Value Investing

Thornburg Value Fund: Not All Rising-Rate Environments Are Created Equal

Thornburg Value Fund’s commentary for the third quarter 2014.

H/T dataroma

When interest rates rise, stocks become less attractive. So says conventional thinking in the investment world. But what underlies that perception? If we look at periods of rising rates, what happens to stock valuations during those times? What happens to p/e multiples when rates are rising in noninflationary environments like the current one—or in inflationary environments? With the third round of quantitative easing in the rearview mirror and rising rates on the way, these questions are important not just for fixed-income investors but for holders of the Thornburg Value Fund also.

Below we’ll look at equity market performance in inflationary and non-inflationary environments, touch on the health of the U.S. housing markets, and then discuss activity within the portfolio.

Thornburg Value Fund’s performance for the quarter

But first, a note on performance. For the third quarter of 2014, the Thornburg Value Fund declined 0.60% (for the A shares without sales charge), versus a return of 1.13% for the benchmark S&P 500 Index.

For the year-to-date, the fund rose 6.93% (again, A shares without sales charge) versus 8.34% for the benchmark. After we examine the macroeconomic themes and their possible impact on the portfolio, we’ll look at top- and bottom-performing sectors, overweight and underweights, and which stocks impacted performance.

Thornburg Value Fund: Inflation Matters

It’s an interesting exercise to note that the average valuation of the S&P 500 Index over the past 25 years is itself a seldom-reached number; valuations are often well below the average forward multiple of 16.8x, and often above it. It isn’t so much the number itself that carries import as it is the direction in which valuations are headed through a cycle. And that brings us to the question of which way valuations are headed within the context of the current interest-rate environment.

It’s instructive to look at the behavior of equity valuations in high-inflation versus low-inflation environments. Conventional wisdom has it that stock valuations (and thus prices) decline as rates rise, that p/e multiples compress, as higher interest rates signal central bank efforts to slow growth, and that those efforts often precede recession. While stocks usually do get cheaper during a rate hike cycle, they don’t necessarily have to. Let’s look at the direction of valuations in non-inflationary versus inflationary environments.

Thornburg Value Fund: Not All Rising-Rate Environments Are Created Equal

Chart 1 shows the forward p/e multiples of the S&P 500 Index in the inflationary-rate-hike environments of the 1970s (blue line), 1980s (gold), and 1990s (olive) on the vertical axis, with the 10-Year U.S. Treasury yield plotted horizontally. In those environments, with much higher bond yields / inflation pressures, the movement over time of the forward p/e ratio of the S&P 500 Index is sharply downward, meaning equity valuations compressed. This might be considered the typical understanding of equity market reactions to rising rates. But the real picture is more nuanced.

Chart 2, on the other hand, shows the forward p/e multiple of the S&P 500 Index in the non-inflationary-rate-hike environments of the 1950s (green), 1960s (gray), 2000s (red), and so far in this decade (yellow). In each of these time periods, we see that the normal slope of the p/e multiple line is upward, meaning that even though interest rates were on the rise, p/e multiples were actually expanding during these periods, with prices (likely) expanding.

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Thornburg Value Fund: Continued P/E Multiple Expansion?

Through this lens, we might conclude that during the current non-inflationary environment, with the 10-Year Treasury at a low 2.20% (as of October 14, 2014), with Europe continuing to be a bit of a mess, with China’s growth slowing, oil prices sharply lower and the dollar strengthening, there is a case for continued low inflation in the United States, and that multiples might not suffer compression over the next 18 months or so, but that instead may continue their upward trend. It’s critical to note that we are bottom-up investors and not forecasters, but there is a case to be made that U.S. markets in the months ahead may see multiple expansion rather than compression.

Market multiple expansion (or compression, for that matter) is one thing, but activity within the real economy is what ultimately counts to equity investors, so we’ll take a look at a critical component of it: housing.

Thornburg Value Fund: Pent-Up Housing-Market Demand?

Over the short term, the U.S. housing market has weakened; new-home starts and mortgage originations have been volatile, and there has been a pullback in certain housing stocks (with Toll Brothers down 16% year to date) and we see lower valuations in the sector, which has, incidentally, allowed us the opportunity to add a new homebuilder and a new homebuilding-related company to the portfolio.

But let’s look at a pair of interesting housing-demand metrics that contribute to our long-term constructive view on the sector. The percentage of shared households (this is usually 25- to 35-year-olds living with their parents) has historically ranged between 20% and 22%. During the great financial crisis, as can be seen in the blue line (left axis) on Chart 3, it spiked upwards to 24%, from which point it has not declined appreciably since 2009.

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The unemployment rate for this cohort of the population, simultaneously, spiked upward to 10% in 2008 and 2009. That rate has recently started to tick downward from 10% to below 7%, which is a material improvement. As unemployment among that group declines, they are more able to qualify for mortgages and initiate purchases, so it may follow that the percentage of shared households declines to within its normal range, and new household formation returns to its historical range, which may drive new home building and that sector’s contribution to GDP. Home price affordability still looks very good on a long-term basis, which adds to our view that this normalization may take place.

