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 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.
The majority of underperformance for the quarter came from stock selection in the materials, industrials, and energy sectors, as investors priced in a global slowdown, if not a recession. From a sector allocation standpoint, overweights in the information technology and materials sectors also detracted from performance. On the positive side, stock selection was strongest within the troubled financials sector and partly offset the aforementioned detractors.
Two of the absolute detractors from performance during the quarter, Exxon Mobil and Noble Energy, came from the energy sector, as a substantial drop in the price of oil caused investors to sell companies linked to the commodity.
Exxon Mobil has the most leverage to higher global oil prices among the integrated oil group, so the stock pulled back as oil prices fell during the quarter. However, the company continues to increase its buyback program, as cash flows have hit record high levels over the last few years. Systematic expects this trend to continue as oil supply and demand dynamics remain tight globally. Also, valuation is currently at the low end of its historical range, and Exxon has one of the highest return on capital employed (ROCE) ratios in the group.
Noble Energy, an oil exploration and production company, was hurt by falling oil prices during the quarter. It remains in the Portfolio because, in Systematic’s opinion, the company is executing its strategy well as production rates continue to come in at the high end of expectations. It also has been doing an impressive job controlling costs and has a relatively low risk project pipeline. As such, Systematic believes there is an upside to Wall Street analysts’ earnings projections. Furthermore, its most recent conference presentation gave increased confidence in the exploration part of the business. Given the recent pullback in the stock, we believe the valuation is at the very low end of its historical range and is oversold. Similar to Exxon and Nobel, another energy holding, Williams Cos., also struggled last quarter and hurt Portfolio performance. Within the materials and industrials sectors the worst performers were Freeport-McMoRan Copper & Gold and Walter Industries, respectively.
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. JPMorgan Chase also performed well during the quarter and seems well positioned after the acquisition of Bear Stearns in mid-March and Washington Mutual late last quarter.
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 remains the wildcard.
At times of extreme volatility, it is often 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 your discipline and not let emotion get the best of you. 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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