Thornburg Value Fund commentary for the third quarter ended September 30, 2015.
If there were a theme that seems to have been driving-or rather, dragging-equity markets lately, it’s concern over slowing global growth. In the United States, we are now six years into an economic recovery, but some market participants seem to believe growth of about 2.5% per year may be about all we can expect here. Overseas, concerns over the slowdown in China are dominating financial headlines and driving sentiment. It has not been an easy quarter for global equity markets, which suffered their worst three months since the depths of the eurozone crisis in 2011, with an estimated $11 trillion wiped off the value of shares worldwide.
Against this uncertain backdrop, it was a tough quarter for U.S. equity markets too, with the S&P 500 Index having declined 6.44%, erasing all its gains for the year. Likewise, the Thornburg Value Fund declined 8.28%,* trailing the index for the quarter. For the year to date, however, the Value Fund has done what we hope and work hard for it to do—protect investor capital during down markets-with a decline of 1.92% versus the S&P 500’s decline of 5.29%. So while it has been a difficult quarter, we remain focused on downside protection in shaky markets.
Our Flexible Mandate Lets Us Look Different from the Index
From a sector and capitalization perspective, a few points: your fund operates under a flexible investment mandate and has from the beginning. We’re not limited to the large-cap stocks such as those that dominate the S&P 500 Index. We can invest wherever we see value, in big companies and in small. Lately, we have found a number of small- and mid-cap stocks trading at big discounts to our calculation of intrinsic value. Over the long run, we believe the prices of these securities in the market will more closely reflect our view of these businesses, but our heavier exposure served as a drag on performance in the third quarter. With our small-cap exposure at roughly 12% of the portfolio and mid-caps at roughly 24%, we have greater exposure to this part of the market than our index (the S&P 500 Index has essentially no small-cap exposure and only about 8.5% in mid-caps). Small-caps dramatically underperformed large-caps during the quarter (the small-cap Russell 2000 Index’s decline of 11.9% was almost twice as much as the S&P 500’s 6.44% drop), and this was felt in the fund.
A Neutral View of U.S. Fundamentals
We should emphasize here that our view of U.S. economic fundamentals is pretty neutral. When we survey the landscape of economic indicators, we see an economy on reasonably stable footing. Do we worry more today about recession in the United States? Perhaps. But the crosswinds that have buffeted markets over the past few months may be just that—crosswinds—driven by fleeting factors.
We’ve said before in this space that we believe a rising-interest-rate environment will be more constructive for active managers. The second quarter, with weak global market performance and falling interest rates, was a tougher environment. This showed in the leading and lagging sector performers in the S&P 500. The consumer staples and utilities sectors led the way, while the energy and materials sectors were the worst performing. The sorts of stocks we like, especially in the leading sectors, were relative underperformers. As we’ve seen before, periods of economic uncertainty have helped propel flows into what are viewed as the safest equity investments—what we call “expensive defensives.”
Health Care Catches a Cold
Health care was also very difficult during the quarter. This is somewhat surprising as the health care sector often acts defensively in tough economic environments. This is a presidential election cycle; candidates are starting to float specific policy proposals for public scrutiny. And it was the prospect of prescription drug pricing reform that, late in the quarter, sent the health care sector into a tailspin. On September 21, Democratic presidential front-runner Hillary Clinton responded to a story in the New York Times on inflated drug pricing via Twitter, saying “Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on.”
Indeed, she did. Mrs. Clinton was referring to a story in the New York Times on a 62-year-old drug called Daraprim, which was acquired in August by Turing Pharmaceuticals. Turing had raised the price for one tablet from $13.50 to $750.00, sparking a storm of protest. As the Times notes, there is growing concern about mammoth price increases on drugs that have been on the market for some time—some of them generic—that have been relied upon by doctors and patients for years.
The Affordable Care Act (ACA), it can be argued, solved several problems in the health care system, most notably reducing the portion of the U.S. population that is uninsured. But drug pricing was not among the problems solved. Even with a Democratic president, a Democratic house, and a filibuster-proof 60 votes in the Senate (before Senator Kennedy’s passing), drug pricing was left unaddressed by the ACA. So when a major presidential contender with a history of advocacy in the field proposes a plan to bring those costs under control, investors in the health care sector listened—and stocks of many of those companies sank. The selloff was quite dramatic. Health care accounted for nearly one fourth of the S&P 500’s decline for the quarter.
Our role as active managers is to evaluate the long-term fundamentals of individual companies, and in recent quarters, we have found compelling values in health care, in firms such as Seattle Genetics and GlaxoSmithKline, to name just a pair. Since we’ve seen more value there, our exposure in the sector has been heavier than that of the market, and health care detracted more from the fund’s returns than it did from the index. But again, our job as individual stock pickers is to try to uncover value at what may be tumultuous times in certain areas of the markets, when those areas are out of favor. We believe the recent action in the space is disjointed from the fundamentals, which have not changed so far.
Active Management Lets Us Choose Where a Passive Investment Can’t
With sentiment in a given sector in a shambles and likely to stay that way, fundamentals may not matter much over the near term. But over the long term they will, and that points to why truly skilled active managers, who don’t have to hold every company in the index, can outperform over time. We can search the wreckage for opportunity that may pay off 12 months down the road, and if you’re an index investor, you have no choice but to buy the entire wreckage. So if you have not yet done so, take a look at our video on active management at thornburg.com/videos. It will give you a feel for how we see ourselves and our duty to shareholders and investors.
While recent crosswinds have shown that we won’t outperform every quarter or every year, these corrections provide ample opportunity for us to do what we set out to do when the fund was launched in 1995: to buy promising companies—at a discount to their intrinsic values.
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