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3rd Quarter Review: More of the Same

In economic news, it was pretty much more of the same. The US economy continued to grow at a tortoise pace during the 3rd quarter. On a positive note, wage growth is accelerating and residential real estate values continue to increase around the country, which bodes well for the future. Typically, as people earn more, and feel wealthier, they also spend more, and in doing so drive further growth. Although the US Federal Reserve did not increase rates at its meeting in September, expectations are that it will do so in December.

In Europe, on the other hand, growth remained elusive. Governments appeared more inclined to relax the austerity policies that have been the hallmark of the past few years. The British pound felt the strain from the uncertainty that comes with the Brexit vote. The business community has the most at stake if trade with England’s partners suffers. There is a risk that investment will slow down in the UK, and possibly in continental Europe, until a clearer picture emerges of the terms of separation from the European Union. In the rest of the world, Emerging Markets recovered dramatically this year. Latin America and particularly Brazil led the way on investors’ hope that the impeachment of President Rousseff will lead to more market-friendly policies going forward.

Overall, it was a good quarter as our clients’ portfolios followed the market benchmarks higher and posted broad-based positive returns. As the table below shows, 11 out of our 12 asset classes rose in the 3rd quarter despite—or thanks to—the continued uncertain economic outlook. The only exception was Natural Resources, where the commodity index lost almost 4%. The table below shows how a model 60/40 balanced (i.e. made up of stocks and bonds) portfolio is allocated, and for each asset category, the benchmark returns:


Our investment selections outperformed their respective benchmarks on average in 8 out of these 12 categories during the quarter, a positive outcome (Note that your own portfolio results may differ – please refer to your 3rd Quarter Portfolio Review Report). Let’s take a look at each of the main segments:

Capital Appreciation Segment Review
Looking at the equity bucket first, our investments outperformed their benchmarks in all but one category, US Large Cap. The star segments of the quarter, in a sharp reversal from last year’s lagging performance, were Emerging Markets (+8.3%), and Small Cap (+9.1%) equities. Trailing these two categories yet still rising nicely were Developed Markets (+6.5%) and US Large Cap equities (+3.9%). We outperformed the former but not the latter, with our Large Cap investments lagging the S&P 500 index.

Earlier this year, we started to proactively address the underperformance in US Large Cap by increasing diversification within the category and initiating a gradual shift away from our more concentrated active strategies toward more passive and diversified value strategies. Besides the fact that it takes time to identify and research alternatives, our slow pace in implementing change is also rational: as we’ve mentioned in prior commentary when discussing the hiring or firing of a fund manager, there is a tendency to feel pressure when a fund underperforms its benchmark. However, our experience and academic studies show that once managers have been fired, they tend to outperform the newly hired managers in the years after a change:


Besides well-known behavioral issues, this is mostly due to the reversion-to-the-mean factor in capital markets: investment categories and styles go in and out of favor in cycles. When making hiring and firing decisions, there is a significant risk that we’ll make a change just before the pendulum swings back in favor of the strategy that we just abandoned. In doing so, we end up missing the rebound and compounding the original mistake. By making incremental steps over time, we limit such risk. And although it may sound counter-intuitive, our normal go-to strategy is to reduce our commitment to a fund or manager after an extended period of outperformance. This “rebalancing” from funds that have outperformed into those that lag has a better long-term track record.

Large Cap Value Update
In line with our other Large Cap managers, our average Large Cap Value stock portfolio was up slightly but trailed the S&P500 during the 3rd quarter. We were quite active: we added to our investment in Potash Corp (POT) as the stock price declined, and the discount to our estimate of the company’s value expanded. POT announced a merger with another Canadian fertilizer company, Agrium (AGU). We view this transaction favorably, and feel that, if it clears anti-trust concerns in Canada and in the US, the merged entity’s new scale in production and distribution should benefit shareholders as fertilizer prices recover.

If Potash was an example of adding to our stakes in companies with increasing price-to-value discounts, Cisco Systems and Intel provided examples of the opposite: two investments that have done well but where current valuations warranted some profit-taking. Both are great businesses with dominant franchises, and we anticipate that they’ll continue to do well. The goal is to size our investments relative to how attractive they are.

In August, we liquidated our investment in Apollo Education (APOL). The fallout from another for-profit education company’s bankruptcy raised concerns in our mind that the pending acquisition of APOL by a private equity firm might encounter some regulatory roadblocks. We felt that the upside if the deal closes by year-end ($10 per share) was not big enough to compensate us for the downside risk if it doesn’t. The market seemed to have similar anxieties, as the stock is still trading below our sale price. Usually, when a company is being acquired, its stock price rises slowly as the closing date gets closer. Although our first investment in Apollo a few years ago was profitable, this time around, it was a very poor purchase and we sold the stock at a significant loss.

