29 Oct 2012 Sound Shore - Q3 2012 Commentary ( Portfolio ) Decelerating global economic trends, heightened tensions in the Middle East, and challenges to sovereign fiscal funding failed to stem the rise in equities in the third quarter. Much of the U.S. market’s optimism could be attributed to a (modified) old adage “Don’t fight the Feds” as central banks eased across the developed world, reducing the motivation to sell into global uncertainty. Importantly, yields on stocks compared favorably to other assets such as money market funds (nil yield) and 10-year Treasuries (1.6%) providing scant competition for investors with a long term horizon.
Our strategy over the past 27 years as value investors has been to research and select stocks of sound companies selling below their historic norms for reasons that, we believe, are often discounted and fleeting. It is not unusual, then, to find our list of best performers driven not by sector or theme, but by recognition of specific fundamental improvements.
This was the case last quarter with global pharmaceutical maker Sanofi, internet leader Google, media giant Time Warner, diversified bank Citigroup, and consumer products purveyor Procter & Gamble. The first three of these continued to win within their industries as proved by Sanofi’s extensive emerging markets footprint, Google’s double-digit revenue growth, and Time Warner’s share pickup in cable networks and studios. Meanwhile, internal improvements helped both Citi, which fortified its capital base via the sale of its retail brokerage, and P&G, where management committed to significant cost cutting.
Our biggest third quarter detractor was global utility AES which reversed its prior 2012 gains due to lower power prices and temporary operating issues in Chile. At less than 9 times earnings, AES’s valuation does not reflect potential upside from its country rationalization plan, recently initiated dividend, and future steps to direct surplus cash to debt reduction and share repurchase. Other laggards for the period included health insurer UnitedHealth Group and custody bank State Street, both of which declined about 5 percent due to group plan pricing competition and lower net interest margins, respectively.
Federal Reserve data shows U.S. household market distrust, with equity outflows having continued for five quarters in a row through June, the latest data available. A primary offset to support stocks has been strong corporate repurchase of shares, a reflection of solid corporate balance sheets and a lack of confidence to pursue growth projects. A below-norm P/E of 13.5 times forward four quarter earnings for the S&P 500 also implies that plenty of stock market skepticism remains.
Your portfolio is poised to capitalize on the underlying success of its holdings, in our opinion. It possesses a below-market P/E multiple of 11.5 times forward four quarter consensus and the median security would need to rise over 45% to achieve its historic P/E norm — the median of the past 15 years. Additionally, we estimate the companies we hold are generating free cash (cash generated in excess of capital requirements) equal to 7% of their market value, providing significant potential for dividends and share repurchases as they await greater investor recognition.