Quarterly Commentary and Outlook
Despite widespread pessimism at the end of the second quarter following the Brexit vote, the third quarter saw ongoing US economic expansion and a continuation of the market’s ascent, as shown by the S&P 500 Index. On the economic front, payrolls, new home sales and industrial production helped buoy the market and gave investors the assurance to remain confident about equities.
Fund of America Class A Shares (without sales charge)1 returned 6.82% during the quarter, versus 3.85% for the S&P 500 Index. We would highlight three factors that drove these results:
- Strong stock performance across nearly all the portfolio, including several new ideas;
- Weakness in utilities, REITs and other perceived low-volatility, high-dividend stocks;
- The continued resiliency of the US economy.
Strong Stock Performance
Overall, we had well-diversified stock contributions in the quarter, with particular strength in some of our technology names. New purchases in the portfolio this year have been running at a higher rate than normal. Much of that is attributable to the higher-than-usual M&A activity we have experienced in the portfolio over the last 12-18 months. Of the 21 names we purchased this year and continue to own, 15 contributed positively to the portfolio’s performance, one was neutral and five detracted.
Weakness in Perceived Low-Volatility, Dividend-Paying Stocks
Last quarter, we wrote about high valuations within sectors such as utilities and real estate. With the possibility of an interest-rate hike in December of this year, these income proxies have retreated. Our investment philosophy is built around finding corporate change at reasonable valuations. The rich valuations and lack of corporate change within these areas had kept us away, and, on a relative basis, our under-representation was helpful to performance in the third quarter.
A Resilient US Economy
The Fed appears to believe that the economy can withstand an interest-rate increase in December and that it will not hinder the expansion. While, over time, each strong economic data point has often been matched by a weak data point, the broader overall trend remains marginally positive. This slow and unsteady path of recovery and expansion, which has been consistent since 2009, continues to support the stock market. Nevertheless, the market has repeatedly encountered catalysts for concern that have led to a number of pullbacks.
While all of these selloffs seemed justified at the time, in hindsight, these concerns appear to have far outweighed their actual economic consequences. Thus, this stealth bull market has continued to roll.
Notwithstanding the ubiquitous political agita—a symptom of the season—we are of the view that the economy and market could well continue to muddle through. We believe that we do not currently have problematic inflation and that employment is growing. With a price/earnings ratio of roughly 17x for the market,2 valuations are reasonable for this kind of low-interest-rate environment, in our view. Even with modestly higher short-term rates, longer-term rates could remain favorable. Importantly, we believe the Fed governors’ desire to raise rates stems from their wish to normalize interest rates so that they have some ammunition to combat future declines in the economy, rather than from an intention to slow down the economy. Lastly, we see little-to-no evidence of investor exuberance in the equity markets. Overall, we see a scenario where, beyond the elections and a likely December rate rise, the market and the economy could both grind forward in a slow, unsteady trajectory.
We believe the portfolio represents a compelling collection of stories of corporate change that has been lifted by several new ideas in the last few quarters. With the strong free-cash-flow-generation that the portfolio is producing, we believe we are well positioned for a multitude of environments.
Portfolio Review
The top five contributors to performance for the quarter were Hewlett Packard Enterprise, Biogen, Halozyme Therapeutics, Pack-aging Corporation of America and eBay.
- Hewlett Packard Enterprise (HPE, Financial) reported its earnings and announced that the company will spin off and then merge its software divi-sion with UK-based Micro Focus.
- Biogen (BIIB, Financial) stock rose in the quarter as the company reported solid second-quarter earnings. It also announced the departure of its CEO, which led to market speculation about a potential takeover of the company.
- Halozyme (HALO, Financial) contributed positively as the company reported second-quarter royalty revenue that continued to grow. In addition, Biotech stocks generally rebounded in the third quarter.
- The announcement of an industry-wide price increase for containerboard had a positive impact on Packaging Corp of America (PKG, Financial).
- Having revamped its website, eBay (EBAY, Financial) began to see a positive revenue response, and it increased its guidance for fiscal year 2016.
The top five detractors to performance for the quarter were Olin Corporation, Martin Marietta Materials, Inc., Lowe’s Companies, Inc., Wyndham Worldwide Corporation and Hertz Global Holdings, Inc.
- Olin Corporation (OLN, Financial) reported earnings that were below expectations, primarily due to a portfolio mix shift in its caustic soda busi-ness, coupled with a rise in the prices it pays for natural gas and ethylene.
- Martin Marietta (MLM, Financial) was impacted by some bad weather in its core markets as well as some delays in project starts.
- Lowe’s Companies (LOW, Financial) sold off on lower-than-expected comparable store sales in the second quarter and also—following recent weak retail census data—on concerns about the health of the US consumer.
- Wyndham Worldwide Corporation (WYN, Financial) was affected by worries about the potential impact of Zika on its Florida business and by continuing concerns about increased defaults in its timeshare business.
- Hertz (HTZ, Financial) stock was a detractor this quarter after a competitor disclosed that industry operating conditions in Europe were more challenging in the third quarter.
We thank you for your continued support, which we aim to reaffirm with strong results.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
The commentary represents the opinion of the Fund of America team as of the date noted and is subject to change based on market and other conditions. The opinions expressed are not necessarily those of the firm. These materials are provided for informational purpose only. These opin-ions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistic contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security.
