M A R K E T C O M M E N TA RY
During the first half of 2016, global equity markets were volatile and the U.S. equity market emerged as one of the best performing developed markets. In January and February, concerns about China’s economic outlook, low oil prices, and the trajectory of the global economy led to a steep decline in equity prices. The U.S. market rebounded sharply and was approaching an all-time high until the United Kingdom voted on June 23 to leave the European Union (“Brexit”), triggering a “flight to safety.” Following the vote, global equity markets declined sharply, U.S. government bonds rallied, and the U.S. dollar strengthened significantly against several major currencies, especially the British pound. The S&P 500 subsequently recovered to end the first half of the year up 4%.
After raising the federal funds rate in December 2015 for the first time in nine years, the Federal Reserve left short-term interest rates unchanged during the first six months of 2016. While the U.S. economy showed signs of improvement (e.g., lower unemployment rate, healthy wage growth, a rebounding housing market), the future path and pace of interest rate changes remains uncertain given tenuous economic and financial conditions abroad.
As beneficiaries of the “risk-off” market sentiment, Telecommunication Services (up 25%) and Utilities (up 24%) were the best performing sectors of the S&P 500, and Consumer Staples (up 10%) appreciated notably. Energy (up 16%) also performed strongly as Brent crude prices temporarily climbed above $50 per barrel in May for the first time since November 2015. Low to negative interest rates in major economies around the globe increased concerns about future profitability in the Financials sector, which was the worst performing sector (down 3%). Companies in the more cyclical sectors are now priced at a discount to their more defensive counterparts (e.g., Utilities).
I N V E S T M E N T S T R AT E G Y
As part of our investment process, our portfolio managers and global industry analysts often step back and ask, “If we were starting from scratch, would we still own the same securities?” Using this framework, we revisited and retested our thinking on many of the Fund’s holdings and concluded that recent market conditions have created long-term investment opportunities in many economically sensitive companies, such as Financials.
In the case of Financials, given heightened market volatility and changing valuations, we conducted numerous discussions about investing in this sector and extensively reviewed individual holdings. Our bank analysts put together “bull” and “bear” presentations that argued for and against the portfolio’s positioning in Financials. Using a rigorous team-based review process, our equity and fixed income teams vetted recommendations, presented devil’s advocate arguments, stress tested assumptions, and assessed relative valuations.
As a result of this process, we reaffirmed our conviction and recently added to selected holdings, including American Express (AXP, Financial), Bank of America, Goldman Sachs, and MetLife.a Facing the challenges of a potentially weaker global economy and low interest rates, the Fund’s financial services holdings trade at inexpensive valuations. However, banks are expanding lending across various categories and credit quality has increased over the last five years. Additionally, many of these companies now have capital ratios that are meaningfully higher than they were prior to the global financial crisis. We believe reasonable earnings growth is possible with no change in the interest rate environment. However, interest rates are at historically low levels, and if they were to rise (or simply stop falling), profitability within the Financials sector would increase. Two of the Fund’s holdings, Bank of America and Goldman Sachs, are highlighted below.
Bank of America (BAC, Financial)
The largest bank in the United States by deposits, Bank of America has leading positions in the lines of business that comprise the majority of its revenues, including consumer banking and wealth management. Since the financial crisis, Bank of America has gained market share in its core businesses and navigated ever tougher regulatory requirements, while increasing capital and liquidity. As a part of its restructuring plan, management has simplified the business, reduced expenses, and implemented a more customer-focused strategy. Longer term, improved fundamentals and potential cyclical tailwinds (e.g., additional loan growth, higher rates, increased capital markets activity) could produce a significantly higher return on assets, as well as multiple expansion, dividend increases, and/or share repurchases.
Bank of America—trading at 0.8 times tangible book value and nine times forward earningsb—has one of the lowest valuations among its peers. While a prolonged low interest-rate environment would continue to pressure net interest margins and profitability, we believe the bank’s inexpensive valuation, strong business franchises, and capable management team make it a compelling investment opportunity. Hence, we added to the Fund’s position in Bank of America, which comprised 3.2% of the Fund on June 30.