But what does this mean? How great a contribution does residential construction typically make to GDP? Historically, as Chart 4 shows, it has averaged around 4.5%. It climbed during the housing boom to more than 6%, and declined to less than 3% by 2010, from which it has begun to rise. With a recovery in new household formation underway, that contribution may climb to within its normal range, providing the U.S. economy a tailwind.

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Thornburg Value Fund: Portfolio Commentary and Activity

Within the portfolio, health care was an area of strength for the quarter, led by top-performer Gilead Sciences, Inc. (NASDAQ:GILD). Investors are awaiting Gilead’s new all-oral hepatitis C combination treatment, which may turn out to be the biggest drug ever. This new treatment will have high cure rates, and lower side effects than any other hepatitis C treatment currently available.

One of our non-U.S. holdings, China Mobile Ltd. (ADR) (NYSE:CHL), performed well during the quarter. The company is ahead of expectations in rolling out its 4G network and in attracting 4G subscribers. Recent actions by the Chinese government appear to be beneficial to China Mobile. The government is limiting the handset subsidies carriers can offer customers and is pushing three major carriers to spin off cell-tower assets into a combined tower company. These two actions should increase the efficiency and profitability of China Mobile.

Chinese internet provider Alibaba Group Holding Ltd (NYSE:BABA) performed strongly since its recent IPO. We originally did our work on Alibaba as a private company back in 2011, supporting investments in Yahoo and Softbank, both big owners of the Chinese e-commerce giant. Our in-depth research work and long-standing relationship with management positioned us well for the company’s recent IPO.

Energy was the weakest-performing sector of the S&P 500 Index, as crude prices fell during the quarter. Many of our energy investments—including Franks International NV (NYSE:FI), Total SA (ADR) (NYSE:TOT), and Inpex Corp (TYO:1605) —have business fundamentals tied to crude prices, and performed poorly during the quarter due to this headwind. One bright spot within our energy holdings was Dresser Rand, which received a take-out offer from Siemens at a premium market price. .

Galaxy Entertainment Group Limited (HKG:0027)’s stock was under pressure during the quarter due to weak gaming revenue. The Chinese government is increasing scrutiny and cracking down on corruption, which is impacting Macau’s VIP gaming customers.

Cumulus Media Inc (NASDAQ:CMLS) reported weak advertising revenue growth during the quarter. The high-margin nature of advertising revenue magnifies the impact of this weakness on profitability. Earnings and cash flow should be aided in the coming months by political advertising spending and the sale of a land asset. Even so, we have recently reduced our investment in the company.

New additions during the quarter included MasTec, Inc. (NYSE:MTZ), Micron Technology, Inc. (NASDAQ:MU), Rentokil Initial plc (LON:RTO), Helen of Troy Limited (NASDAQ:HELE), Orion Engineered Carbons SARL (NYSE:OEC), Tri Pointe Homes Inc (NYSE:TPH), and Oaktree Capital Group LLC (NYSE:OAK). Sales during the quarter included Bright Horizons Family Solutions Inc (NYSE:BFAM) (price target), Life Time Fitness, Inc. (NYSE:LTM) (deteriorating same store sales), Valeant Pharmaceuticals Intl Inc (NYSE:VRX) (strong performer for us since purchase, we have some concerns surrounding the sustainability of their model in a more competitive acquisition environment), Tupperware Brands Corporation (NYSE:TUP) (fundamental deterioration), and Softbank Corp (OTCMKTS:SFTBF) (we reduced our implicit Alibaba exposure when we bought Alibaba shares directly).

Thornburg Value Fund: Investment Outlook

While we remain constructive on the outlook for the U.S. economy, we are certainly watching global developments closely. Slower global growth, protests in Hong Kong, and the ongoing Ebola outbreak are each on top of our list of near-term concerns, and could impact growth prospects for the U.S. economy. We have continued to work to bolster the consistent earning characteristics of the portfolio to attempt to ensure that the portfolio is reasonably well positioned for any potential market outcome. This has been particularly challenging given our lack of enthusiasm broadly for consumer staple or utilities stocks in the United States (which, on a fundamental, bottom-up basis, tend to look expensive to us). In part, we are using a higher cash balance to compensate. Finally, we have increased our small- and mid-cap exposure somewhat this year, as we have found opportunities in smaller companies more compelling. This isn’t entirely surprising given the stark performance difference for the year-to-date through September: the S&P 500 Index (which represents large-cap stocks) was up 8.3%, the S&P 400 Mid Cap Index was up 3.2%, and the S&P 600 Small Cap Index was down 3.7%.

Thank you for investing alongside us in the Thornburg Value Fund.