MARKET COMMENTARY
U.S. equities appreciated modestly during the second quarter, supported by decent first quarter corporate earnings and a strengthening global economy. Earnings at U.S. companies grew at their fastest pace in nearly six years during the first quarter, with ten of the 11 sectors in the S&P 500 reporting positive earnings growth, according to FactSet. Financial and technology companies were among the sectors that reported the biggest improvements in earnings, while earnings in the energy sector declined, driven by lower oil prices. The Russell 1000 Value Index appreciated 1.34% for the period, bringing its gain for the year to 4.66%. Market leadership continued to favor growth during the second quarter, particularly mega-cap technology companies that are expected to benefit during an economic expansion. The so-called “FAAMG” stocks (Facebook, Amazon, Apple, Microsoft and Google) have been a key driver of the S&P 500’s return this year, contributing roughly 29% of that index’s year-to-date gain (source: Bloomberg). Semiconductor stocks had been on an absolute tear over the past 22 months until a violent sell-off began on June 9th that saw the Philadelphia Semiconductor Index decline nearly 9% in the final three weeks of the quarter. Financials also performed well, particularly in the latter part of the quarter, on evidence of a more benign regulatory environment that should benefit the industry, while energy shares were the biggest losers as even a modest oversupply of crude continues to put pressure on oil prices. The Russell growth indices significantly outperformed value during the quarter across all capital ranges, while small caps underperformed their large and midcap counterparts.
Nearly a decade after the European sovereign debt crisis, growth appears to be returning to the eurozone as the gross domestic product of the 19-country bloc grew at an annualized rate of 1.9% during the first quarter, significantly outpacing the 0.7% annualized gain in the U.S. The upswing in the eurozone has been broad- based with nearly all countries in the bloc experiencing growth. Political uncertainty has also eased given the victory of centrist Emmanuel Macron in the French presidential elections, allowing investors to focus on improving economic fundamentals. In Asia, Japanese stocks gained as that country’s economy picked up speed in the first three months of 2017, extending its most recent stretch of growth under Prime Minister Shinzo Abe to five quarters, the longest expansion in Japan since 2006. The current expansion offers hope that the prime minister’s policy of increased government spending and easy monetary policy (“Abenomics”) may be easing decades of sluggish growth and deflation. Meanwhile, the MSCI Emerging Market Index posted a gain of 5.47% for the quarter despite a sharp decline in Brazilian stocks as President Michel Temer faces a criminal inquiry amid allegations that he agreed to pay hush money to a witness in that country’s biggest-ever corruption probe. If found guilty, he could be removed from office, potentially derailing blockbuster economic reforms his government is currently overseeing in Congress.
Financial stocks performed well despite a flattening yield curve, a lack of progress on tax reform, and lowered guidance on trading revenues. This was primarily due to improved expectations of a more benign regulatory environment with the newly appointed heads of regulatory agencies and the Treasury’s bank deregulation recommendations to ease existing rules. This was further evidenced in late-June with the CCAR (Comprehensive Capital Analysis and Review) results where capital returns across the board beat high expectations. Citigroup (C, Financial) will be returning 125% of its earnings to shareholders in the next four quarters, with a major increase in its share repurchases and a 100% dividend increase. Regions Financial, a large regional bank, will be returning 150% of earnings, demonstrating that regulators share the view that banks are over-capitalized. This will likely be followed by a recognition that the actual cost of capital for the banks, and financials in general, is lower than is being discounted in the market.
As mentioned previously, energy stocks were the worst performing group during the quarter as investor sentiment has been battered by inventory rebalancing that is taking longer than expected. Even though major OPEC producers and Russia have cut production, U.S. inventories (reported weekly and the most visible inventories in the world) remain elevated. We see the gradual rebalancing process as a transitory issue and instead note that outside the Permian Basin, capital investment remains at severely depressed levels. Since oil prices collapsed in late-2014, more than $1 trillion of capital investments have been canceled or deferred, and the oil sector’s proved reserves sit near multi- decade lows. The recent decline in crude prices has already had an impact on the domestic oil rig count as it dropped in the last week of June for the first time in 24 weeks. The U.S. Energy Information Administration (EIA) just released data also showing that productivity per rig in the Permian basin declined for the first time since they started tracking the data three years ago.
We believe today’s oil price is insufficient to justify the necessary investment to maintain global production levels, and expect to see increasingly apparent signs from the global lack of investment over the coming months and years. Brent, the international benchmark for oil, closed the quarter at $47.92 a barrel, down 58% since hitting a high of $115.06 a barrel three years ago. While the major integrated oil firms have been able to adapt to lower prices by cutting costs and focusing on more profitable assets, others have struggled, particularly producers and service companies where the stocks are trading at trough levels with multiples last seen in early-2016 when the crude oil price was substantially lower. We believe too much attention and importance has been made of the 700,000-1 million barrel growth per day in the Permian Basin, which accounts for a little more than 5% of global oil production. Given that the global oil markets already have limited excess supply, we believe that both sentiment and fundamentals could in fact turn more positive in the near term.
