Aristotle Value Equity commentary for the first quarter ended March 31, 2016.
Sluggish economic growth, a fragile oil price recovery and uncertainty surrounding global monetary policy led to U.S. stocks ending the first quarter just slightly above where they began, as the S&P 500 posted a total return of 1.35%. However, as is often the case, the quarter’s endpoints did not tell the whole story, as volatility abounded. How soon investors seemed to forget that the S&P 500 Index began 2016 with a decline in excess of 10% for the first six weeks of the year in sympathy with sinking Chinese shares on reports of a more significant-than-expected slowdown in China’s manufacturing economy. During that period, commodity prices continued to fall and the U.S. dollar strengthened further, making U.S. goods less competitive globally.
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About midway through the quarter, however, the tide shifted. An oil price recovery, central bank easing outside the United States and stable American economic data contributed to a rally in U.S. equities, as the S&P 500 Index surged more than 12% from its February 11 inflection point. Stocks also benefited from a weakening in the U.S. dollar; despite a strong start to the year, the WSJ Dollar Index, which measures the dollar against a basket of 16 currencies, fell 4% in the first quarter—its largest drop in nearly six years.
With respect to style, we saw a shift in performance in the first quarter. Within the Russell U.S. equity indices, so-called “value” stocks outperformed their growth counterparts across the capitalization spectrum. When performance is analyzed by market cap, mid cap companies posted the best performance, followed by large caps; these segments reported low single-digit returns. Small caps overall posted narrow losses, but the dichotomy between growth and value was greatest among the smallest companies, with small cap value advancing while small cap growth declined. Performance varied widely by sector, underscoring the importance of our commitment to broad diversification to manage risk. Eight of the ten sectors in the S&P 500 Index advanced, led by Telecommunication Services and Utilities, each up more than 15% for the quarter. Concurrently, both Health Care and Financials declined more than 5%.
Overall, international developed equity markets trailed the U.S. stock market in the first quarter on economic weakness as well as concern over the potential “Brexit,” or U.K. withdrawal from the European Union, as the June 23 date for the U.K. referendum drew closer. Continuing its aggressively accommodative monetary policy, the Bank of Japan followed the European Central Bank’s lead and lowered Japanese interest rates into negative territory. Further monetary easing by several developed market central banks notwithstanding, the MSCI EAFE Index (net) reported a total return of -3.01% in U.S. dollars. In a reversal of recent quarters, the dollar weakened against other developed market currencies, resulting in a -6.52% local currency return in the MSCI EAFE. While most developed country indices reported low-to-mid single-digit declines in U.S. dollar terms, there were some notable exceptions: resourcerich New Zealand and Canada posted low double-digit gains. At the other end of the spectrum, Italy and Israel each declined more than 10%.
On the other hand, emerging markets bounced back in the first quarter after languishing for three years, aided by the firming prices of oil and other commodities as well as central bank easing around the world. Despite looming concerns over potential credit-rating cuts, emerging market equities outperformed their developed counterparts in the first quarter, with a few notable exceptions. The MSCI Emerging Markets Index (net) posted a 5.71% total return in U.S. dollars; its gain was a more moderate 2.73% in local currencies, reflecting relative weakness in the American greenback. Latin America was particularly strong, with the MSCI indices in Brazil, Peru and Colombia all advancing more than 20% in U.S. dollar terms. A few emerging markets did decline in the quarter, however—most notably Greece, -12.23%, and China, -4.80%, both in U.S. dollars.
Amidst uncertainty over the timing of the next U.S. interest rate hike, long-term U.S. Treasury yields reported their steepest quarterly decline in more than three years. The yield on the 10-year Treasury fell to 1.784% as of March 31, its lowest quarter-end level since the end of 2012 and down from 2.273% on December 31.
On the commodity front, oil prices were extremely volatile. The 3.5% gain in U.S. crude masked its roller coaster quarter, as oil prices surged 46% from their February 2016 low (yet remained 60% below their June 2014 high). Natural gas prices, on the other hand, plunged 16% in the first three months of the year. Meanwhile, gold notched its largest quarterly gain since 1986, rising 16.5% in the first quarter. Such a leap reflected continued economic concerns as gold regained some of its luster compared to other asset classes.
