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 Large Cap Value Wrap 40 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 and industrials 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 along with an underweight to financials hurt performance. On the positive side, Portfolio holdings within the financials sector held up much better than the Index and partly offset Portfolio detractors.
Two of the absolute detractors from performance during the quarter, Freeport-McMoRan Copper & Gold and Exxon Mobil, were in the materials and energy sector. 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. 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.
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.
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. Finance stocks Bank of America, Prudential Financial, and JPMorgan Chase also appreciated during the quarter. In particular, JPMorgan Chase benefited from being one of the most solvent firms and seems favorably 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 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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