24 Jul 2012 Legg Mason Value Trust - Q2 2012 Commentary ( Portfolio )
During the second quarter of 2012, equity returns cooled from the torrid pace set during the first quarter as some macro economic data pointed to slowing growth and the EU debt crisis returned to headlines. Stocks sold off early in the quarter as the Federal Reserve indicated a diminishing appetite for further easing, saying additional action would require “severe circumstances.” In addition, March, April and May non-farm payrolls missed consensus estimates by wide margins and reports out of China pointed to slowing economic growth out of the world’s second-largest economy. Compounded with the EU debt crisis, demand for commodities collapsed sending oil down -18% in May alone. Reports postulating a “Grexit,” Greece exiting the euro currency, swirled during the quarter, but the Greek population ultimately decided to elect the pro- bailout and pro-euro New Democracy party. As conditions deteriorated, heads of state and central banks stood ready to implement policy changes and provide further easing. Specifically, the Federal Reserve added $267 billion to “Operation Twist” and extended the program through the end of 2012 due to slowing consumer spending and employment growth. The program aims to lower long-term rates, which should help ease strain on the financial system and spur lending. Spain announced a $24 billion bailout for troubled lender Bankia, effectively nationalizing Spain’s third-largest banking institution. Finally, during the late June EU summit, leaders decided to speed the creation of a singular regulatory body for banks and bolstered support for ESFS and ESM, EU bailout funds. The unconventional efforts late in the quarter resulted in equities posting their best June gains since 1999. Despite weakening financial conditions that resulted in government intervention, two-thirds of S&P 500 companies reported consensus-beating operating earnings, with 10% meeting expectations. Health care stocks reacted to reports and speculation surrounding the Affordable Care Act, colloquially known as “health care reform” or “Obamacare.” Ultimately, the Supreme Court voted five to four in favor of the individual mandate, because the Constitution grants Congress the power to levy taxes.

Although equities posted one of the strongest Junes in over a decade, second-quarter returns eroded last quarter’s gains, with the Dow losing -1.9%, the S&P 500 shedding -2.8%, and the technology-heavy Nasdaq composite trading down -4.8%. The best-performing sectors were telecom services and utilities, returning +14.1% and +6.6%, respectively, while consumer staples gained +2.9% and health care jumped +1.8%. On the other hand, consumer discretionary, industrials, and materials lost between -2.6% and -4.2%. Energy, financials and information technology posted the largest losses of Q2, falling -6.0%, -6.8% and -6.7%, respectively. Large-cap stocks outperformed small-cap, which outperformed mid-cap names. Specifically, the large-cap Russell 1000 Index dropped -3.1%, the small-cap Russell 2000 Index traded down -3.5%, and the mid-cap Russell MidCap Index lost -4.2%% during the quarter. Value stocks outpaced their growth counterparts, as the Russell 1000 Value Index shed -2.2%, compared with the -4.0% slide in the Russell 1000 Growth Index.

Ecommerce platform eBay added to portfolio performance as a beat-and-raise quarter erased fears of a declining Marketplaces business. Despite what is arguably a European recession and mixed economic growth in the U.S., Marketplaces managed to post double-digit growth in non- vehicle gross merchandise value (GMV) traded on the side and company revenue. Investors had previously worried that the Marketplaces business would continue to lose market share in ecommerce, but we believe management's prediction of maintaining share is more than possible if growth remains at current levels. In addition, PayPal revenue jumped more than 30% and improved take rates, solidifying eBay's spot as a leading payments platform. Shares of eBay remain attractive, and we believe the market still undervalues the Marketplaces business and underappreciates PayPal's odds of maintaining its rapid growth.

Shares of online retailer Amazon contributed to portfolio performance, ripping higher following blow-out earnings. Amazon's traditionally razor-thin operating margin widened, pummeling consensus estimates, as revenue mix shifted toward high-margin third-party sales. Prior to the announcement, analysts and investors worried that the introduction of Kindle Fire may have cut deeper into operating margins than management forecast. In addition to the traditional online business, shares of Amazon offer attractive long-term growth prospects in digital content, cloud computing and local commerce. We believe Amazon's Kindle Fire device strategy positions them well to maintain or grow share of media sales despite ongoing transitions from physical to digital formats. Despite torrid growth and consistent execution, shares of Amazon trade just above one times forward sales, which is attractive relative to historical averages.