PORTFOLIO REVIEW
NWQ Large Cap Value portfolios posted positive returns (gross of fees) for the second quarter that exceeded the Russell 1000 Value Index, lifting results for the year-to-date period as well above the benchmark. Stock selection was positive broadly as sector returns exceeded the benchmark in all areas with the exception of healthcare (slightly lower) and consumer discretionary (significantly lower). Financial services was the largest contributor to performance given both our higher weighting relative to the benchmark and superior stock selection. Commercial lender CIT Group and Citigroup were the two largest contributors to portfolio performance during the quarter. Utilities was also a top contributor to performance, with our investment in Calpine Corp, followed by the producer durables sector. Producer durable gains were led by our airline holdings. These gains were partially offset by weakness in the consumer discretionary sector, particularly our investments in
Viacom, Macy’s, and Advance Auto Parts. Viacom declined as pay TV net adds and advertising spending were both weaker than expected, reviving concerns of a secular downturn, while Macy’s and Advance Auto Parts reported disappointing same store sales and earnings. Macy’s is among a parade of retailers shutting stores and cutting jobs as shoppers increasingly opt to make purchases online. Our underweight in the healthcare sector also detracted from the portfolio’s performance relative to the benchmark, although nearly all of our healthcare holdings posted gains for the quarter. While our energy sector returns exceeded their benchmark, absolute returns were negative (in particular Newfield Exploration) and we were overweight the sector during the period.
TRADING ACTIVITY
New investments during the quarter included Coca-Cola Company (KO, Financial), Delta Airlines (DAL, Financial), RenaissanceRe Holdings (RNR, Financial), Bank of Ireland (ILDBY, Financial), and Viasat (VSAT, Financial). We purchased Coca-Cola stock following weakness in its share price. The stock has underperformed the broader staples index over the last five years as earnings have modestly declined largely due to foreign exchange headwinds and slowing emerging markets (particularly Mexico, Brazil and China). While there has been a shift away from carbonated soft drinks (CSDs), particularly in developed markets, KO has been able to compensate with pricing as well ”as growth in its non-CSDs segment, which has driven 2 3% organic revenue growth on a foreign exchange neutral basis. Going forward, two core catalysts will be 1) top line acceleration from refranchising, abating foreign exchange headwinds and the potential for an acceleration in emerging markets, and 2) meaningful margin expansion from refranchising and a massive cost savings program. Additionally, we are optimistic regarding the company’s new management and its restructuring plan. We believe the incoming CEO, James Quincey, is more focused on transitioning the company over time away from CSDs and changing the culture to focus on how KO should evolve over the next decade.
We also initiated a position in Delta Airlines following the stock's relative underperformance this year. We view Delta as a best-in-class airline, with an irreplicable hub-and-spoke model centered by their Atlanta hub. The company's underperformance stems from its exposure to transatlantic routes, an area where competitive dynamics are likely to persist. While this will be a headwind, we believe Delta is well-positioned to outperform peers on the domestic front, and their investment grade balance sheet and strong free cash flow generation should allow for a meaningful return of capital to shareholders. With the company trading at a discount to legacy peers for the first time in a multi-year period, we believe the stock is setup well going forward. Delta’s stock has appreciated meaningfully since our investment.
RenaissanceRe Holdings, a global provider of reinsurance and insurance, is also a new position in the portfolio. We believe RNR is a world- leading franchise and value creator, and a decade ahead of peers in transforming into a capital light “asset manager” of catastrophe risk, which is unrecognized in RNR’s stock price. The company’s gradual move towards being an asset manager (higher multiple) versus pure underwriter (low multiple) accelerated in 2016, and we believe is significantly underestimated by the investment community. We believe RenaissanceRe remains a great example of a well-managed business with an attractive risk/reward.
Conversely, we eliminated our positions in Phillip Morris and Symantec during the quarter as the stocks had reached our price targets and we no longer found their valuations attractive. The sale of Symantec enabled us to reduce the portfolio’s technology exposure given the group’s dramatic appreciation. We also eliminated our position in XL Group in favor of establishing a position in RNR. Although XL has outperformed over the last few months and may have additional upside, RNR is a higher quality name with better risk/reward and upside. â–
Past performance is no guarantee of future results.
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors.
The statements contained herein reflect opinions of NWQ Investment Management Company, LLC (“NWQ”) as of the date written. Certain statements are forward looking or based on current expectations, projections and information currently available to NWQ and are subject to change without notice. There is no assurance that any predicted results will actually occur. The securities identified herein are based on the institutional representative account, which may vary from securities held in other client accounts. These securities represent relevant contributors or detractors from performance over the period described and include all of the new and eliminated positions purchased or sold in the representative account during the period. Such securities do not represent all of the securities purchased, sold or recommended over the past year and the reader should not assume that the securities identified necessarily were or will be profitable. All investments carry a certain degree of risk of loss and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Value style investing presents the risk that the holdings or securities may never reach their full market value because the market fails to recognize what the portfolio management team considers the true business value or because the portfolio management team has misjudged those values. In addition, value style investing may fall out of favor and underperform growth or other style investing during given periods. This report contains no recommendation to buy or sell any specific security and should not be considered investment advice of any kind. Individual portfolio returns and holdings will differ based on client restrictions, date of account inception, substitutions, cash flows and other factors that are specific to individual accounts (e.g., tax loss sale requests). Accordingly, not all client portfolios will achieve the same results. Holdings are subject to change without notice. Index returns are provided to represent the investment environment during the time periods shown. Index returns do not reflect taxes, transaction costs, investment management fees or other fees and expenses that would reduce performance in an actual account. It is not possible to invest in an index. Statistical data was taken from sources which we deem to be reliable, but are not guaranteed. NWQ’s Form ADV Part 2A is available on the SEC’s website at www.adviserinfo.sec.gov or upon request via email at [email protected].
