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Risk-Off, Risk-On

Following a steep correction over the first six weeks of 2016 (which saw the S&P 500 decline 12% from its recent peak, hitting a fresh 52-week low), equity markets rebounded in late February and March, with domestic market indexes finishing the quarter up nearly from where they had started.  The sell-off in January was precipitated by plunging oil prices (which hit a 13-year low of $26 per barrel in February), as well as recurring fears of a slowdown in China (and potential ripple effects for the global economy).

Recently, oil prices and interest rates have been the biggest drivers of market sentiment.  Oil declined nearly 18% in Q4 of 2015, and heading into January that slide showed no signs of abating, with some analysts predicting prices as low as $15 per barrel.  Sustained prices at that level threaten the viability of a number of U.S. shale oil producers, whose production costs generally range between $30 and $60 per barrel.  Therefore, investors feared not just a wave of bankruptcies and defaults from energy producers, but also the follow-on impact to creditors, banks, and industrial equipment manufacturers.

Meanwhile, against a backdrop of muted global growth and increasingly aggressive monetary stimulus in Europe and Japan, the U.S. Federal Reserve’s stated intent to further raise interest rates (following a 0.25% increase in December) seemed oddly out-of-step.  Considering the U.S. economy’s meager wage growth and below-target inflation (thanks in part to low energy prices), many were skeptical of the need to raise rates.       

As it turned out, the Fed backtracked a bit at its meeting in March, signaling that it would target a more moderate pace of rate increases than it had indicated previously.  Investors cheered what was, in effect, an incremental monetary easing, and the yield curve shifted downward:

 Yield Curve Shift Q1 2016

Source:  www.treasury.gov

As for oil prices, opinion turned more favorable in February based on a couple of factors.  First, the number of oil drilling rigs currently deployed in the U.S. has declined more than 75% over the past 18 months:

Rig count vs price

Rig count is an important leading indicator for oil production, because the production rate of oil wells naturally declines over time (particularly for shale wells).  Therefore, continued capital investment is essential just to maintain production at its current level, and prevent reserves from shrinking.  However, most major oil producers announced significant cuts to capital spending within the last year, and according to an analysis by the Wall Street Journal, the largest publicly traded energy companies only replaced (in the form of added reserves) about 75% of their 2015 production.

Second, tentative signs of cooperation between several major oil producing countries (both OPEC and non-OPEC members) tantalized the market with the prospect of a freeze in output, ahead of a summit meeting scheduled for mid-April in Doha, Qatar.  Investor optimism over possible production cuts helped crude prices rally from $26 to $37 in the last several weeks of the quarter.

Among the universe of U.S. equities, Q1 reversed trend from the past few years, with value stocks outperforming their growth counterparts.  This pattern held true across the entire spectrum of domestic equities, but was most pronounced among small and mid-cap stocks.  As concerns of an economic slowdown mounted in early January, investors more skeptically discounted the “prospective” or “adjusted” earnings which are integral to the bullish narrative for growth stocks.  Moreover, a floundering stock market undermined another necessary precondition—the opportunity to issue new shares at attractive multiples.

As might be expected, sectors which previously profited the most from new equity issuance and M&A activity—mainly technology and health care—were laggards in Q1.  Financial stocks also declined, but this had more to with a reset of interest rate expectations following the Fed’s comments in March (banks and insurers stood to increase earnings if interest rates rose).  On the flip side, interest rate-sensitive sectors such as real estate and utilities benefited from a “lower for longer” interest rate scenario.  Finally, the market turmoil at the beginning of the quarter boosted returns for precious metals—traditionally a safe haven during periods of stock market volatility.

Among international equities, developed market indexes were modestly lower in Q1, while emerging markets advanced in the low single digits.  From the perspective of the U.S. investor, both asset classes experienced a slight tailwind from currency appreciation—the U.S. dollar lost ground vs. many foreign currencies as interest rate expectations were revised lower.  In our Q4 review, we pointed out that a significant valuation gap had emerged between domestic and international equities (particularly emerging market equities) by the end of last year.  In response, we modestly raised the allocation to international stocks in our model asset allocation portfolios, and implemented this change throughout Q1 as part of our rebalancing trades for each client.

