26 Apr 2012 Legg Mason Value Trust - Q1 2012 Commentary ( Portfolio )
The first quarter proved both profitable and eventful for investors, extending the powerful rally that began in October 2011. Most indexes reached post-crisis highs and a few did even better, attaining notable longer-term heights. On a sector basis, during the first quarter, the U.S. market was led by financials, with information technology and consumer discretionary close behind. In addition to a strengthening economy, regulatory and political action drove the biggest returns as the quarter came to a close. As a group, the financials reacted positively to the conclusion of the Fed’s latest round of stress tests, with many large banks able to increase both their dividend payouts and share repurchase programs. Health care names rallied on news that during oral arguments the U.S. Supreme Court expressed skepticism toward the individual mandate of the Affordable Care Act. This portion of the law requires citizens without coverage to purchase private health insurance. Among the lagging sectors, utilities put in the only negative performance.

U.S. investors found little to worry about in the first quarter, with economic data on balance showing signs of sustained strength. At the same time, this period seems eerily similar to the starts of 2010 and 2011, when rallies ran aground on the rocks of double-dip fears. On this front, we found the Economic Cycle Research Institute’s (ECRI’s) March 22 presentation – which argued that the combination of lower baseline growth and higher economic volatility in developed markets will make for more frequent recessions – very relevant for investors focused on the sustainability of the market’s rally. Markets are discounting mechanisms; they tend to reflect at least in part the effect of a recession regardless of whether one is actually happening. Both the 2010 and 2011 declines, pullbacks of - 19% and -16%, respectively, came after similar rallies and despite the economy ultimately avoiding a recession. Even if there are not more frequent recessions as ECRI argues, it may not matter to investors if they confront more frequent “growth scares” that drive stock prices lower.

Through the end of March, U.S. economic data has been either largely positive or quiescent. However, we believe there are more than enough building blocks to fashion a 2012 version of the growth scares that plagued 2010 and 2011. As if on cue, April opened with a weak jobs report that appears to be a perfect first step. All that would be required to make 2012 rhyme with 2010 and 2011 would be a further spike in oil prices driven by the standoff over Iranian nuclear ambitions, a further weakening in the eurozone, a hard landing in China that disproportionately saps global growth, and the ever-present possibility of an unforeseen event. If enough of these threads come together, the probability of revisiting the market draw- downs of 2010 or 2011 escalates.

The collapse in correlations and volatility over the past few months raises the odds that the inevitable correction comes sooner rather than later. While many investors have been contentedly enjoying the +28% rally in the S&P 500 from October to March, our attention has been drawn to the record collapse in correlations. Over this time, the median three- month correlation of S&P 500 stocks to the index has fallen from 0.85 to a multiyear low of 0.47, close to the average median correlation since 1974. Pollet and Wilson’s 2008 paper “Average Correlation and Stock Market Performance” suggests collapses in correlation result in powerful equity returns, which is exactly what we have seen. However, the opposite stands true as well. Periods of low correlation set up below-normal average returns. Likewise, volatility, which also was substantially elevated relative to its long-term average in the summer and fall of 2011, has fallen to within a few points of 22- year lows. Similar to correlation, periods of high volatility tend to set up high returns, and periods of low volatility – like right now – tend to set up periods of low returns. With the ingredients for another growth scare appearing to coalesce in early April, investors would do well to remain focused on the long-term opportunity presented by current equity valuations, while weathering the storm of short-term concerns.

Apple reported blockbuster results for its fiscal first quarter, sending the stock on a tear to above $600 per share. The tech giant reported earnings nearly +40% above consensus estimates as sales of iPhone and iPad units more than doubled over last year, and gross margin expanded over +600 bps. The company continues to develop new products (with fanatic subsequent demand), and it has significant room to grow internationally, most specifically in China. Management also recently announced new capital allocation priorities in returning cash to shareholders in the form of a $2.65-per-share quarterly dividend1 (for a 1.7% yield), and a $10 billion share repurchase plan. However, the stock trades at around 14 times forward earnings, approximately in line with the market, despite growing earnings at nearly twice the market's rate.

The financials sector was the worst-performing group in the S&P 500 during 2011, but it rebounded to lead the index in the first quarter as the U.S. economy continued to show signs of improvement and fears of a debt crisis in Europe subsided. Large-cap banks, including Citigroup and JPMorgan, benefited from this upswing and were among the largest contributors in the portfolio over the past three months. Both companies were in the headlines last month as the Federal Reserve completed its 2012 Comprehensive Capital Analysis and Review (CCAR) for the 19 largest banks in the U.S. JPMorgan was among the 15 banks that passed the stress test convincingly and received the Fed’s approval to initiate a buyback program and raise its dividend. The bank’s board promptly authorized a $15 billion share-repurchase plan, $12 billion of which would be utilized this year, and raised its dividend by 20%, to a 2.8% yield. Citigroup, on the other hand, was not allowed to authorize a buyback or raise its dividend, as it would miss the minimum capital requirement initiatives if it returned capital to shareholders.

