Ken Heebner's 2012 Annual Letter, Beats S&P
The Year in Review and Economic Outlook
The year 2012 started auspiciously with good news on the unemployment front: On January 19, the Labor Department reported initial jobless claims for the second week in January fell by 50,000 from the week before, marking the largest weekly drop since 2005 and trimming the overall unemployment rate to 8.3%. The Conference Board's Consumer Confidence Index swelled from 61.1 in January to 71.6 in February and held on at 70.2 in March (later revised to 69.5). The long-suffering housing market remained a bit sluggish though overall it was a strong quarter for the economy and the equity market as measured by the S&P 500 Index which grew 12.6% over the first three months of the year.
The party was short lived and the equity market reversed course early in the second quarter of 2012. By the end of May, the S&P 500 Index had lost most of its year-to-date gains. To blame were dismal April job numbers as well as re-emerging doubts about the financial health of a number of European countries. April employment grew by only 115,000 (revised to 68,000) and only a paltry 69,000 new jobs were added in May (though that number was later revised upward to 87,000). Consumer confidence began to falter and by June, the Conference Board reported an Index drop to 62. But the news was not all bad: "green shoots" emerged in the economy, most notably new single family home sales as initially reported in May climbed 7.6% (revised to 3.1%) from April and 19.8% from May of 2011. The equity market, however, was slow to notice, being otherwise preoccupied with ongoing financial negotiations within the Euro zone.
The third quarter started out on weak footing, undermined first by reports of three consecutive monthly declines in retail sales (for the first time in four years), and by more European economic uncertainty. Yields on Spanish and Italian bonds climbed while the 10-year U.S. Treasury bond yield plumbed new depths on July 24. Housing again emerged as an economic foil. On July 31, the S&P/Case-Shiller Home Price Index was released highlighting an increase in housing prices in 20 metro areas from April to May. In mid August, we learned the number of new building permits issued in July climbed 6.8% from the month before. Automobile and truck sales also picked up dramatically in August, benefiting – along with housing – from the low interest rate environment.
Housing reports continued to provide the best economic news in the fourth quarter with housing starts for September clocking in at a seasonally adjusted rate of 872,000, up 15% from August and 34.8% from one year earlier. Although that number is good, we believe the potential is even greater given the fact that for roughly 50 years prior to the recent housing slump, the U.S. residential market added on average 1.5 million new units per year. As the year drew to a close, concerns about European finances abated although they were replaced by domestic fears of the "fiscal cliff" and whether Congress and the President could agree to extend current tax brackets and other provisions. Uncertainty reigned until the early hours of 2013 and we surmise the political wrangling as well as financial apprehension weighed heavily on consumer confidence which, according to the Conference Board, declined from 71.5 in November to 65.1 in December.
Though the market rallied well off the lows of the summer months with expected earnings on the S&P 500 Index in 2013 of $105, the earnings yield is 7.4% compared to a 1.7% yield on the 10-year U.S. Treasury bond. We believe this spread represents good value for the U.S. equity market looking ahead to 2013.
The CGM Mutual Fund portfolio was positioned to benefit from strong economic growth in the U.S. economy in 2012. The two biggest concentrations, money center banks and homebuilders, were the major contributors to the Fund's 2012 results. Other smaller industry holdings produced mixed results with losses in energy stocks and gains in automobiles and airlines. The Fund's performance in the fourth quarter was adversely affected by its investment in Herbalife Ltd. (NYSE:HLF), a company that sells nutrition, weight management, and personal care products. While Herbalife's operations performed well in 2012, the price of its shares declined following criticism of its operations by some market participants. We believe this criticism was unwarranted, and the Fund continued to hold the stock at year-end.
The fixed income section of the portfolio fluctuated between 25% and 28% of total Fund assets during the year ended December 31, 2012. It was predominately invested in shortterm U.S. Treasury notes reflecting concerns that interest rates would rise. The one long-term bond was sold in the fourth quarter of the year. On December 31, 2012, CGM Mutual Fund's three largest industry positions in the equity portion of the portfolio were in money center banks, housing and building materials and airlines. The Fund's three largest equity holdings were Citigroup Inc. (NYSE:C), Morgan Stanley (NYSE:MS) and Bank of America Corporation (NYSE:BAC). The Fund was 27.5% invested in short-term U.S. Treasury securities.
Robert L. Kemp
G. Kenneth Heebner