Given the relatively flat performance for equities in Q1, the best performing investments in our asset allocation portfolio were concentrated in the “Income & Preservation of Capital ” and “Other Assets” buckets, which collectively advanced about 2-3% for the quarter.  Every bond category tracked by Morningstar had positive returns in Q1.  High quality credits such as government and municipal bonds benefited from a “flight to quality” during January’s stock market correction, and long-term bonds rose the most from lower interest rate expectations (bond prices move in the inverse direction of interest rates, which declined across the yield curve).  As with international stocks, global bonds also received a slight currency tailwind, from the perspective of the U.S. investor.

Municipal bonds continued their strong relative performance.  Over the past 3 years, munis have been among the best-performing fixed income investments, for a few reasons.  First, they are generally viewed as very secure credits—particularly following a post-recession recovery in tax receipts—and therefore serve as a safe haven during periods of heightened stock volatility.  Second, muni bonds have no direct exposure to the “risky” areas of the market over the past few years, such as emerging markets or commodity prices.  Finally, a slowdown in new muni bond issuance has limited supply, particular of longer maturity bonds.  This forces muni fund managers to bid up prices for the bonds already in circulation, when rebalancing portfolios or investing new inflows of money.

Though muni bonds are generally recognized high quality credits, one glaring exception is the recent experience of Puerto Rico, which announced a partial default in January.  At one point in time, Puerto Rico’s bonds were attractive to investors because of their “triple tax free” status (for U.S. investors, the income from these bonds is exempt from federal, state, and local income tax).  The commonwealth was also successful in using tax incentives to lure multinational companies (particularly pharmaceutical companies) to relocate operations there.  For a time, this was a boon to the local economy, but most of these tax breaks were eventually phased out by 2006, leading these same multinationals to move on to greener pastures.  Unfortunately, Puerto Rico’s public spending did not adjust to the lower tax receipts.  Instead, its leaders continued to tap receptive debt markets in order to meet budget shortfalls, until the levels of debt became untenable (those interested in a more detailed version of this history may enjoy a recent Planet Money podcast on the topic).  Fortunately, the municipal bond funds we’ve chosen for our clients’ portfolios tend to take a very conservative view when evaluating credit (mirroring our own thoughts on the proper role of fixed income in a portfolio) and therefore have shunned Puerto Rican debt almost entirely.

Large Cap Value Portfolio Update
Despite a slow start to the year, our LCV portfolio recovered in March, bringing year-to-date results into positive territory (albeit slightly behind the S&P 500’s 1.3% return).  The March rebound was particularly strong among our holdings in the energy/utility and materials sectors, which benefited both from an uptick in oil and gas prices, as well as signs of restraint from the Fed regarding future interest rate increases.  The top-performing LCV stocks for the quarter were Cemex (+30.7%), Aggreko (+16.9%), Valmont Industries (+16.8%), and Hewlett Packard Enterprises (+16.6%).

At the same time, a delay in the pace of interest rate hikes was an incremental negative for financial stocks, many of which had already priced in an expected earnings boost from higher rates.  Bank of America (-19.7%) and Wells Fargo (-11%) were among the laggards in Q1.  Healthcare stocks also struggled, due to continued regulatory scrutiny over drug pricing, merger accounting, and tax inversions.  Both Novartis (-15.8%) and Pfizer (-8.2%) dragged down returns.  On the subject of Pfizer, its planned $160 billion merger with Allergan was scuttled in early April when the U.S. Treasury Department announced new regulations designed to curb inversions.  This does not fundamentally change our outlook for either company; we think both remain attractive on a stand-alone basis.

During the quarter, we took advantage of an opportunity to add to your investment in American Express (AXP), with the stock trading near its 52-week low (and nearly 50% below its all-time high).  The company’s earnings growth stumbled lately due to the loss of a major co-brand partnership with Costco (which accounted for approximately 8% of AXP’s annual billed business).  To management’s credit, they have historically insisted on—and achieved—a high rate of return on invested capital.  Because of this discipline, they were unwilling to continue the relationship with Costco on the terms demanded by the retailer.  One silver lining to the dissolution of the relationship is that AXP stands to realize a $1 billion gain from the sale of their Costco lending portfolio.  We remain confident that management will find attractive uses for this capital, and that a combination of business-building investments and share buybacks will resume earnings-per-share growth over the intermediate term.  Currently, AXP trades at a much lower earnings multiple than peers such as Visa (V) or Mastercard (MA), but we expect this gap to narrow in the future:

AXP PE Chart

Aside from the purchase of AXP, the rest of our LCV trades in the quarter were to trim or eliminate positions.  For taxable accounts, we reduced the weight in Vulcan Materials (VMC)—matching the trade we had done for non-taxable accounts in late 2015.  We also trimmed our position in AGCO Corporation (AGCO), as that stock’s relative performance caused the position size to increase beyond a level which we felt was justified by its valuation.

