Wedgewood Partners Q3 Letter
Review and Outlook: Our Composite (net-of-fees) gained approximately +8.76% during the third quarter of 2013. This compares favorably to the gains in the Standard & Poor’s 500 Index of +5.24% and +8.11% in the Russell 1000 Growth Index. Through September 30, our year-to-date 2013 performance of +17.4% trails both the stock market and our benchmark of 19.8% (S&P 500 Index) and +20.9% (Russell 1000 Growth Index).
During the quarter we trimmed back positions in Charles Schwab and Cognizant Technology and we added to existing positions in Perrigo. Our only new position was the purchase of M&T Bank (our first new purchase since October 2012). We did not eliminate any holdings during the Quarter.
Our largest contributors to performance during the quarter were Cognizant Technology (+31.1%), Schlumberger (+23.3%) and Gilead Sciences (+22.6%). Our largest performance detractors for the quarter were Monster Beverage (-14.1%), Coach (-4.5%) and M&T Bank (-3.7%). While we are pleased with our absolute and relative performance during the 3rd Quarter, particularly in the context of the current four-and-a-half year bull market, our year-to-date performance has been challenged by current macro-related investment process headwinds.
In terms of current portfolio positioning, due to the net trimming of a few holdings during the second quarter, portfolios are overweight in cash, though we expect it to be put to work as soon as the market serves up opportunity.
However, at the present time, our bench of prospective new companies to invest in is still quite bare. It is not that we haven’t identified terrific companies that we would like to own – there are plenty in fact. The gating factor continues to be valuation, particularly in the context of a booming bull market. That said, our current short list of our most attractive purchase candidates largely reside within the current portfolio.
Our philosophy of investing as business owners continues to drive a process that seeks to maximize the reward of long-term equity appreciation and minimize the risk of permanent capital losses. While we own high-quality, exceptionally profitable companies that can grow at a double-digit rate over a market cycle, we also will not pay just “any price” for these qualities, paying particular attention to valuations. In terms of quantifying these factors, through the third quarter, we have constructed the portfolio with companies that, using IBES estimates, exhibit a weighted average, long-term earnings growth rate that is over 10% faster than our Russell 1000 Growth benchmark, yet the price to earnings ratio of the portfolio is roughly 15% cheaper than the benchmark. Over a three to five year period, we expect our upside market capture and downside market capture ratios to fall in-line with these metrics.
In Investing 101 we all learned that the value of any business is the cumulative future cash flow generated over the life of the business – discounted back to the present by a combination of an investor’s required rate of return and in consideration of the time value of money. This seemingly simple, straightforward construct occurs in anything but real-time as corporate prosperity; expectations of risk and interest rates are three variables that are in a constant state of flux. At any given time, one variable may be so dominant as to render the other two irrelevant. However, without question, over longer periods of time – say, five-plus years – corporate prosperity (or the lack thereof) emerges as the most dominant variable in wealth creation. Indeed, successful businesses have been the elixir of wealth creation on these shores since Henry Hudson sailed into harbor of New York in 1609. Even the casual observer of the stock market can recite any number of the most successful publicly traded companies of the day. Said casual observer immediately understands too why Warren Buffett and Bill Gates are ranked as the first two individuals on the Forbes 400 list of the world’s richest people – Microsoft and Berkshire have been meteoric in their wealth creation over the past several decades. However, with this Letter we continue to chronicle the out-sized impact that the Federal Reserve’s Quantitative Easing (QE) monetary policy as had on the stock market. Indeed, more than 100% of the stock market’s gains since this bull began in 2009 have come during the weeks of Fed purchases.
After US Federal Reserve Chairman Ben Bernanke whispered the “T-word” (taper) back in May, the US Federal Reserve Open Market Committee recently surprised financial markets by maintaining the pace of asset purchases, which put talk of a “taper” on hold for, at least, the next few months. While we do not position the portfolio according to monetary policy, we think it might be helpful to note what we perceive to be its short-term effects on our relative performance. During much of the quarter, our investment process was in favor relative to the benchmark (Russell 1000 Growth Index), though, year-to-date the market has more amply rewarded investment factors such as low profitability and high valuations, both of which run counter to our process of owning excellent businesses that exhibit peer-leading profitability and trade at historical, relative and absolutely attractive levels. In addition, if yields available to investors revert to all-time low levels, especially given the prospects of perpetual monetary easing, we would expect a “reach for yield” could re-emerge, which we think is another form of speculation gone haywire. In any case, and regardless of interest rates, we expect that our portfolio of best-in-class companies will continue to generate superior profitability and growth, relative to the average business, and we will be patient until the market inevitably serves up valuation disconnects, which is when we plan to take full advantage of the opportunity.
While “QE” has no doubt revived the animal spirits of investors and speculators across nearly every asset class, paradoxically, the one class of “investors” that is absent from Chairman Bernanke’s bash is corporate CEOs. The paradox, as it were, is that with corporate profit margins at post-World War II highs – as well as in the context of a long-in-the-tooth bull market – one would think that any rational CEO would minimize share repurchases and dividends payments so that every plug nickel of cash on the corporate balance sheet, plus retained earnings, would be aggressively re-invested into capex so as to capture these once-in-a-generation highs in profitability. Indeed, according to J.P. Morgan the Dividend over Capex Ratio recently matched the +60-year high set in 2004. An aging corporate asset base will ultimately generate less cash, meaningfully so, without the concomitant investment (capex) in fresh assets.
We echo Jeremy Grantham’s words: the system is not functioning properly. To be blunt, QE is like a morphine drip on the economy, the term structure of interest rates, and speculative behavior – and has distorted the rationality of Corporate America. Chairman Bernanke’s “Great Experiment” looks to be eagerly adopted by his likely successor Janet Yellen. We don’t know when it will end, but it will. Given the market’s and economy’s addiction, and both psychological and physical dependence on the Fed’s opiate, the inevitable withdrawal won’t likely be pleasant.
Philosophy and Process