U.S. airlines, including United Continental, outperformed the broader index as jet fuel prices fell sharply in the second quarter. Airlines have continued to successfully pass costs to customers through pricing and charges for incidentals, while reducing capacity and increasing focus on improving returns on invested capital. Going forward, we believe that the airline industry is undergoing structural changes that could warrant multiple expansions and create strong future upside potential for United Continental.

PepsiCo shares rose steadily during the second quarter on the back of better-than-expected first-quarter earnings, an increase in its quarterly dividend, and reports of activist investor Relational Investors initiating a stake in the global beverage giant. Pepsi has increased sales in each of the past 10 quarters and met or beaten analysts' earnings and sales forecasts in each of the past eight, yet the stock is discounting negative growth into perpetuity at current levels, based on our analysis. Pepsi's capital allocation policy has also been very shareholder-friendly, and management expects to return $6 billion to shareholders in 2012, equaling almost all of its free cash flow (FCF) and representing a 6% owner's yield2. Further, the involvement of an activist shareholder hints at additional measures to unlock shareholder value. Trading at 17x 2012 and 16x 2013 P/E multiples and a ~6% FCF yield, we believe Pepsi has the potential to generate above-market returns for long-term shareholders.

Fabless semiconductor manufacturer Marvell Technology detracted from portfolio performance during the quarter as skepticism over hard-disk-drive unit growth weighed on the semiconductor industry. The stock was also hurt by the threat of share loss in Marvell’s wireless segment. On the other hand, Marvell posted better-than-expected growth in the first quarter of the April 2013 fiscal year as the hard drive disk supply chain normalized and Marvell gained share in notebook and enterprise drives. We believe the market underestimates Marvell’s growth potential in hard disk drives, solid state drive (SSD) controllers and other future growth opportunities, providing a compelling valuation and significant upside potential.

Ford shares fell more than 20% in the second quarter despite a solid first-quarter earnings beat and positive comments from management. The company reported record North American operating margins well above 2011 numbers and maintained guidance above consensus for the year. Investors, however, paid attention to losses in Europe and Asia and traded out of the stock due to weak second-quarter expectations, in our opinion. Our investment case is reaffirmed by Ford's strong performance in the U.S., and we expect the new global product platform will provide additional tailwinds in global markets. Furthermore, we believe management’s recent moves to de- risk their pension liability is a strong step toward pushing ratings agencies Standard & Poor’s and Moody’s to upgrade Ford to investment grade, a move that Fitch made just before the earnings release.

JPMorgan shares dropped nearly 10% in early May after the bank disclosed a large, unexpected trading loss stemming from a strategy designed to hedge its balance sheet in a stressed credit environment. The bet was well publicized throughout the quarter and the position incurred further losses as other traders took counter-positions. While the event raises questions about oversight and the ability of CEO Jamie Dimon to manage such a large and complicated organization, we believe that despite this, JPMorgan is a high-quality enterprise with a strong management team and this event is an outlier. From a valuation standpoint, we maintain that the current price at nearly half book value is not discounting the bank’s strong balance sheet and earnings power, nor the macroeconomic tailwinds in place, including increased capital market activity and a pickup in the U.S. housing market. JPMorgan remains a high-conviction idea for us and we have used the stock's recent weakness to add to the position.

MetLife’s stock has been punished since mid-May when the Federal Reserve announced that the insurance company did not meet the minimum capital requirements of the CCAR stress test. This failure, coupled with uncertainty surrounding the company’s transition to a non-bank systemically important financial institution (SIFI), has increased investors' skepticism about MetLife's ability to return cash to shareholders in the near term. The fact that the Fed has not yet conferred with management about rerunning the stress test leads us to believe they will not oppose MetLife’s de-banking transition, which will be much more favorable to their capital structure. In addition, in May management detailed its new strategy to reach an ROE of 12% to 14% by 2016, which assumes a repurchase program of approximately 15% of the company’s current shares outstanding. Trading at only 60% of book value with a dividend yield3 well above the risk-free rate, we believe this stock more than discounts the near-term obstacles.