Finally, we made the difficult decision to eliminate our remaining position in Chesapeake Energy (CHK), resulting in a permanent loss of capital.  We first invested in CHK in June of 2012, shortly after the company’s CEO and co-founder, Aubrey McClendon, was stripped of his role as Chairman at the behest of activist investors including Carl Icahn (and about six months before McClendon was ousted from the CEO role as well).  McClendon was a quintessential “wildcatter”; an aggressive risk-taker and one of the first energy executives to realize the promise of hydraulic fracturing technology.  Over a period of 24 years, he built Chesapeake Energy into the nation’s second-largest natural gas producer, borrowing heavily to assemble a portfolio of leaseholds amounting to more than 16 million acres.

Our original investment thesis for CHK was that the stock price did not reflect the value of the oil and gas assets owned, even using lower energy prices. We realized that the company’s debt levels were high, but the private market for acreage containing oil and gas was supporting valuations higher than our assumptions and was very liquid,  making debt reduction seem very feasible. We anticipated that natural gas prices (which had already declined 80% from their peak by the time of our initial purchase) would eventually recover, as marginal producers would cut production. For a time, this thesis played out.  Natural gas prices, which had been $2.60/MBTU at the time of our original purchase, reached sustained levels between $3.50-$4.50/MBTU for the next two years, during which time CHK’s new management sold non-core assets and reduced net debt from $12.3 billion to $9.9 billion.

Unfortunately, the business of extracting oil and gas is very capital intensive.  Despite higher realized prices and less onerous interest payments, CHK was nevertheless reinvesting substantially all of its available cash flow in the drilling and completion of new wells (in order to replace the production from depleted wells).  From mid-2014, oil and gas prices dropped 50-60% in 18 months (natural gas dropping as low as $1.50/MBTU in early March).  As prices dropped, the market for land sales dried up. CHK faced the possibility that its operating cash flows could fall to a level that would violate certain covenants on its debt.  There was the additional possibility that CHK’s $4 billion line of credit could be reduced or amended if it were forced to recognize an impairment charge on its oil and gas reserves.  Either development could trigger bankruptcy—an outcome which we would not have contemplated at the time of our original investment.

Our best guess is that CHK is worth considerably more than its current market price (assuming higher mid-cycle prices for oil and gas).  However, given the strong possibility of a binary outcome (i.e. it is either worth $10, or worth $0), we no longer considered it an appropriate investment for our clients.  Simply put, the fundamentals of the company have deteriorated to the point where it is no longer in control of its own destiny.  As a result, our success as investors is now more dependent on luck (energy prices recovering sooner rather than later), rather than undervaluation based on a conservative appraisal of the company’s value. We reluctantly acknowledged that the stock should be sold.

Though disappointed with the outcome of this particular investment, we remain confident in our value investment process.  We know that not every investment will work out, but we are confident that our discipline of buying stocks at a significant discount to fair value will continue, as it has in the past, to result in more winners than losers. Our decades of experience leads us to believe that the past few years may have set the stage for a long period of outperformance from value stocks, similar to what we experienced after the collapse of the technology bubble back in 2000.

As always, we thank you for your trust in our services.

Disclosure Brochure Offer
Securities laws require Bristlecone to make available every year to clients the latest version of our disclosure brochure (Form ADV Part 2A). This form contains important information about our firm, such as services, business practices, potential conflicts of interest, a summary of our Disaster Recovery Plan, and Privacy Policy.

If you receive your 1st quarter statement by mail, a copy is included for your convenience. If you elected to receive your statements through our online portal, the disclosure brochure is available for download on our website by clicking here, but we’ll be happy to mail you a copy free of charge (call 877-806-4141 or email clientservices@bristlecone-vp.com)

You may also find additional information about our firm at our website, and through the Investment Adviser Public Disclosure system at www.adviserinfo.sec.gov. We are also required to adopt a code of ethics and provide a copy of which to clients upon request. The current version is available on our website by clicking here or by contacting our firm at the telephone number or email address listed above.

Please contact us immediately if you have had any changes in your investment objectives or financial circumstances. Any changes could impact how we manage your portfolio and will become part of your client file. You should also contact us at any time during the year if your investment goals and/or financial circumstances change. Should you hold equity securities in your portfolio, you will be responsible for the voting of proxies with regard to those investments. We typically do not vote client proxies unless specifically requested.

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.