Goldman Sachs (2.5% of the Fund) is a leading global investment bank, securities broker, and investment manager that provides financial services to a diversified client base that includes corporations, financial institutions, governments, and high-net-worth individuals. Since the financial crisis, Goldman Sachs has deleveraged its balance sheet, shed risky assets, and increased its liquidity. As European competitors (e.g., Credit Suisse, UBS, Royal Bank of Scotland) continue to cut costs and retreat from investment banking, Goldman has an opportunity to further increase its market share in many key businesses. While regulatory requirements have increased, this should reduce the probability of large trading losses. Finally, although market turns can be sudden and difficult to predict, Goldman Sachs has demonstrated an ability to remain profitable: over the past 16 quarters, its return on common equity has averaged an impressive 10%.
Continuing macroeconomic uncertainty has led to diminished primary debt and equity issuance and weaker secondary market trading conditions. Many of Goldman Sachs’ key clients, such as hedge funds and active asset managers, are experiencing net asset outflows. In this period of slower activity, the company has maintained its global network while downsizing naturally through attrition. The weak operating environment and concerns about Brexit have weighed on the stock, which was down 17% during the first half of 2016. However, after carefully analyzing the company’s risks and opportunities, we recently added to Goldman Sachs because it is an increasingly dominant player, has a highly profitable business, and trades at an attractive 0.9 times tangible book value.
Maintaining a Diversified Portfolio
In addition to Financials, we significantly increased the Fund’s holdings in AstraZeneca, a UK-domiciled global pharmaceutical company, and Charter Communications, a U.S. cable telecommunications company that recently merged with Time Warner Cable. We also initiated several new holdings in the Fund, including Anadarko Petroleum (a U.S.-based independent oil and gas exploration and production company with international operations) and Union Pacific, which is highlighted below.
Union Pacific (UNP, Financial)
While scores of railroads once operated in the United States, the industry is now concentrated: there are two major railroad lines east of the Mississippi and two in the West. We recently initiated a position in Union Pacific, which owns an irreplaceable railroad franchise covering 23 western states.
The North American railroad industry has many attractive characteristics: companies operate in regional duopolies and have high recurring revenue, substantial ability to control their costs, and extremely high barriers to entry. Union Pacific has the opportunity to increase its earnings as a result of growth in its domestic intermodal business, as well as a construction and housing recovery in the West. In addition, continued growth of the Mexican economy and increased trade with the United States should benefit its U.S.-Mexico business. With low leverage and a projected reduction in capital expenditures, management has the ability to increase share buybacks over our investment horizon.
In 2015, Union Pacific faced the perfect storm of challenges, including record low natural gas prices that suppressed coal volumes, a significant reduction in oil and gas drilling activity, a strong U.S. dollar that hurt exports, and a broad slowdown in global trade. These factors combined to cause the biggest decline in Union Pacific’s traffic volume since the 2009 recession, and its stock underperformed the S&P 500 by 34% last year. While these headwinds are substantial, we believe that most of them are largely cyclical rather than structural in nature. Therefore, we believe these short-term concerns have created a rare opportunity to initiate a position at an attractive valuation. Over the last decade, the company has generally traded at or above S&P 500 multiples but now trades at a discount. On June 30, Union Pacific represented 1.4% of the Fund.
I N C L O S I N G
While many investors focus on current market volatility, it is important to recognize there is always uncertainty when investing. Our experience through similar and even more volatile periods in the past reminds us that the best investment opportunities often arise in periods of uncertainty and trepidation. We seek to capitalize on these opportunities through our bottom-up research process and multi-year time horizon which provide us with the fortitude to stay with our convictions, even in periods of volatility or portfolio underperformance.
We have weathered past periods of underperformance and have conviction in our Funds’ holdings over our three- to five-year investment horizon. We remain optimistic about the long-term outlook for the holdings in the Fund, which collectively traded at 13.2 times forward earnings on June 30, a substantial discount to the S&P 500’s 17.9 times forward earnings. Patience and persistence are essential to long-term investment success. We encourage our shareholders to adopt a similar view of investing.
Thank you for your continued confidence in our firm. As always, we welcome your comments and questions.
For the Board of Trustees,
Charles F. Pohl, Dana M. Emery,
Chairman President
July 29, 2016
