Third Quarter 2008
The market environment during the third quarter was characterized by uncertainty, volatility, and government intervention. On one hand, investors sought safety at any cost as the yield on U.S. Treasury bills went negative. On the other hand, some investors appeared to be looking to call a bottom on the back of government intervention to bolster the financial system. Company fundamentals were largely ignored in favor of broader macroeconomic calls during the quarter. As a result, Systematic’s bottom-up focus on company-specific attributes and prospects was not rewarded during the quarter, and the Systematic Select Equity Wrap Portfolio underperformed the Russell 1000® Value Index.
The market environment can be illustrated through an examination of the performance of two factors: earnings estimate revisions and price-to-book value. Investors shunned those companies with the best (most positive) earnings estimate revisions, while rewarding those with the lowest price-to-book ratios. In many cases, the companies with the lowest price-to-book ratios were the most distressed, and in some cases on the verge of bankruptcy. However, they were also precisely the companies most likely to benefit from a government bailout. The companies with the best earnings estimate revisions did not receive nearly the same benefit from government intervention, because they had not suffered nearly as much in its absence. Furthermore, as investors grappled with the thought of a looming recession, they seemed unwilling to believe that companies with improving earnings estimates would be able to sustain those estimates in a slowing economy.
During the third quarter both absolute and relative performance were disappointing. Poor absolute performance was spread across various sectors during a difficult quarter for U.S. equities, but was most harmful in the energy, materials, and industrials sectors. From a relative performance standpoint, the vast majority of underperformance for the quarter came from stock selection. Systematic follows a disciplined approach to stock selection, so the companies in the Portfolio share common characteristics of good valuation, based primarily on earnings and cash flow, and better earnings prospects compared with peers. When those characteristics go unrewarded by investors, as they did during the third quarter, the Portfolio will likely underperform. Stock selection was worst within the industrials, financials, and materials sectors. Sector allocations also modestly hurt performance, as an overweight to the information technology sector and an underweight to financials detracted during the quarter.
Two of our largest detractors from performance during the quarter, ConocoPhillips and Freeport-McMoRan Copper & Gold, came from the energy and industrials sectors. Both sectors were hard hit by the fears of an economic slowdown. ConocoPhillips is an integrated energy company operating worldwide. The company continues to execute both operationally and financially by improving its resource exploration and production base while returning cash to shareholders via stock repurchases and dividends. It is also among the most undervalued energy companies relative to its integrated peers, but the stock underperformed last quarter due to falling energy prices.
Freeport-McMoRan Copper & Gold is engaged in the exploration, mining, and production of mineral properties worldwide. A result of last year’s merger between Freeport-McMoRan and Phelps Dodge, it is one of the largest copper companies in the world. Systematic believes consolidation in this industry is very positive for copper pricing, as there is increased discipline on the supply side. Copper prices continue to trend up as supply/demand dynamics are very tight, with China being the biggest driver, and Freeport-McMoRan continues to improve production and surprise the Street with higher volumes. In addition, higher efficiencies have lowered the cost structure. Systematic expects the company to generate up to $2.5 billion in free cash flow in the upcoming year, which should lead to more share repurchases and increased growth of the dividend. Valuation remains extremely compelling at ten times next year’s earnings, but the stock has recently underperformed due to falling commodity prices, especially in the copper marketplace.
One stock that added to performance during the quarter was BB&T Corporation, a bank holding company operating primarily in the Southeast and mid-Atlantic regions. The company is attractive for its conservative underwriting standards, a corporate philosophy that has shown up during quantitative work on the company. While no bank has been immune from the broader macroeconomic headwinds facing the financial sector, BB&T appears better-positioned than most, boasting strong capital levels that should allow it to gain market share in an increasingly challenging business environment. Added positives are its reasonable valuation and its well-covered, solid dividend rate of almost 5%, a payout whose safety company management recently reiterated to Wall Street.
The outlook for the equity markets is unclear, since home prices continue to decline, credit conditions have worsened materially, and unemployment has increased. On the bright side, commodity prices have eased substantially, and inflation readings are likely to recede significantly in the months ahead. The amount and effectiveness of government intervention remain the wildcard.
At times of extreme volatility, it can be tempting for investors to abandon their time-tested strategies due to the pull of fear and greed. However, experience teaches that it is exactly these times when it is most important to follow one’s discipline and not let emotion take over. Sticking to its discipline is precisely what Systematic is doing and will continue to do going forward.
The views expressed represent the opinions of Systematic Financial Management, L.P. as of September 30, 2008 and are not intended as a forecast or guarantee of future results.
Disclosure
Any sectors, industries, or securities discussed should not be perceived as investment recommendations. Any securities discussed may no longer be held in an account’s portfolio. It should not be assumed that any of the securities transactions discussed were or will prove to be profitable, or that the investment recommendations we make in the future will be profitable.
The Russell 1000® Value Index is a trademark of Russell Investments. Russell® is a trademark of Russell Investments. An investment cannot be made directly into an Index.
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