“Trend is not destiny because trend can be changed”-Gene Epstein
Stock market gyrations driven by headlines emanating from Europe have returned. In May voters in France and Greece rejected political leaders supporting fiscal reform. Markets lurched again in June following German Chancellor Merkel’s statement, “Not during my lifetime,” regarding a proposal that Germany back-stop new Eurozone bonds that would fund bailouts. Investor mood flipped to euphoria on June 29th (a bit bipolar?) following news from the latest European Summit that steps toward a coordinated continent-wide funding mechanism had been agreed upon in principle. Judging from the stock market’s 2.5% rally one would think all problems had been solved but, before getting too excited, remember this is the 19th summit European leaders have held to address the Euro crisis. In this quarterly update, I’ll highlight the drivers I believe are most important for long-term investment success: corporate earnings, the economy, and resolution of government fiscal issues at home and abroad.
Earnings generated by companies owned in your portfolio increased nearly 13% in the first quarter, exceeding the 9% earnings growth of the S&P 500 member companies. Businesses continued deploying free cash flow in shareholder friendly activities, with 31 of 35 companies on Ayrshire’s holdings list raising dividend payouts 13.6% on average during the last year, and 20 of 35 companies reducing the number of shares outstanding. Despite generally good first quarter results, many management teams were cautious when presenting their outlooks for the coming quarters. Uncertainty surrounding the Eurozone crisis, slowing growth in BRIC member nations, and the upcoming Presidential election in the USA are impacting the real economy. These uncertainties are reflected in stock valuations. The S&P 500 is currently selling at a multiple of 12x earnings. In 2007 the market was selling at 17x earning and in 2000 at its peak, the S&P was selling at 24x earnings. At some point the historic relationship between corporate earnings growth and stock price appreciation will return and the stocks owned in your portfolios are positioned to perform well.
The global economy is entering its fifth year of navigating the headwinds of deleverage. Since the market bottom was made in March 2009 the economy has been slowly crawling forward, constrained by overextended consumers, severe government budget deficits, and central banks with limited options to spur economic activity. Economic data remains mixed with an overall bias toward slow improvement. On the positive side, it appears that the domestic housing market has finally stabilized. However, job growth has slowed and the ISM Manufacturing data released for June slipped below 50 (signaling contraction) for the first time since 2009. With interest rates near zero in the USA, the cost of money is not deterring activity; it is the lack of demand driven by the painful process of deleveraging.
Regarding government fiscal reform, it is not a matter of “if” but “when” action will be taken. Indecision emanating from weak leadership is economic poison. When nations begin undertaking real fiscal reform consumer and business confidence will improve. In the United States, no fiscal reform is likely until after the November election. In the near term, it is probable that the “fiscal cliff” often discussed by the media (the Bush tax cuts expire simultaneously with mandated government spending cuts) will be deferred until 2013. In Europe it is unclear whether the Euro will survive intact. If member nations agree to forego financial autonomy and decide to evolve into a “United States of Europe” where the fiscal policies of Euro member nations are linked under one body, then it is probable the Euro will survive. If member nations cannot agree to surrender fiscal autonomy then a breakup of the Eurozone is more likely.
During the quarter I purchased The Hershey Company in client accounts. Hershey yields 2.2%, has a history of repurchasing its shares, and generates a return on invested capital exceeding 25%. Management is conservative and operates under a five year strategic plan that I believe presents growth opportunities in any economic environment. I sold client positions in Reckitt Benckiser and the China iShare exchange traded fund after owning both for many years. Results had failed to live up to expectations so it was time to move on.
Looking forward, I expect the markets to remain in a trading range until real fiscal reform is achieved. The headwinds presented by deleveraging continue and are likely to remain for the foreseeable future; there is no quick fix. The Federal Reserve has stated it will continue to keep interest rates low through at least 2014 and with the 10-year treasury yielding 1.58%, it is difficult to get excited by the prospects of owning treasuries. On the fixed income side, there are limited opportunities to gain additional yield so it is important for investors to adjust expectations. Equities are inexpensive by historic measures, reflecting the economic and fiscal uncertainties facing global markets. In the last quarterly note I pointed out that the VIX was signaling complacency, a warning to investors to be wary of adding new positions. While the equity markets have in fact experienced a down quarter, the VIX isn’t saying “buy” yet either. Therefore, I intend to look cautiously for opportunities where the risk/reward balance appears favorable.
Thank you for entrusting Ayrshire Capital with the management of your money. I look forward to speaking with you in the coming quarter.
JM Sam Nevin, Jr.
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