“Do what you can, with what you have, where you are”-Theodore Roosevelt
It is easy to mistake Teddy Roosevelt’s comment as something said by Fed Chairman Bernanke. The Fed has waged a herculean battle over the last five years to inject liquidity into an economy hampered by collapsing money velocity. As consumer and business confidence recovers so will money velocity, enabling the Fed to unwind its QE programs. Although our investment process emphasizes fundamental analysis, we are cognizant that ending these programs could create unintended macroeconomic consequences and affect stock and bond valuations so we are monitoring “where we are” in the process closely.
The economy is in a slow, grinding recovery with US GDP forecast to advance 1.8% in 2013 versus 2.2% in 2012. Revenue growth is anemic and cost cutting continues to augment results. Management teams have been battle tested and are now turning toward mergers & acquisitions to find growth, which helps support equity multiples. The fourth quarter of 2012 was the strongest period of M&A activity in North America since the second quarter of 2008, and the deal flow in early 2013 remains active. Many companies owned in your portfolios have excellent M&A track records (Sigma Aldrich, Diageo, Roper Industries, to name a few) and we expect them to continue to deploy excess cash flow intelligently. Some businesses could also become acquisition targets (Peoples United, Hillshire Brands) and that would be fine with us, too, if the price is right.
We believe the eventual unwinding of the Fed’s current monetary policy presents a greater challenge to bonds. When interest rates eventually rise, bond valuations will decline. What are the triggers that may signal higher rates? The Fed Open Market Committee has stated it will remain “very accommodative” as long as unemployment exceeds 6.5% and inflation doesn’t surpass the targeted rate of 2% by more than half a percent. Because the economy is moving closer to these signal points, we are reluctant to replace maturing bonds. Instead, we have reinvested a portion of the cash into dividend paying stocks. Our rationale is as follows: a bond payment (coupon) remains constant until the instrument matures. In contrast, a stock has the ability to raise its dividend, which increases the yield. In a moderately inflationary environment stocks are better positioned than bonds, generally speaking. Because not every client can tolerate the volatility of owning stocks (nor is it prudent for every client to own solely equities) we do hold shorter maturity bonds to help navigate market choppiness.
We began the year most worried that action (or inaction) by politicians would damage the fragile recovery. The budget sequestration is being enacted, slightly lowering the growth rate of government spending, and taxes have risen. Staff members in the administration and in congress have begun leaking hints to the press of potential areas of compromise that could evolve into real tax and entitlement reform. Because current fiscal policy is clearly unsustainable, the question is “when” not “if” compromises will be negotiated. Internationally, the Euro continues to be held together through fitful actions of its member nations. Geopolitical risks have risen with aggressive military chest-thumping from North Korea’s young leader, Kim Jong Eun. Iran is holding presidential elections this summer and we can only hope the next leader will help alleviate Middle East tension.
During the quarter we purchased shares of Hillshire Brands (HSH), General Mills (GIS), and VMware Incorporated (VMW). Prior to completing a major restructuring in mid-2012 Hillshire Brands (1.5% yield) was known as The Sara Lee Corporation. HSH’s management team has gotten off to a strong start redefining the business as a branded food company and unit sales have responded to management’s efforts to reinvigorate the product portfolio. We purchased shares of General Mills (3.1% yield) in early February because we were attracted to its improving business trends and favorable dividend yield. New product introductions and line extensions have driven sales and we think these actions will help the company post good results for many quarters. VMware, a participant in “cloud computing,” was purchased in March following a period of weak stock performance. We’ve watched the company for many years and believe the stock’s valuation has fallen to a level that presents a favorable risk/reward profile. On the sale side, we eliminated our position in Williams Partners (WPZ) due to a weak outlook for business in 2013 and we trimmed our holding in PVH Corporation because the stock had become overweight in client portfolios and was trading near its high.
Finally, equity markets have gotten off to a very strong start in 2013, advancing faster than underlying economic activity. The VIX volatility index has fallen to a level suggesting investor complacency. Given this combination, we wouldn’t be surprised to see markets pause for a while following the recent strong advance so we plan to be more wary putting cash to work in the coming quarter. Stocks remain reasonably valued but we’d rather be nimble than complacent. Thank you for entrusting Ayrshire Capital Management with your money. We look forward to speaking with you in the coming months.
JM Sam Nevin, Jr.