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2015 in Review: “Oil, Commodities & Currencies… Oh My!” The Sequel

During the fourth quarter, global equity markets recovered from a sell-off in Q3, though the impact was modest (and from today’s vantage point, short-lived). The S&P 500 index rebounded 7% during Q4, yet barely eked out a positive return for the full year (+1.4% including dividends, the index’s worst performance since 2008). In fact, the only domestic equity category to generate meaningfully positive returns last year was Large Cap Growth, which was up in the mid-single digits. Moreover, leadership within that category was heavily concentrated in a handful of large technology companies known as the FANGs. Stripping out the performance contributions of Facebook (+36%), Amazon (+122%), Netflix (at +131% the top performing U.S. large company stock last year) and Google’s parent company, Alphabet (+49%) would have resulted in a negative return for the rest of the S&P 500. The FANGs’ average price-to-earnings ratio soared from 49 to 120 times, according to Bloomberg.

For the second year in a row, Large Cap outperformed Small Cap, and Growth outperformed Value. We can tease out the extremities of this trend by overlaying the performance of the iShares S&P 500 Growth ETF (IVW) with the iShares Russell 2000 Value ETF (IWN):
Value vs. Growth 2015

Small cap underperformance accelerated in the second half of 2015, and by mid-January, the Russell 2000 index had declined more than 20% from its recent peak, meeting the technical definition of a bear market. (As an interesting aside, New York Times published a fascinating article last fall pointing out the growing valuation discrepancy between small cap stocks that are members of the Russell 2000 index, and those that are not—a trend researchers attribute to the rising prevalence of passive investment vehicles tracking that index).

Outside of the U.S., developed market stocks were modestly higher, both in Q4 and for the full year. The MSCI EAFE index increased about 5%,%, in local currency terms. Unfortunately, the strong dollar remained a headwind for U.S.-based investors. Measured in U.S. dollars, the MSCI EAFE return (-0.4%) lagged the local currency return for the third consecutive year. We touched on the strong dollar in past commentaries, but the trend over the last 18 months has really accelerated:

USD FX 18 mo

Emerging market currencies lost the most ground vs. the dollar during this period, but even developed markets in Canada and Europe were not immune. While Euro weakness had a proximate cause in continued quantitative easing by the European Central Bank (yields on short-term government debt are currently negative across much of the Eurozone), the common thread among the remaining currencies are domestic economies heavily tied to the fortunes of commodity and natural resource markets.

The Bloomberg Commodity index declined 10.5% in Q4 (and almost 25% for the full year). Nearly every type of commodity has been in a downward price trend, but the biggest negative impact comes from the global supply glut in crude oil, which has driven the price down from a peak of $115/barrel in June of 2014, to recent lows below $30. The double-whammy of weakening local economies and weakening currencies made emerging market equities among the worst performing asset classes last year (the MSCI Emerging Markets indexdeclined roughly 15% in dollar terms, after accounting for dividends).

Looking at the recent trends described above, our investors might wonder why we even bother investing in asset classes such as international stocks and commodities, where macroeconomic issues including currency exchange rates or global oil prices can create such a drag on performance. To answer that, it helps to look back at how asset class returns have varied over time. Since 1996, Callan Associates has produced a color-coded table of annual returns by asset class, called the “Callan Periodic Table of Investment Returns.”  A quick glance at this table demonstrates the power of diversification, as leadership among the various asset classes consistently shifts. For example, while an investor who had omitted emerging markets exposure over the last 5 years would have looked prescient, missing the outsize returns of this asset class from 2003-2007 would have substantially reduced a global portfolio’s risk-adjusted returns. These are volatile asset classes, but used in moderation they play an important role in diversifying the core stock and bond positions in a portfolio.

While it is impossible to predict precisely when certain asset classes will go in and out of favor, we have the sense that after several years of underperformance, the stage is set for emerging market equities to regain their day in the sun. According to Morningstar, the Vanguard 500 index currently trades at 17.3x prospective earnings, and 10x projected cash flow. By comparison, the MSCI Emerging Markets index trades at 11.5x earnings and 4.4x cash flow. GDP growth rates remain higher in the developing world, and currency movements tend to self-correct over time (a weak currency makes a country’s goods more price-competitive in the global market, eventually spurring export growth).

