Wedgewood Partners Third Quarter 2012 Review and Outlook
This philosophy has yielded a process that revolves around analyzing a potential holding for five fundamental factors that are important markers for a favorable risk/reward opportunity. These five factors are at the company, security and portfolio levels and include: sustainably superior competitive advantage(s), compelling valuation, double-digit growth, exceptional financial strength, and limited overlap with existing portfolio holdings. Every company in our portfolio must exhibit all five of these factors; otherwise they are avoided or sold.
We do not think these factors change very quickly or very often, with the exception of valuation. So the rate at which these factors change is about the same rate that we think about adding new names to the portfolio. In other words, we become more interested in a company as it exhibits more of our process factors. But that can take a long time and other ideas might take precedence. For example, we began following Coach (COH) in early 2008 after observing the Company’s extraordinary track record of profitability, double-digit growth, rock-steady financials and compelling valuation. These factors were byproducts of Coach’s long history of proliferating “affordable luxury” products – or accessories that confer a fractionally higher level of status at fractionally higher prices.
However, we were unsure about the sustainability of this edge.
In July 2012, we initiated positions in Coach as we are convinced that the Company managed to solidify its competitive edge, evidenced by the fact that they have maintained a return on invested capital far superior to its competitive peer group of publicly traded suppliers, rivals & substitutes. The Company’s competitive edge has been strengthened over the past decade as Coach has maintained rigorous contact with consumers, interviewing tens of thousands per year. Of course, this helps with short-term fashion trends, but more importantly and more sustainably, we think this helped Coach understand that luxury consumers were less interested in exclusivity related to physical shortages of a product and more interested in exclusivity related to “virtual rarity” – or the abstract feelings of privilege and of exclusivity. Elements like country of origin and even the quality of materials have been deemphasized in favor of accessibility.1 As a result, Coach now manufactures about 75% of its products in China, which reduces cost of goods relative to European and American made luxury products. Further, Coach sells 90% of its products through direct channels which protects gross margins from the pricing pressures of wholesalers. Prior to the Coach acquisition, the Fund lacked a holding that was focused on retail apparel and accessories, so we think this position adds diversity.
Coach exhibited most of our process factors as early as 2008, but at any one time, our list of potential holdings that exhibit four out of five factors, usually hovers in a range of about 15 to 25 names, with the majority of those names exhibiting an unattractive valuation. But valuation is a very dynamic element and it can change especially rapidly in volatile markets. On the other hand, during market rallies or other periods of market placidity, the valuations of our potential ideas generally maintain their unattractiveness.
Over the past 12 months (through the end of September), we have added just two new stocks to the portfolios - Charles Schwab (SCHW) in January and Coach (COH) in July. This level of action on our idea generation is about in-line with the past 20 years (exclusive of the Fund), as we have collectively owned a total of about 100 stocks, including the 20 that are in portfolios at the end of the Quarter.
Suffice it to say, we believe we have a very discriminating process with much higher and more deliberate thresholds for portfolio inclusion than many of our domestic large cap growth peers. For instance, the top 10 large cap growth mutual funds (by assets under management), as classified by Morningstar®, held an average of about 200 equities, with the portfolios turning over an average of about 55% during the trailing 12 months. For disclosed positions, these funds, on average, added about a dozen and a half new stocks to their portfolios during the first six to seven months of 2012. If we annualize that average, then those funds are buying into well over 30 new stock ideas per year - about a third of what Wedgewood has done during our collective, 20-year history of idea generation! We think it is difficult - particularly from a portfolio management perspective - to exercise high conviction in so many new ideas, while at the same time, maintaining conviction in another 100 to 200 portfolio holdings.
So while the turnover of the Fund is about 25% for the trailing 12 months, our “idea” turnover is also very low relative to our largest peers. But our turnover statistics are byproducts of our Philosophy and Process, which are designed to focus our attention on the rare business that has attractive long-term risk and reward characteristics. There are not many great ideas that meet these criteria, but we are content to patiently wait for years until these ideas become investable.