Our best performing stocks during the quarter were Bank of America’s warrants (+33%), Cemex (+29% – the Mexican peso goes up when polls show Donald Trump losing favor with US voters.), the two Hewlett Packard stocks (HPQ +26% and HPE +25%), and Bank of America (+18%). The biggest decliners were Dynegy (-28%), Aggreko (-27%), NRG (-25%), QVC (-21%), and Exxon Mobil (-6.1%).

Shares of Dynegy and NRG, two power producers, have been a lot more volatile than expected. After being up sharply earlier in the year, both were down on a pullback in electricity prices in their region during the 3rd quarter. Aggreko’s shares were up year-to-date on the London stock market but the US dollar price suffered from the decline in the British pound. We have no control over currency fluctuations, but the depreciation of the pound will help Aggreko’s sales overseas in the short to medium term. QVC’s stock was down when it warned that sales during the 3rd quarter were softer than anticipated. Management blamed some company-specific reasons for the decline and is addressing them. Although each situation is different, we continue to hold these positions. We believe these companies’ underlying value has been modestly affected if at all, relative to the decline in the share price.

Finally, since it is one of our biggest investments, we also wanted to comment on the situation with Wells Fargo. As most of you know, the company was recently fined $185 million by the Consumer Financial Protection Bureau, a Federal Agency, due to fraudulent behavior by about 5,000 employees who were opening fake accounts to make their bonus quotas. The financial impact of the fine is small and irrelevant, but the damage to Wells Fargo’s reputation will linger on a while longer, and we expect that its consumer bank division will underperform in the near future. The CEO was ousted in early October, some key managers have forfeited their bonuses under pressure from Congress, and the incentives which created the fraudulent behavior were scrapped. We would not be surprised to see more bad news surface as the bank will be scrutinized closely by regulators and consumer advocates in the months ahead. Eventually though, the company will address these issues and media attention will subside. While by no means we excuse Wells Fargo’s behavior, the company has historically done well for both shareholders and customers. Although management’s response when these issues surface was slow and inadequate, we feel that the company’s long-term competitive advantages have not been impaired. They are rooted in the size of is branch network, a conservative loan underwriting culture, and a focus on operational efficiency. Ultimately, these will carry the day. We plan on holding our investment for now.

Income and Preservation of Capital Segment Review
The biggest news on the bond side of your allocation was that, once again, the Federal Reserve held off from raising short term rates. It did signal that it might do so before year-end if growth and employment remain strong enough.

The bond market did not wait though, and rates set by investors rose. After a first half of the year during which returns exceeded the interest received, the US bond market’s return in the 3rd quarter was very subdued as interest rates on treasury bonds rose off their lows. For reference, the yield on the 10-year treasury bond rose from 1.4% in July to 1.6% at the end of the quarter. It is closer to 1.75% as we write this commentary. Funds focusing on long-term US treasuries experienced a small loss. Thanks to tightening credit spreads, the corporate bond market, and so called “junk bonds”, outperformed the aggregate bond market benchmark.

Our US fixed income fund selection had mixed results. Funds focused on corporate bonds and shorter maturities exceeded the Barclays Aggregate index. Meanwhile, a combination of higher yields and strong supply of new bonds led our municipal bond funds to underperform the broader bond market.

Other Assets Segment Review and Portfolio Positioning
Our main reason behind our increasing allocation to this category over the past couple of years is to protect our balanced portfolios from an increase in rates and provide better risk-adjusted returns in a low bond yield environment. This bucket is made of low duration assets, such as merger arbitrage funds, variable rate preferred stocks, special situation and other event-driven strategies. With rates rising a bit during the quarter, the Other Assets category performed particularly well, with all our funds outperforming the broad bond market (and our core bond holding, the Vanguard Total Bond Market fund). We believe that the 3rd quarter demonstrated the diversification benefit of these non-traditional asset classes.

Protecting Yourself from Cybercrime
With weekly revelations of online data being stolen and as more of our clients access their financial accounts online, we’d like to remind you that Bristlecone employees will never ask for your account numbers, social security number, password or login information in an email. If you receive a message purportedly from Bristlecone, or any financial institution for that matter, asking for this information, consider it a scam. Do not click on any link or attachment, and immediately delete the email.  Similarly, do not send us any email containing such sensitive information, either. Safe online practices start with a strong, unique password that you change regularly, for each of your online accounts. Since it would be impossible to remember all these passwords, this NY Times articlesuggests some secure ways to store them.

Finally, we urge you to contact us immediately if you believe that you’ve been the victim of identity theft or that your accounts may have been compromised.

As always, we appreciate your trust in our services.

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.