April 30, 2020
Dear Fellow Shareholder,
Equity and bond markets were extremely unsettled in the Fund’s second fiscal quarter that ended in April 2020. Global economies experienced the twin shocks of the spread of Covid-19 and a collapse in the price of oil.
Over the course of the quarter, Covid-19 went from being a regional problem in a couple of provinces in China to becoming a global pandemic. This led to massive disruptions in the global economy and financial markets. Economic activity came to a grinding halt as governments around the world mandated a shutdown of business and industrial activity. Initial jobless claims which were running at an average of less the 220K at the beginning of the year jumped to an unprecedented high of 6.8 million at the end of March.
In addition, the adoption of social distancing to control the spread of Covid-19 led to several industries collapsing. Retail, leisure, travel, autos and luxury goods industries were hit hard as was energy. Industrials, Financials and Energy sectors were down over -20% over the quarter while Health Care, Consumer Discretionary and Information Technology sectors were down less than -5%. Bond yields dropped from 1.51% at the end of January to 0.64%. The VIX index of market volatility jumped from 18.8 at the end of January to a high of 82.7 in mid-March before dropping to 34.1 at the end of April.
The S&P index dropped -8.4% in February and -12.5% in March before rebounding by 12.7% in April. The extremely easy Monetary policy adopted by the Fed, which included setting the Fed Funds rate close to zero and buying bonds reassured financial markets and caused the equity and corporate bond markets to stabilize. The Government also added over $2.3 trillion of Fiscal stimulus by providing loans and grants to companies and stimulus checks to individuals.
We have positioned the portfolio more defensively. We view the recent sharp rebound in equity markets as being driven by massive Monetary and Fiscal stimulus provided by Governments and Central Banks, rather than an improving economic outlook. As a result, we have underweighted cyclical stocks and Financials.
Given the increased volatility of the market, and the expected impact of the coronavirus in slowing down the global economy, we believe it is prudent to move the Fund into companies with low leverage, high quality of earnings and high profitability. We emphasize companies that have ample cash which would allow them to weather a recession better. In addition, we have tilted the Fund towards larger companies as large caps tend to have stronger balance sheets. We have reduced the importance of Value factors in the portfolio as Value does not do well in recessions. But we believe it is prudent to include it in a multi-factor context. In addition, our technical overlay also continues to help portfolio performance.
In mid-February, we sold out of Cisco (CSCO, Financial), Euronet Worldwide (EEFT, Financial) and Rent-A-Center (RCII, Financial). Cisco and Euronet Worldwide missed earnings for the quarter. For Cisco, this was the third consecutive quarterly miss as weak macroeconomic environment put pressure on sales with slower enterprise and service-provider spending. This may last a few quarters before company transitions to a healthier mix of software and recurring sales. Euronet saw sharp downward revisions to earnings estimates for fiscal 2020 and 2021 years.
We replaced the three positions with Fiserv (FISV, Financial), Ansys (ANSS, Financial) and Chipotle (CMG, Financial). All three had above average alpha scores and positive technicals. All three service-oriented companies are growth defensives. Ansys surprised to the upside the with last two earnings announcements.
In mid-March, we rebalanced the portfolio and made it more defensive by rotating into higher quality, more stable and defensive, typically larger market cap stocks such as P&G (PG, Financial), Costco (COST, Financial), Hersheys (HSY, Financial), Danahar (DHR, Financial), Lab Corp, Waste Management (WM, Financial), Public Storage (PSA) and NextEra Energy (NEE). We sold stocks that are more economically sensitive such as Hilton Worldwide (HLT), Financial stocks such as Discover Financial Services (DFS) and Synchrony Financial (SYF), and Industrials such as Oshkosh (OSK) and ManpowerGroup (MAN). We sold Metlife (MET) which declined due to interest rates being near zero.
The Fund paid income of 38 cents in aggregate for the November to April period, which corresponds to an annual dividend yield of 7.26%. We are very encouraged by the results of our innovative dividend income process for the half.
The Fund held 61 equity securities diversified across sectors, and the top five equity holdings as of April 30, 2020 were Microsoft (MSFT), Apple (AAPL), Alphabet (GOOGL), Amazon (AMZN) and Nestle (XSWX:NESN). The Fund has small overweight positions relative to the S&P 500 index in Communication Services, Consumer Staples, Health Care, and Information Technology, and underweight positions in Consumer Discretionary, Energy, Financials, Industrials, Real Estate and Utilities. The forecast PE ratio of the Fund is 22.2x, slightly above that of the S&P index at 20.5x, but companies in the Fund have higher profitability than those in the benchmark. The Fund’s Return on Equity of 20.6% is higher than that of the benchmark at 14.1%.
We believe that the Fund is appropriately positioned to perform in-line with the S&P 500, while its income generated (yield) is expected to exceed the benchmark. We are very positive on the outlook for monthly dividend income generation heading into the fiscal third and fourth quarter.
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