ii) We remain constructive on the investment environment over the medium term supported by attractive valuations, excessive corporate liquidity, a growing economy and ample global liquidity.
iii) Forward risks are no longer tilted towards deflation / double digit recession but instead include inflationary pressures and the corresponding impact on sovereign creditworthiness.
iv) With the recovery in both economy and markets, our ability to find attractive single name short opportunities is increasing, and our short exposure is shifting away from indices towards individual equities.
v) In the Glenview and GO Funds, we continue to withdraw capital from long fixed income strategies and redeploy capital in long equity strategies with superior risk / reward characteristics.
vi) With the evolution of risk scenarios that now include inflationary pressures, we have adjusted our alternative hedge positioning towards protection from rising interest rates as well as mortgage putback liabilities, while harvesting a portion of our sovereign CDS hedges.
Our funds performed well and inline with our long-term expectations, driven by the following:
i) Broadbased success in our investment portfolio, led by strength in healthcare (Life Technologies, McKesson, Medco and Thermo Fisher Scientific), technology (Flextronics, Xerox and BMC) and specialty financials (Aon and AIG).
ii) Continued steady performance from our corporate fixed income portfolio, driven by a diverse set of names including Cengage, Mueller Water Products, MBIA, Terrestar and Ceridian.4
iii) Modest positive returns from our US Treasury hedge as the first signs of inflationary pressures emerged, raising yields and reducing bond prices.
iv) Offsetting these gains, our short equity portfolio performed approximately inline with the broader equity markets in the quarter on a cash on cash basis, producing negative returns.
While our portfolio holdings are diversified by industry, end market and growth drivers, we felt that the common elements of modest valuations, above consensus earnings growth and accelerating productive capital deployment would all serve to promote value for our largest equity holdings. It is therefore not a coincidence that of our eight largest individual equity winners in the quarter, all of them beat consensus earnings for the September quarter, and six of them were aggressive repurchasers of their own shares. We believe these trends of secular growth, excess capital deployment and a modest expansion of valuation multiples will continue to drive positive absolute returns from our investment portfolio in 2011 and beyond, and we discuss many of our positions in depth in the “A TenYear View – Looking Back and Looking Forward” section of this letter.
As the quarter progressed and valuations expanded, we were able to broaden our short portfolio to include more single names that should be negatively impacted by the coming economic, fiscal and monetary environment:
a) We established short positions in a series of REIT equities whose valuations reflect exceedingly low cap rates proportional to the exceedingly low interest rate environment. We do not believe that our core competency is predicting forward interest rates, but we are exceedingly comfortable betting that over the course of the next year, twelve months will pass. As we examine the term structure of interest rates, a 3.3% 10-year bond yield is comprised of a one year yield of 25bps, and therefore the subsequent nine years average 3.65% (of which the last eight years are 4%). For REITs that reflect a 6% cap rate, a 70bps move over the two years will create 10% multiple compression solely by moving two years forward on the term structure of interest rates. Should inflation accelerate above expectations, this rate rise would be even more pronounced, and the multiple compression more significant. While we don’t expect REITs to implode, we do believe they will underperform over time.
b) We established short positions in cruise lines and other travel related equities that will likely see profits eroded by declining revenue on aging assets combined with inflationary cost pressures including oil.
Furthermore, asset intensive travel industries such as hotels are also often valued on cap rates and susceptible to the same valuation compression as REITS, as described above.
c) We broadened our portfolio of shorts in companies that derive a significant portion (or all) of their revenue from government sources whose ability to grow such spending is impaired by their own balance sheet constraints and fiscal deficits. Such companies are likely to see decelerating revenue trends and more intense pricing and margin pressure as a result of the deteriorating financial health of their government and government related customers.
d) In healthcare, we expanded our short positions in companies that we believe will come under more intense pricing and reimbursement pressure as the healthcare reform debate migrates from coverage back towards bending the cost curve.
In general, we still believe that low valuations and strong liquidity make it a challenging market to generate absolute returns in short equities. However, those conditions are less pronounced than at any time over the past five to six quarters, and therefore it is natural that our individual short equity portfolio has begun to expand.
Here is the full letter:
Glenview Capital Management - 3-23-11