Aristotle Value Equity – Performance & Attribution Summary
Against this economic backdrop, Aristotle Value Equity portfolio advanced modestly in the first quarter of 2016. The Aristotle Value Equity Composite posted a total return of 1.10% gross of fees (1.01% net of fees), modestly trailing the Russell 1000 Value Index, which rose 1.64%, and the broad S&P 500 Index, which gained 1.35%. For the year ended March 31, 2016, the Aristotle Value Equity Composite posted a total return of 1.22% gross of fees (0.88% net of fees), outperforming the Russell 1000 Value Index, which reported a total return of -1.54%, while underperforming the S&P 500 Index return of 1.78%. Longer-term performance remained strong, with the Aristotle Value Equity Composite gaining 11.37% gross of fees (10.93% net of fees) annualized for the five years ended March 31, 2016. This result was ahead of the Russell 1000 Value Index, up 10.25%, and slightly behind the S&P 500 Index, up 11.58%.
The modest underperformance in the first quarter resulted primarily from security selection in the Consumer Staples and Financials sectors. The portfolio’s lack of exposure to the Telecommunication Services sector also detracted from relative return, as it was the second-best performing sector in the quarter. (All sector under- and overweights relative to the benchmark result from bottom-up security selection rather than tactical allocation decisions.) Meanwhile, favorable security selection in the Information Technology sector added value, as did the portfolio’s significant underweight in the worst-performing sector, Financials. Overall, however, the negative factors slightly outweighed the positive in the quarter, yielding modest underperformance relative to the value benchmark.
Japanese financial services firm Mitsubishi UFJ Financial was the most significant detractor from relative return in the first quarter. Shares of large Japanese banks suffered from downgrades on the expectation that the Bank of Japan’s negative interest rate policy adopted in January would put downward pressure on earnings. However, Mitsubishi UFJ Financial Group, Inc. has the lowest exposure (only 15% of profits) to domestic lending of the major Japanese banks due to its subsidiaries, including Union Bank of California and its stake in Morgan Stanley. We met with management in Tokyo during the quarter and were favorably impressed by the candidness of management and the progress that has been made toward “westernizing” the bank, such as changing the board composition. (Now more than half of the board members are independent.) Among the catalysts we see for Mitsubishi UFJ in the coming years are the potential for continued market share gains, additional profitability enhancement and return of capital to shareholders in the form of further share repurchases and dividend hikes.
Global integrated pharmaceutical and ophthalmology firm Novartis was also a major detractor from performance. Shares of Novartis AG sold off on disappointing fourth quarter 2015 earnings, as global sales were negatively affected by the strong U.S. dollar. The company’s Alcon eye care unit was particularly weak, precipitating some management changes and reorganization of its product lines.
Despite the near-term pullback, our investment thesis remains intact. Within our multi-year investment horizon, among the catalysts we have identified for Novartis are: margin improvement due to its portfolio transformation; market share gains in eye care (via Alcon) and biosimilars (through Sandoz); cost savings realized from restructuring its procurement and manufacturing processes; and realization of its equity ownership in Swiss pharmaceutical and medical diagnostics firm Roche Holding AG.
Aggregates and construction materials producer Martin Marietta was the most significant contributor to relative return. After a weak second half of 2015, Martin Marietta Materials, Inc. rebounded on record sales and earnings for the year and a favorable outlook for 2016. Management reported margin expansion in all of its business segments, completed several bolt-on acquisitions and returned more than $600 million to shareholders through dividends and share repurchases. Given its ability to raise prices consistently in a poor construction market, we continue to see the potential for Martin Marietta to further enhance its profitability as infrastructure spending normalizes in the coming years.
Global electric utility AES was also a meaningful contributor to performance in the quarter. While all three of the portfolio’s Utilities holdings outperformed that sector within the benchmark, AES Corporation was the top contributor as management reported gross and operating margin improvements for the fourth quarter. Though year-over-year revenues fell, this decline was in line with peers. AES also raised its quarterly dividend by 10%, resulting in an attractive 4.6% yield given the low interest rate environment. Longer term, we still see considerable value in AES as the company’s experienced management team continues to execute on its strategic plan of focusing on core (competitively advantaged) markets, reducing overhead costs and returning cash to shareholders via dividends and share repurchases.
Aristotle Value Equity – Recent Portfolio Activity
During the first quarter of 2016, we sold one position and added a new investment to Aristotle Value Equity client portfolios. When EMC Corporation announced late last year that it would be acquired by privately held Dell Inc. for a combination of cash and VMWare, Inc. tracking stock, we put the position “on hold” while we analyzed the transaction. Ultimately, we decided to divest our long-time position in EMC to make room for what we view to be a more attractive investment opportunity, Amgen Inc.
To illustrate our disciplined investment process, we outline the thesis behind our latest investment here.