Rounding out the categories in our “capital appreciation” bucket, our allocation to real estate (via TAREX) was up modestly in Q4 yet finished the year down 3.6%, about in line with that fund’s target global benchmark. U.S. REITs fared slightly better last year (up about 2.5%), but as we discussed in our Q2 comments, we continue to prefer the more flexible approach of the Third Avenue fund, given the current lofty valuations of traditional U.S. REITs.

On average, the fixed income investments we owned in 2015 fulfilled their “capital preservation” mandate, if nothing more. Even though the Fed telegraphed a rate increase for most of the year, the yield curve for investment-grade bonds shifted upward only slightly, and the return for the Barclays Aggregate Bond index was essentially flat. Tax-free municipal bonds fared slightly better, delivering positive returns in the range of 2-3%. Laggard bond sectors included High Yield and Emerging Market debt (down 4% and 6% respectively, according to Morningstar). The High Yield segment showed strain as investors re-evaluated the wisdom of lending to energy companies, with oil and gas prices down more than 50% in the last 18 months, and energy companies comprising nearly one third of new high yield offerings in 2014.   A sell-off in the riskiest junk bonds caused high-yield credit spreads (relative to U.S. treasuries) to double over this period:

BAML HY Spread resized

Meanwhile, Emerging Market bonds fell victim to credit downgrades (Brazil’s debt rating was cut to junk status last year as that country officially entered a recession) as well as the aforementioned currency weakness. Though we do not own any High Yield funds for our clients, we did have a very small exposure to Emerging Market debt via the Templeton Global Income Fund (GIM), which was down about 7% for the year.

Toward the end of last year, we expanded our allocation to “hybrids” (securities with debt and equity characteristics) in our model portfolio with the addition of a preferred stock issued by US Bancorp (USB-PH). Similar to our other preferred stock investment in Wells Fargo, this security pays a qualified dividend (taxed at a preferential rate), the value of which floats at a spread to LIBOR, subject to a minimum yield (in this case, 3.5% annually). We purchased USB-PH at a slight discount to par value, so the current yield is around 4%, and will adjust upward if LIBOR exceeds 2.9%. Like Wells Fargo, US Bank is a solid investment grade credit (rated A+ by S&P) which significantly outperformed its peers during the 2008 financial crisis, thanks to strict underwriting discipline and limited loan losses (both companies remained profitable in 2008-09).

Large Cap Value Update
The average Bristlecone Large Cap Value (LCV) account did substantially worse than the S&P 500 in Q4 and in 2015 whose returns including the reinvestment of dividends were 7% and 1.4% respectively (please refer to your quarterly portfolio report for actual performance).

The majority of this performance lag is attributable to the portfolio’s holdings in energy and natural resource-related companies. With oil prices down 70% from their recent peak and natural gas prices off more than 50%, we are not surprised to see pure-play energy companies like Chesapeake (CHK) or Exxon (XOM) struggle. What has surprised us is the magnitude of the impact on companies with a less direct relationship to oil and gas prices—power producers such as Dynegy (DYN), NRG Energy (NRG), and Aggreko (ARGKF).

Dynegy is an independent power producer with generating assets spread across most of the U.S. About half of the company’s generators burn natural gas, and the rest burn coal. For decades, coal was the staple fuel source for the nation’s electric grid. More recently, growing environmental concerns are prompting stringent emissions control mandates for coal-fired power plants. In some cases, the cost of bringing older plants into compliance with new emissions standards does not make economic sense, and the plants have been decommissioned. At the same time, the shale-drilling renaissance in the U.S. lowered the cost of (cleaner-burning) natural gas to such an extent that it is displacing coal as the dominant fuel for electricity generation.

