4Q 2013 Asset Management Letter

January 22, 2014   ·   By cfgadmin   ·   Comments Off on 4Q 2013 Asset Management Letter   ·   Posted in Asset Management Letter Archive

“Salad Days”

While concerns of Sequestration, Obamacare , Debt downgrade, budget standoffs, Eurozone debt, Iran, Syria, and the dreaded “tapering” of Quantitative Easing rippled through the market, the S&P 500 shrugged it all off and retuned 29.6%[i] for the year. Of course, the more appropriate index for our comparisons, the Morningstar Moderate Target Index was up 14.21%ⁱ. While we certainly welcome positive rates of return, when the earnings for these same S&P 500 companies are only on track for four or five percent growth in 2013, we become more cautious than bullish. That being said, markets can certainly trend higher if Quantitative Easing is not removed too quickly and earnings drift along at positive levels. Companies generally have not spent significant money on capital expenditures or hiring so their balance sheets appear far more secure than their leveraged counterparts from the 2007/08 timeframe.  This conservative stance along with low interest rates, stock buybacks, and merger /acquisition activity could push a fairly valued market to higher levels. Notice we say “fairly valued” and not cheap as the market could easily oscillate the other way if interest rates rise rapidly, Eurozone issues reappear, China real estate crashes, or a “Black Swan” event occurs that no one else expects.

We have framed these cross currents in the market for a reason. Sometimes investing is like a good salad (We realize we are showing our age). Good salads have different entities that are not great by themselves but when paired with others they work very well together. We like to think we have a sophisticated palate for investing that can identify value. In today’s environment, the options are not simple. As we mentioned in last quarter’s letter, “Investing, when it looks easiest, is at its hardest”. Thus, a simple index fund when the market is 58 months into a rally is not something that tickles our fancy. However, the individual pieces that we use in our portfolios (your salad) do excite us.

For instance, one of the asset classes we use in our portfolios is convertible securities. Convertibles are equity-linked instruments that offer upside market participation with potential downside resilience in equity market declines. We employ this asset via two of our funds, American Century Equity Income and Calamos Growth and Income. The manager of Calamos actually wrote the definitive book on convertible investing, “Investing in Convertible Securities” in 1988. Since convertibles can be viewed as a hybrid of stocks and bonds they may provide investors with opportunity to manage both returns and risks in a way stocks and bonds individually can’t. Active management can purchase convertibles that perform more like equities or more like bonds depending on their market outlook. Historically, this has meant these investments have provided asymmetric returns with less downside and significant upside capture. This, of course, lines up with our cautious view of the market.

Specifically, Calamos Growth and Income was up 17.58%ⁱ in 2013 and American Century Equity Income was up 19.83%ⁱ. As expected, these funds were not up as much as the market. However, in our mind, they are spicing up our allocations in an appropriate way. To that end, some services such as Morningstar and Lipper struggle with classification of these two funds as they can’t place them into a simple category or style box such as large value or large growth. In fact, both of these funds have changed over the past three years in their classification when nothing has changed in their investment style. We mention this as we feel that the ingredient that these funds add to our overall portfolios is more important than their nominal classification and we are happy with the funds’ performance even if they don’t land in the top quartile of a simplified category. As a side note, Calamos and American Century Equity both land in the top quartile of Lipper Rankings for flexible and equity income funds for 1, 3, 5, and 10 yr time frames but they differ via Morningstar’s categories. For instance, Calamos only lands in top quartile of Moderate allocation for the 10 and 15 year time frames. American Century only lands in it for 1 yr and 15 yr time frame.

We pull back to the salad analogy again here as these funds and all of our choices are not just Iceberg lettuce and a salt shaker. They are tomatoes, raisins, almonds, croutons, romaine and vinaigrette. They blend together for a more pleasing experience for our clients even when they don’t seem so good by themselves (think raisins). Then, if you add to that the fact that convertibles are trading at a discount to their normal valuation, then we believe we are providing additional spice at an attractive price point.

We realize we placed great emphasis on one ingredient (convertibles) within our investment mixture. However, we felt it was more important than the normal year-end letter where we recap the past and attempt to forecast the future. We think it is folly to forecast the unknown. There is a reason that old saying of “Economists have predicted nine out of the last five recessions” is so popular. Most experts expected 6 to 10% market returns in 2013 and anticipate similar results in 2014.  We, of course, can’t remember a pundit in recent history that didn’t expect positive results. Our thought is that history doesn’t repeat itself but it does rhyme to paraphrase Mark Twain. Since 1925, the S&P 500’s average yearly gain is 10.4%ⁱ with 5% of that return earnings growth, .9% P/E expansion, and 4.5% from dividends. Dividends are not near 4.5% and earnings growth was 4 to 5% last year. Thus, the 10% number is a little lofty but since the overall direction is up we want to be in this market in a careful and deliberate manner. Thus, we will continue to invest according to the long term trend with a goal of smoothing out the market volatility in hopes of capturing the “Salad days” like we experienced last year.

Please call with any questions or stop by for a sandwich, soup… or salad.