Review and Outlook
The Wedgewood Partners, Inc. Large Cap Focused Growth Equity Composite outperformed the Russell 1000® Growth Index during the third quarter of 2012. Leading performers during the quarter were Google (GOOG), Cognizant Technology Solutions Corp. (CTSH) and Gilead Sciences (GILD). The leading detractors were Cummins Inc. (CMI), Expeditors International of Washington (EXPD) and Varian Medical Systems (VAR). During the Quarter, we initiated a new position in Coach and added to our Cummins weight. We trimmed our weights in Verisk (VRSK), Gilead, Visa (V), American Express (AXP), Google and National Oilwell Varco (NOV).
Our view of the current 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 from a weakening macro environment. 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. The growth miracle in China is even sputtering. 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 horizon. Ominously, “Shadow Leading Economic Indices” have rolled over.
Consider that the Fed has tripled the size of its balance sheet in order to keep short and long-term interest rates at artificially stimulated generational lows for months on end. Not to be out done, our politicians have cranked up the printing presses to the tune of $1.5 trillion dollar budget deficits. The U.S. “high-powered” monetary base has ballooned from $800 billion in 2008 to $2.6 trillion. Yet with so much “stimulus,” the U.S. economy can only muster recession-like 1.5% GDP growth. Indeed, the gain in GDP in the three years of this expansion was the worst of any recovery period since World War II. As for the potential burden of servicing the interest burden on our burgeoning federal debt, it would take little more than an up-tick in interest rates for the Fed’s monetary policy to suddenly morph into fiscal policy. Non-stop threats to raise taxes has led to unprecedented levels of public policy uncertainty – and attenuated paralysis in the private sector. Indeed, $1.4 trillion in excess bank reserves, plus $2 trillion on the books of S&P 500 companies are “frozen” because businesses simply do not know what the policy-related myriad of their respective cost structures are going to be over the next year or two; much less over the next decade or two.
The short-interest rate risk premium lows in the U.S. stock market (as high in the fall of 2011 as since the brutal bear market lows during 1974) have dissipated with the recent advance in stocks. We also worry that corporate profit margin expectations continue to be 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 and into 2013. Indeed, year-over-year earnings expectations at the beginning of the year for a robust +10% increase have since steadily fallen to just +1%. We suspect that after a dismal 3rd quarter earnings season that such earnings expectations will fall markedly further. Yet, that is the nature of investing. Uncertainly breeds volatility, yet, without fail, volatility breeds opportunity. Temperament is the rare attribute required to be a successful investor. The current environment requires it in spades. We endeavor to be up to the task.
As for our outlook, since we view risk in terms of permanent capital loss, we believe a stock’s valuation relative to company fundamentals is paramount for measuring risk. In terms of reward, we believe growth rates are the most relevant proxy. The portfolio, as constructed at the end of September 2012, based on IBES estimates of three to five year earnings growth, prospectively offers 10% more growth than the Russell 1000® Growth Index, while the portfolio comes with a forward P/E that is 20% cheaper than the Russell 1000® Growth Index. We no doubt like such risk/reward odds.
Google (GOOG) contributed to the portfolio’s relative outperformance, after the stock appreciated 30% during the Quarter. We believe this was a relief rally, as much as it was the stock catching up to the Company’s torrid growth from the past few years. Much of the relief had to do with Google’s strategy for newly acquired Motorola Mobility. While the Company has been light on specifics, rumors emerged that Google would sell the commodity feature-phone and set-top box units of Motorola by year-end, in order to focus exclusively on Android smartphones. We think a more focused Motorola is a good strategy that could drive increased adoption of Android-based smartphones, which ultimately drives Google’s rapidly growing mobile advertising business. As the stock’s forward price to earnings multiple expanded back to double-digits, we trimmed positions. The Company’s competitive edge is still very robust and we continue to think the stock is cheap, especially relative to its potential growth rate.
Gilead Sciences was among our top performers during the third quarter. We believe that the stock's strong performance over the past three months, as well as the past year is quite warranted, as the company is on the cutting edge in developing a cure for the hepatitis C virus (HCV). The Company’s journey down this path began last November with their $11 billion purchase of Pharmasset, Inc. Pharmasset’s flagship drug candidate (PSI-7977, now GS-7977) is undergoing trials indicated for all-oral treatment of HCV and if ultimately approved by the FDA, Gilead could possess a multi-year, multi-billion dollar revenue opportunity. We believe that the market, more recently, has better recognized this opportunity, so we trimmed our positions during the quarter.