Founded in Thousand Oaks, California in 1980, Amgen (Applied Molecular Genetics) Inc. is one of the early pioneers of the biotechnology industry. We have long viewed Amgen as a high-quality health care company, given its decades of success in developing novel treatments using biopharmaceuticals. The company evolved over time, first applying biotechnology to oil extraction, chicken farming, specialty chemicals and dyes before focusing on palliating and curing diseases.
Amgen has expertise in developing and commercializing biologics and small-molecule compounds for disorders affecting the blood, bones and cardiovascular system and for cancer-fighting therapies. Upon building operational scale and financial flexibility, the company began acquiring biologics as well as developing them internally. In recent years, Amgen has also added operations outside the United States, including acquisitions of two privately held pharmaceutical firms: Bergamo in Brazil and Mustafa Nevzat in Turkey. Amgen has also allied with Astellas Pharma, Inc. in Japan (currently a holding in our Global Opportunities client portfolios) to develop and market pharmaceuticals.
As described below, Amgen satisfies all three criteria requisite for inclusion in Aristotle Value Equity client portfolios.
Despite our classification as a “value” manager, our process neither begins nor ends with valuation. Rather, we begin by identifying businesses we believe are of high or improving quality. In our view,
Amgen exhibits several high-quality characteristics, including:
- Physician trust supported by dominant franchises with quality reputations;
- Marketing scale, and Amgen is also actively building its sales presence outside the United States;
- Expertise in developing new compounds, as industry-leading scientists develop new compounds and serve as advisors on licensing and potentially acquiring new therapies;
- Experienced at maintaining exclusivity via patents and legal expertise, keeping barriers to entry high (e.g., patent protection for Enbrel®, for treatment of plaque psoriasis and various types of arthritis, may extend to 2028);
- Financial strength, with zero net debt and strong free cash flow generation (7.5% of market cap annually); and
- Significant global scale and financial flexibility, which can provide a competitive advantage and qualify Amgen for the “short list” of potential buyers of new pharmaceutical assets.
Once the necessary, though not sufficient, criterion of quality is met, we analyze the company’s valuation. A dearth of success with new products in recent years has brought Amgen’s valuation down to a level that we view as attractive for a company of this quality. Given recent drug approvals and Amgen’s pipeline, however, it appears to us that the lull in development is now nearing an end.
We believe attractive investments are often found in companies continually striving to become better. We refer to these companyspecific drivers—which we must identify before the market sees them to capture potential hidden value—as catalysts. Among the numerous catalysts we have identified for Amgen, which we believe will cause its stock price to appreciate toward our value target within our three- to five-year investment horizon, are:
- Growth of recently launched oncology drugs as Amgen expands their applications to other diseases;
- Growth of recently launched cardiovascular drugs, including RepathaTM to treat statin-resistant high cholesterol and Corlanor® for chronic heart failure;
- Growth and market share gains of biosimilar portfolio via inhouse development as well as strategic partnerships; and
- Shareholder-friendly use of free cash flow, including dividends, acquisitions and in-licensing of new products.
This information is for illustrative purposes only and is not a recommendation to buy or sell a particular security. There is no guarantee that the securities discussed will prove to be profitable. Please refer to disclosures at the end of this document.
Aristotle Value Equity – Outlook
So, what do we expect in the coming quarters? As our loyal readers know, our long-term investment perspective causes us to focus on the horizon, not on the waves. However, when seas are rough, we understand that it is difficult to ignore the waves.
As discussed, government policymakers around the world have been very actively intervening in the economy, attempting to spur growth and inflation. We expect this will continue.
We remain convinced that negative interest rates are not the norm. Yet in the first quarter, Japan joined many European countries in implementing this policy. While U.S. interest rates and economic growth are (for now) on an upward trajectory, it is hard to imagine that path being sustained unless joined by a majority of other countries. We believe that the problem for some time has been a lack of demand for credit, not a lack of its supply. Thus, throwing more cash where it is not needed could do more harm than good.
We believe there is a natural order to the economy that political and monetary policies have little ability to change longer term. Shortterm attempts at fixes (such as negative interest rate policies) may placate those asking for something to be done. However, other than during times of extreme distress, these unnatural hindrances to the natural order of the economy may not have their intended effects.
Thus, we at Aristotle Capital, while cognizant of macroeconomic factors over which we (and corporate management teams) have no control, choose to direct the vast majority of our efforts toward activities within our control—that is, studying and identifying unique businesses (like Amgen) that have the potential to thrive regardless of the environment.