Clearly, investors have some apprehension about the pace of this change and the risk of coal power plants becoming “stranded assets.” However, Dynegy’s management has proven adept at acquiring coal-generating assets very cheaply (typically at a small fraction of the “replacement cost” of building a new gas-fired plant), and subsequently improving the environmental compliance and operating efficiency of these assets, to prolong their useful lives (and profitability). Currently, DYN trades at $10 per share, yet management expects the company to generate about $3.30 per share in free cash flow (FCF) for 2016, an astounding 33% FCF yield. Meanwhile, either the decommissioning of aged power plants (a reduction of supply) or an increase in natural gas prices (the fuel used for marginal power generation) could create upward pressure on wholesale electricity prices, further improving Dynegy’s results as the company manages the transition to a cleaner energy future.

NRG is similarly engaged in wholesale power generation, but also owns a retail electricity business (which partially hedges the company’s exposure to volatile wholesale electricity prices). NRG currently has a market capitalization of $3 billion, less than 5x the amount of free cash flow it generated in the last 12 months (and only 3.5x expected FCF for 2016). As a utility, NRG admittedly carries a significant amount of debt, but much of it is collateralized by specific renewable energy projects (i.e. solar) and is therefore non-recourse to the parent company’s equity shareholders. Even so, NRG’s next significant debt maturity ($1.1 billion) is not due until 2018, yet the company already held $2.2 billion in cash on its balance sheet as of Sep 30, 2015.

Aggreko PLC (ARGKF) is the world’s largest supplier of temporary power, deploying its fleet of diesel generators all over the world, particularly in emerging market countries (where local electric grids are often woefully inadequate to meet growing demand). Unfortunately, about 18% of the firm’s 2014 rental revenues came from customers in the energy, mining, and chemical industries—businesses that have curtailed capital expenditures due to a global downturn in commodities prices. Moreover, the firm’s heavy exposure to emerging market currencies pressures its financial results, reported in the British Pound. Notwithstanding all of these headwinds, Aggreko is still solidly profitable, relatively cheap (trading at 10x earnings) and carries only a modest amount of debt (slightly less than one year’s pre-tax cash earnings). We think the cyclical drop in demand from energy and mining customers is temporarily overshadowing strong secular growth trends in emerging market electricity demand. In the longer term, we expect that the compounding value of the core business will outweigh cyclical weakness among one of the major segments. In the meantime, the stock’s 3.3% dividend is well-covered, even by currently depressed earnings.

Our trading activity was limited in the fourth quarter—mostly related to tax mitigation efforts. For taxable accounts, we paired trades in Chesapeake Energy (CHK) and NRG Energy (NRG), in order to harvest unrealized losses for clients who had capital gains to offset from earlier in the year. We also sold a very small position in Seventy Seven Energy (SSE), a spinoff from CHK that no longer met the size criteria for inclusion in our Large Cap portfolio. Finally, we trimmed our position in Vulcan Materials (VMC) for non-taxable accounts (where doing so would not add to a tax liability for 2015). VMC was actually the best-performing stock in the LCV portfolio last year, but it is worth reflecting on our ownership history in this company, as it illustrates the measured, long-term orientation of our investment approach.

We originally purchased VMC in the summer 2008, well over a year into the housing bubble’s burst, and mere months before it morphed into a global financial crisis. At the time, the stock had already declined more than 65% from its peak, and it appeared that the shares represented a compelling value to the “normalized” profitability of the company. As it turned out, Vulcan was in the midst of an unprecedented sales decline, while simultaneously grappling with the largest debt burden in the company’s history. The stock continued to fall and we added to our position twice more in 2010, at levels 15-25% below our original cost.

Over the next few years, Vulcan rationalized their production to adjust to a lower level of demand, and trimmed debt via asset sales and discretionary free cash flow. Even so, the stock languished below our original purchase price until late 2013, when it began to rise in concert with a strong uptick in U.S. construction activity. Along the way, we trimmed the position twice (once for taxable accounts), at prices 47% and 130% above our weighted-average cost. In terms of annualized total return, our VMC position has now handily outperformed the S&P 500 index over our holding period, even though our purchase and sale decisions were imperfectly timed, and even though most of our clients had an unrealized loss on this position a full four years after we initiated the investment!

As always, thank you for your continued trust and support, and please accept our best wishes for a happy and prosperous 2016.

One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.

Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.