on this front. As a result of the fragmentation, Verisk is a serial acquirer of smaller competitors, but is often able to execute their acquisition strategy on quite favorable terms.
Some of the Portfolio holdings that detracted from performance were Qualcomm, Cummins (CMI) and Cognizant Technology (CTSH).
Qualcomm (QCOM) also detracted from performance during the quarter, particularly after the company disclosed that one of its suppliers of silicon wafers, specifically at the 28 nanometer process node, was struggling to keep up with demand and would serve to limit revenue growth for the fiscal year ending September 2012. Qualcomm mentioned that it has committed additional expenses towards supply procurement and expects the supply shortage to ease by the December quarter. With one of the largest net cash balances in Corporate America and ample free cash flow generation, the company has enough resource to aggressively address this problem. We added to the Qualcomm position during the quarter, as the stock was trading at the lower-end of its historical valuation range.
Cummins had been firing on all cylinders - bad pun, but perfectly descriptive - until their recent stumble. In early July the company confirmed fears of a significant slowdown in all of their key global markets. Lack of demand in Brazil, China and India were the main culprits in the company's reduced 2012 guidance. We still remain bullish on the company's longerterm growth prospects. At Wedgewood we usually avoid "cyclical" companies, but from time-to-time, superior business models emerge in the cyclical space, particularly if such companies deploy technological advancements as a differentiator to their relative competitive advantage. Cummins is one-of-a-kind on this score. Cummins finished 2011 in truly record fashion. For the full year 2011, revenues grew 36% - a terrific performance given the tough global economic turbulence. 2011 was a record in revenues, profitability and operating cash flow. Cash from operations ($2 billion) was double their previous record. Furthermore, revenues are up 67% over the past two fiscal years – and profits have tripled. In fact, the current revenue run-rate is +26% over the company's pre-recession peak. The dividend has been increased 125% over the past two years. The company's long renaissance is a great American corporate story – rivaling that of the renaissance of Harley Davidson. Both Standard & Poor's and Fitch upgraded the company to a rating of A. Cummins lost their Arating back in 1978. Cummins is uniquely diversified across four divisions (engines, parts and components, distribution and power generation). Cummins is also uniquely diversified across global markets. Indeed, some of their relationships (in India for example) date back over 40 years. The global nature on government-mandated increases in fuel economy for truck engines will drive demand for the company's best-in-class engines, parts and components for years to come. By 2015, the emissions standards will have largely converged. Over the next few years the National Standard 4 in China will drive a significant wave of emissions-related demand for the company's compliant engines and parts. The opportunity in China could be two-to-three times the opportunity relative to the Euro 6 and Euro 5 emission standards.
Cognizant Technology also detracted from performance during the quarter, in part when shares fell -19.2%, in one day, after the company revised its forecasts to include slightly slower future revenue growth due to the challenging macroeconomic environment. The last time Cognizant lowered revenue growth guidance was in July 2008, a period that also featured a challenging macroeconomic environment. Regardless of the economic environment, the company continues to maintain its competitive advantage in the highly attractive IT consulting industry. As is typical of most companies in this industry, nearly all of Cognizant's cost structure is variable. This affords the company tremendous bargaining power relative to customers, since Cognizant has few fixed costs to justify. Cognizant continues to further differentiate itself from its industry peers by aggressively reinvesting in the company's value chain. Specifically, Cognizant continues to expand its outsourced-IT offerings into new and existing industry verticals, such as Manufacturing and Retail & Logistics, by attracting experienced talent from the same industry verticals, and then converting these veterans into world-class consultants. Cognizant further arms their consultants with IT-delivery resources that are primarily located in India, which, thanks to wage-arbitrage, lowers the overall cost of an IT-based function, relative to insourcing. This unique value chain consistently enables Cognizant to offer products and services that enable cost-conscious clients to convert traditionally fixed-IT costs into variable expenses. Clients are then more able to focus on their respective core competencies. This value proposition is still intact and has led Cognizant to quite a bit of market share take over the past few years. Cognizant's financial strength consists of record free cash flow and ample net balance sheet cash, which enables much of this reinvestment flexibility. During the quarter, we added to the position at what we believe were compelling valuations.
We were quite busy during the second quarter. We sold our holding in Teva Pharmaceutical. Despite the stock's seemingly compelling valuation, the execution risk the company faces in maintaining double-digit growth have, in our opinion, become too great. We trimmed our positions in Perrigo and Visa. We added to existing holdings in Varian Medical Systems, Expeditor's International, Qualcomm, Cognizant Technology Solutions, Schlumberger, Cummins and National Oilwell Varco.
Despite the dire headlines of an U.S. economy that is no better than stall speed, as well as the non-stop numbing headlines out of Europe, we believe that our portfolio today represents an excellent balance of both growth and value and remain optimistic about our positioning for the future.
We hope these letters give you some added insight into our portfolio strategy and process. As always, please do not hesitate to contact us if you have any questions or comments about anything we have written in our letters.
On behalf of Wedgewood Partners we thank you for your confidence and support.
David A. Rolfe, CFA
Chief Investment Officer
Dana L. Webb, CFA
Senior Portfolio Manager
Michael X. Quigley, CFA
The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. We do not undertake to advise you as to any change in figures or our views. This is not a solicitation of any order to buy or sell. We, our affiliates and any officer, director or stockholder or any member of their families, may have a position in and may from time to time purchase or sell any of the above mentioned or related securities. Past results are no guarantee of future results.
Guru Discussed: David Rolfe: Current Portfolio, Stock Picks
Stocks Discussed: QCOM, CTSH, CMI, BRK.A, BRK.B, PRGO, VRSK,