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As the quarter progressed, conviction among investors of a strong economic rebound waned. The biggest driver for this has been the European sovereign debt crisis sparked by Greece’s problems. Suddenly world markets had a second reminder of the delicate nature of current economic growth and the stock market had one of its worst months of May ever. In reaction to these sovereign debt issues and the European Central Bank’s bailout of Greece several European countries are announcing stringent cuts in government spending that, if passed, will create very rapid fiscal tightening in their economies. In addition the U.S., despite the political rhetoric being thrown around, will see fiscal tightening in 2011 as spending from the stimulus bill ends and a chance remains that no compromise on extending parts of the Bush tax cuts is reached. A second leg of market weakness late in June would seem to reflect these concerns among investors.
Fed Chairman Bernanke recently told Congress that he foresees a 'muddle along' economic scenario that would inhibit the Federal Reserve from raising interest rates in the near future for fear of choking off what growth there is in the economy. Although we have believed the sentiment for the economy has been too strong until recently, investors have been overly negative on the stock market in general, and have reacted by holding extremely high levels of cash and low yielding bonds. That has led to high quality equities being very oversold in our opinion, especially given the low level of interest rates, and the relatively modest return on almost all other competing asset classes. The pieces seem to be in place for strong upside in the stocks of companies with special franchises and sustainable growth. Historically, widespread pessimism has led to interesting opportunities for disciplined investors.
As the economy has rebounded the surge in earnings for cyclical companies has mostly run its course. In the second half of this year their comparisons with the same period in 2009 will get much more difficult even with continued strong growth; the weaker recovery we foresee indicates that expectations for cyclical businesses got ahead of themselves. This optimistic pricing of cyclical companies has a mirror image in the extremely cheap valuation being given to growth stocks, particularly large cap growth. Quality large cap growth stocks are at the lowest relative valuation we have seen in a long time. The S&P 500 growth index has a forward P/E of 12.5 times and the Russell 1000 growth index has a forward P/E of 12.8 times. Consistent growth will become more in demand as the sluggishness of the recovery becomes evident.
Consistent growth is the focus of our portfolio. We have minimized the exposure to consumer spending growth in the portfolio and focused on companies with high rates of recurring revenue producing consistent earnings streams. That focus is on business services and health care as well as technology and energy, where we see long periods of underinvestment leading to increased spending over the next three to five years.
In the quarter we sold two stocks:
Monsanto, which faces turbulence from continued declines in RoundUp pricing and farmer resistance to high prices for its latest generation of seeds, was sold at the beginning of the second quarter.
State Street Corporation, which we decided was too dependent on rising interest rates over the next six months to restart earnings growth (bond rates have fallen since our sale).
We purchased two stocks to replace those sold:
Expeditors International is a leading logistics provider, essentially a travel agent for freight. While they do not own the planes, ships or trucks that the cargo travels upon, they do have long-standing relationships with those that do. They also cultivate deep partnerships with customers that need to move their goods around the world. Expeditors becomes critical to both parties because they are an important source of volume for the carriers and they can use their buying power to negotiate better terms for clients that are using the shipping services. The investment thesis is predicated upon growing international trade with an emphasis on the China-US trade lane both by air and sea. We believe they can grow their earnings per share at 16% annually for the next five years.
American Express has substantially reduced its credit risk by closing or shrinking the credit lines of customers taken on during the credit boom. We wanted to increase the porfolio’s financial services exposure without buying a large bank and American Express’s international customer base could provide an additional boost to growth even if the U.S. consumer remains timid.
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This material represents an assessment of the market environment at a particular
point in time and is not intended to be a forecast of future events or a
guarantee of future results. This information should not be relied upon as
research or investment advice regarding the fund or any stock in particular. |
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