Investment Update from James C. Baird | Chairman and Founding Principal
April 30, 2013
Dear Valued Clients & Friends:
Final numbers are out and the U.S. economic growth during 2012’s final quarter slowed substantially. According to the U.S. Bureau of Economic Analysis (BEA), the 3.1% growth seen in the third quarter shrank to 0.4% in the fourth quarter. This is up from the initial estimates of 0.1% but still down significantly from the prior quarter. As you may recall, however, the primary driver of the decline was defense spending, which dropped by 22.2%, representing the biggest drop in over 40 years. Corporate after-tax profits rose 3.3% during the quarter, although they were down 1.1% year-over-year.
The March employment report was quite disappointing as total payroll jobs rose only 88,000. This followed a 268,000 gain in February. Analysts’ consensus forecast was for a 193,000 rise in March. January and February received net revisions of 61,000 more jobs than initially reported. The unemployment rate decreased to 7.6% in March from 7.7% in February, but the decline was due to a drop in the labor force. In fact, the U.S. Labor Force Participation Rate fell to 63.3% which is the lowest level since 1979.
Domestic equities continued their winning ways during the first quarter of 2013. The S&P 500 Index squeaked past its October 2007 closing high, setting a new record close by a mere four points on the quarter’s last trading day. For the quarter, the S&P 500 rose by 10.03%.
Durable goods orders increased 5.7% in February, but the U.S. Department of Commerce said a big part of the reason was that new orders for commercial aircraft were almost double those of the month before. Excluding transportation, orders for durable goods actually fell 0.5%, the first decline in six months. Business spending on capital goods was up 10%. March Durable Goods orders numbers will be released on April 24th. We will know then whether February’s numbers were an anomaly or the beginning of a trend.
Home prices in 20 U.S. cities measured by the S&P/Case-Shiller index were up 0.1% in January, which was 8.1% higher than last January. Phoenix, one of the markets hit hardest by the housing bust, saw the biggest yearly increase. All 20 cities had year-over-year price increases, and in all but one city, those increases were accelerating. Despite these improvements, the average home price is now only back up to where it was almost 10 years ago, still well below peak levels.
The head of the Euro Zone finance ministers’ group called the bailout agreement with Cyprus, which involved imposing a tax on large bank deposits, a “template” for managing future Euro Zone debt problems. The reference raised fears of a possible run on Cyprus’ banks and potentially those of other troubled countries. Cyprus’ central bank said that 37.5% of deposits over €100,000 at the country’s largest lender would be converted to special shares in the bank, while another 22.5% will be frozen in non-interest-bearing accounts while the country restructures its banking system.
Our view remains that the near term outlook for the global economy is mixed at best, with the possibility for both upside surprise in the latter half of 2013, as well as the always present risk of another black swan event. We have continued to trim our most conservative hedged equity strategies, and removed the last of our short-term bond “placeholder” positions which we will describe in detail below. At the same time we are very aware of the ongoing need to manage downside risk, as we are now 4+ years into this recovery.
Since our last communication in late January, we have made a handful of portfolio changes described below:
1. In early February, we added portfolio exposure to Master Limited Partnerships (MLP’s). We do not typically dedicate extensive detail to portfolio changes in our communications, but we chose to provide more commentary behind this individual decision as we believe it will be interesting to many of the readers of this letter:
a. Background on industry: MLP’s received their tax favored status in the 1986 Tax Reform Act, which created the tax-qualifying conditions for MLP structures. The MLP business focuses on the mid-stream “processing and transport” of hydrocarbons (oil, gas, etc.). Energy “consumption” has historically been relatively inelastic to changes in commodity prices. In other words, it is less impacted by the volatility of commodity price moves. MLP’s are basically “toll roads” of hydrocarbons and receive fees to transport oil, gas, etc. Successful MLP’s focus on stable and growing cash flows. The U.S. continues to see a significant energy infrastructure build-out, not only in natural gas, but perhaps even more so in oil according to many experts. In fact, if allowed to occur, the U.S.’s “energy renaissance” could create millions more U.S. skilled jobs and transform the U.S. economy. MLP’s will also likely serve as a nice inflation hedged down the road when rates rise. We believe that it is still relatively early into a longer-term U.S. energy renaissance.