Expeditors International of Washington Inc. detracted from performance during the quarter. Expeditors continues to exhibit a best-in-class return on invested capital relative to its domestic and international third-party logistics rivals and suppliers due, in part, to Expeditors’ lean capital base as well as its highly integrated network of agents in 60 countries around the globe. Not only does Expeditors negotiate shipping rates and consolidate customer freight for forwarding, but they also perform the extremely important function of customs broker for around 75% of their customers, by our estimates. To paraphrase a popular saying in the logistics industry, “you date your forwarder but you marry your customs broker.” In other words, freight forwarding and consolidation is a commodity, where rivals compete on price. It is the customs brokerage functions that add the most value for Expeditors’ clients, particularly for smaller to mid-size businesses that do not possess the scale or expertise necessary for worldwide distribution. These clients tend to be stickier than non-custom brokerage clients. However small and mid-sized businesses have been disproportionately affected by the global macroeconomic slowdown, so there have been substantially fewer profitable opportunities for Expeditors. In terms of growth, while Expeditors has registered a contraction in EPS, year to date versus 2011, we believe these depressed results are transitory, as trade growth is already at a historically low level relative to worldwide GDP growth. When trade reverts to the historical mean, we expect Expeditors will return to double-digit earnings growth, but in the mean time, the Company has $1.25bn of net cash on its balance sheet while the stock trades near decade-low valuations.
Verisk Analytics detracted from our performance during the quarter. While little known to investors even today, Verisk has a long and rich history dating back to its incarnation in 1971. Prior to Verisk’s IPO, it was discreetly called Insurance Services Office (ISO) and began as a nonprofit association for U.S. property and casualty insurance companies. Such insurance companies are regulated by the states and these regulations were quite burdensome and required significant data and documentation. Yet from state to state, insurance companies’ regulatory filings became a duplicitous task. This is where ISO stepped in to become a central – and quite critical - depository and gatherer of data for the association of insurance companies. Over the course of the next 25 years ISO would morph into a private for-profit company, leveraging their access to reams of valuable data and then in turn creating even more valuable analytical products and services. They branched into actuarial loss estimation, standardized policies and proprietary risk classification. In late 2009, the association of insurance companies desired, and needed, the considerable liquidity embedded in their joint ownership of Verisk, so the association sold their respective stakes in Verisk through an IPO that raised $1.9 billion. (An aside: Warren Buffett was the only association shareholder who kept Berkshire Hathaway’s respective shares.) We first invested in these shares in August of 2011. Today, the Company’s suite of risk assessment services and decision analytical tools includes, of course, the P&C insurance industry, but also covers the reinsurance, mortgage & financial services, healthcare industries and government entities. Verisk counts all of the top 100 P&C insurance companies as clients – with a not-so-insignificant renewal rate of 98%, while over 70% of the company’s revenues are prepaid, booked subscriptions. This unique franchise, as one would suspect, generates uniquely attractive operating margins in excess of 40%. The Company’s products and services significantly underpenetrate all of the non-P&C industry verticals. We expect Verisk to continue to capitalize on an annual double-digit growth opportunity, as well as to continue to execute a smart consolidation of industry actuarial peers in conjunction with meaningful, opportunistic share buybacks.
Varian Medical Systems also detracted from performance during the quarter. During the quarter, the Centers for Medicare and Medicaid Services (CMS) proposed to reduce reimbursement rates for radiation therapy in freestanding clinics by more than what investors were expecting. The freestanding clinic market represents about 15% of Varian’s US Oncology revenues and about 5% of the Company’s total revenues. Interestingly, hospital radiation therapy reimbursement rates were proposed higher, despite its identical value proposition. We think that, similar to 2009, the ultimate rate cut will be much lower and clinics will have much more certainty about future reimbursement, which should boost the currently depressed demand for Varian Oncology products in the US.
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 continued confidence.
David A. Rolfe, CFA , CFA
Chief Investment Officer
Dana L. Webb
Senior Portfolio Manager
Michael X. Quigley, CFA
1 Jean-Noël Kapferer, Abundant rarity: The key to luxury growth, Business Horizons, Volume 55, Issue 5, September–October 2012, Pages 453-462, ISSN 0007-6813, 10.1016/j.bushor.2012.04.002.
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.