Despite the recent rebound, financials trade below the market on 2012 price-to-earnings (P/E) and price-to-book (P/B) multiples as investors adjust to a new regulatory framework for the companies. Higher capital buffers will pressure large banks’ returns, but we believe that expectations embedded in the stock prices of Citigroup and JPMorgan are far too pessimistic and that these names present attractive risk-reward trade-offs for long-term investors at current levels.

The energy sector underperformed the broader index in March as commodity prices cooled their ascent from the October trough. Hess was a detractor from performance as integrated oil companies began to sell off shortly after we initiated a position in the name. We continue to like the stock, as it is the most attractive among its peers in terms of cash flow and we also like management’s recent actions to de-risk their portfolio and improve margins.

Norfolk Southern detracted from portfolio performance during the quarter as coal volumes depressed revenue and earnings. As natural gas prices continued to fall and unseasonably warm weather swept through major U.S. population centers, utility coal volumes, which account for nearly a quarter of Norfolk Southern's profits, fell -15% year over year. On the other hand, coal remains competitive with other electricity-generation methods in the long run, causing coal pricing to be a strong tailwind for Norfolk Southern, despite volume concerns. Over a multi-year period, we think natural gas and weather issues are short-term cyclical concerns, creating an attractive entry point into this stock for long-term investors.

Groupon has proved to be one of the most controversial IPOs in history, evidenced by the elevated trading volatility in the stock since inception. Shares closed the first quarter approximately -10% below their IPO price after management reported a slight but unexpected loss for the fourth quarter. The stock reacted negatively despite above-consensus revenue guidance for the first quarter. At the end of March, Groupon restated their fourth-quarter income statement due to an increase in reserve accruals for returns and disclosed that its auditors said the company had a “material weakness in controls” related to its financial statement close process. Despite this recent negative development, we believe investors are too pessimistic about the potential for earnings to disappear quickly, which is atypical for an advertising platform generating this level of revenues. Meanwhile, we believe Groupon's poorly understood competitive strengths, combined with the growth potential of the industry as a new form of advertising, provide a compelling valuation and significant upside potential.

Outlook
Despite the financial market’s inherent complexity, there are often periods where one-dimensional themes drive the action. Recently, we have had to endure incessant chatter and repositioning around “risk-on” and “risk-off” swings in the market. We believe these swings are natural aftershocks to the major market earthquakes of the busted Internet and housing bubbles. The monetary policy response to these earthquakes, in the form of an extended period of near-zero short-term rates, has created its own major market driver. Low short-term rates are pushing investors to chase current income, resulting in a drastic impact on valuations across both the fixed-income and equity markets.

Gauging the demand for yield is the first step in understanding this major market lever. According to flow data from the Investment Company Institute (ICI), during the last five years investors pulled $486 billion from domestic equity funds while putting a record $977 billion into fixed-income funds. This massive shift in investor preferences has driven the 10-year Treasury2 note to a negative real yield, meaning its nominal yield of about 2% is below the rate of inflation. This flood of money has also pushed the yield on “junk” bonds down to approximately 8%, a level approximately equal to the earnings yield (current earnings divided by price) on the S&P 500. Equity investors, like us, love picking on the paltry returns available in fixed income, and Shelby Cullom Davis’ pithy descriptor of bonds being priced to generate “return-free risk” will continue to make the rounds well beyond Warren Buffett’s recent annual letter.

The yield chase has also had an outsized impact on equity valuations. Again, according to ICI flow data, from the beginning of last year through February 2012, equity-income funds have taken in a record $54 billion, while all other equity funds suffered net withdrawals of $36 billion. According to Empirical Research Partners, this has pushed the valuation on the highest-dividend-yielding and highest-payout stocks to 60- year highs. My close friend Jim Morrow of Fidelity Investments recently fleshed out the dividend yield valuation lever in an excellent, but somewhat technical paper. Jim’s data showed that as short-term yields approach zero, high-dividend-payout stocks get progressively more expensive and non-dividend- paying stocks get progressively cheaper. Jim argues that the same risk-seeking investor behavior that drives down yields in fixed-income markets bids up the value of high-dividend- payout streams. Conversely, equity earnings that are retained and not paid out as dividends are viewed skeptically and garner an increasingly low valuation.

Fortunately, the market has provided us with a flanking maneuver that can generate respectable current income, and a potentially attractive expected total return. Equities with low payout ratios, but dividend streams rapidly growing at or above 10%, are selling at a historical valuation discount. In a pattern we see across the market, investors remain extremely skeptical of the future and show little willingness to pay much for future growth, in all its various forms. The irony with dividends, however, is that the S&P 500’s dividend payout ratio of approximately 30% is near all-time lows while the cash flow support for dividends is at historically high levels. In other words, there is ample room for many U.S. companies to increase their dividends at attractive rates for a long time, and the valuation premium investors are attaching to dividends is incentivizing management teams to deliver more of what investors want. Essentially, if a company with good earnings and cash flows seeks a higher valuation, the market is providing a pretty clear playbook.

As investors increasingly look to equities for yield, we are encouraged that valuations of equities beyond high dividend paying stocks may benefit. If so, real long-term value will start to be realized, and we are positioned well for this extremely attractive opportunity.