b. Rationale for adding exposure: We have added 5% MLP exposure to client portfolios as a way to capture participation in this area. In addition to attractive long term growth prospects, MLP’s are also paying 6-7% dividends which have been growing in recent years. Correlations are only about 50% with equities, which indicates we should get good diversification from adding this to our models. As such, we believe this addition will be an effective way to increase our portfolio exposure to alternative asset solutions while still obtaining returns that are competitive with stocks.
c. Funding sources: We sold 100% of two of our most conservative Merger & Acquisition managers. At the time of sale, we intended on replacing this exposure in the near term with a different Mergers and Acquisitions manager, funded from within our US Hedged Equities portion of client portfolios.
d. New Portfolio Position: After extensive research and manager visits, we decided to implement this exposure by using the SteelPath MLP Alpha Plus strategy. This fund is unique in the marketplace in that it provides the tax efficient wrapper of a mutual fund, along with 25% leverage to make up for the return drag one receives due to the tax efficient nature of MLP mutual funds. This is because MLP mutual funds are structured as C-corporations, and therefore pay nearly all of the tax at the corporate level. This setup results in much lower taxes on the mutual fund, but also a lower return due to the tax avoided via the C-corp wrapper. The 25% leverage makes up for the “return drag”, thus allowing investors to receive 100% of the market exposure of an MLP portfolio, without having to own individual MLP’s. It is also actively managed by some of the best specialist managers in the business, and it avoids K-1’s, liquidity issues, and other challenges associated with individual MLP ownership.
2. In mid February, we increased our dedicated U.S. High Yield Bond exposure. Corporate America continues to slowly heal. With rates expected to stay low in the near term, likely followed by a significant rise down the road, high yield bonds continue to be an appealing area in the US bond market to capture attractive yields. With consideration given to near term high yield bond pricing, our investment committee has elected to strategically increase our dedicated high yield exposure. We have trimmed one of our U.S. Core Fixed Income managers, and placed the proceeds into our existing PIMCO High Yield Manager, effectively doubling our high yield exposure. It should be noted that we have other US bond funds that tactically increase / decrease their high yield exposure, and have maintained significant U.S. High Yield Bond exposure throughout the 2009-2013 recovery.
3. In early March, we created another MSCI EAFE Structured Note. EAFE, as you might recall, is an index of stocks from international developed nations. The funding source for this note was a short term bond fund which had been a temporary “parking lot” for a future structured note. This new note has an 18 month term and pays a 15.3% return at maturity if the EAFE index is at all positive when the note matures. It also has a 10% downside buffer, meaning that clients have first dollar protection against the initial 10% decline in this index. For additional details, please read the enclosed PDF and Goldman Sachs disclosure materials.
4. On April 3rd, we had a 12 month S&P 500 Structured Note mature. At maturity, the note provided clients a return of 100% of the index over that time period, which was 11.85%. This note had a 10% downside buffer, so if at maturity the S&P 500 was down 10% or less, clients would have received a full return of principal. Terms for new structured notes were not that compelling, so we rolled 50% of the proceeds into one of our core Large Cap Growth managers and the other 50% into one of our core Large Cap Value managers.
5. In early April, we used our most conservative Merger & Acquisition managers to fund our MLP exposure (described above). We have added a Mergers & Acquisitions vehicle, managed by Mario Gabelli, which has more flexibility in its approach. This strategy not only invests in traditional merger arbitrage opportunities (like the two holdings we sold to fund our MLP exposure), but also invests in companies that they believe are takeover candidates. It has a higher correlation with US equities than a pure arbitrage approach; as such this new position is within the US Hedged Equity part of client portfolios. To fund this portfolio change, we sold our Barclays ETN position.
6. Lastly, on April 23rd we had an 18 month EEM Structured Note (Emerging Markets equities) mature. Per the metrics of the note, as long as the index was positive at maturity (the index was up XX%), this note will pay clients a 21% return. Terms for new EEM Structured Notes continued to be poor, so we rolled the proceeds into an International Small Cap strategy managed by Oberweis. We have held dedicated international small cap exposure in the past, and wish to again add back a small allocation to this asset class.
As we move forward through 2013, we share your relief that our 2012 custodial change is behind us. We thank you again for your cooperation and patience as together we worked through this transition. Going forward we will continue to dedicate ourselves to serving your financial planning and investment needs, never being satisfied with the status quo, and always looking to ensure we remain on the cutting edge of the industry with our ability to deliver comprehensive financial planning and institutional quality investment solutions to our beloved clients.
We are honored to serve you and invite any questions or comments you may have.
James C. Baird
Chairman | Founding Pricipal