Groupon shares dropped sharply on April 1 after the company restated its fourth-quarter income statement due to an increase in reserve accruals for returns and disclosed that auditors had separately concluded the company had a “material weakness in controls” related to its financial statement reporting process. The stock remained depressed through the quarter despite management reporting positive earnings in the first quarter above analyst expectations, as billings more than doubled and marketing costs decreased as a percentage of sales. We continue to believe the company’s business model is misunderstood by the market and current prices provide significant upside potential for patient, long-term investors.

Outlook

We have more confidence in the future than most people, and certainly more than what is currently reflected in market prices. To be fair, this really isn’t saying much. The current 10-year U.S. Treasury note has a negative real yield, which according to Gavekal Research suggests the U.S. economy should shrink by approximately 0.5% annually over the next decade — a worse economic outcome than the Great Depression. Commensurately, the equity risk premium (ERP) suggests U.S. equities are priced for an expected return of over 6% versus the current Treasury yield, which is a multi-decade high premium for U.S. equities and reflects no expected earnings growth. This level of pessimism in the future reflects a bubble, in my opinion, as the flight to safety has become a stampede.

The flight to safety also hurt our relative performance in the second quarter. At a sector level, our performance would have benefited from owning utilities and telecommunications stocks, which traded strongly due to their high dividend yields and resulting bond proxy status. We chose not to own them. Similar to overpriced bonds, utilities and telecommunications stocks are trading at historical valuation premiums to other sectors. Other cheaper sectors, primarily technology and health care, should grow their respective cash flows and dividends at a much higher rate than the bond proxies, and, in our opinion, are mispriced relative to their total return potential. Essentially, high current dividend stocks are generally very expensive, while dividend growth potential is historically cheap.

At a stock level, the Fund’s biggest detractors were Marvell Technology, Ford Motor, JPMorgan and MetLife. Every stock the Fund owns has an attractive gap between market price and our estimate of intrinsic business value, and an investment case explaining why the market’s embedded expectations are likely wrong. Especially when stocks underperform, we attack our investment case to assess whether our appraisal of business value is incorrect. If we decide our original investment case is wrong, we sell the stock. This quarter the investment cases of these detractors continued to hold, and we added to the names as their price declines simply increased their expected return potential. This was true even for JPMorgan, as the Chief Investment Officer debacle erased approximately $30 billion in market value for what will prove to be a much smaller ultimate loss as the malfunctioning hedge is wound down. Collectively, all these detractors are trading at less than 8x this year’s earnings and about 1x book value, despite an average 2.5% dividend yield, and 13% returns on capital. The current prices are simply not justified by the prevailing fundamentals.

The key question as we move into a new quarter is whether the flight-to-safety bubble can be sustained. It is not easy to maintain extreme levels of pessimism or optimism in prices, which is why bubbles ultimately deflate. Unfortunately, valuation alone is not a timing mechanism, and the fears of continued policy errors and a banking crisis in Europe are legitimate. The slowdown in China is also real, and continues to manifest itself in weaker orders for some U.S. companies. Both of these macro overhangs argue for a continued flight to safety, but are countered by ongoing material improvements in the U.S. The U.S. has some very tangible tailwinds, as the housing cycles appears to be truly bottoming, shale oil and gas exploitation has opened up a comparative energy cost advantage, and innovation in technology and health care continues to be a huge competitive advantage.

We believe these U.S. tailwinds will strengthen and sustain U.S. growth, which is clearly not reflected in bond and equity markets priced for zero to negative long-term growth. Most importantly, we remain confident the Fund is positioned to take advantage of the historically wide gap between price and value. Our investments, in aggregate, enjoy fundamental characteristics that are superior to the market on average, but valuation metrics that are more attractive. This should inevitably lead to a long cycle of price and value convergence, as extreme investor pessimism erodes with time.