04 Mar 2013 Sound Shore - 2012 Annual Report ( Portfolio )
Last year saw continued sluggish economic activity for many sectors of the world economy. In the US, S&P 500 revenue and EPS are expected to have increased only marginally from 2011. Fiscal deficits stretched across the globe, unrest continued in the Middle East, and political drama dominated various country headlines. Many thought the US cliff would be an appropriate place for its politicians to visit. Stock markets are said to abhor last year’s type of uncertainty, which, if true, makes the double-digit returns of many world stock markets puzzling. To many, the S&P 500 Index’s strong 13.4% price gain may be surprising enough, but few would have guessed it would be trumped by Germany, France, and Japan, not to mention Ireland and Greece (as measured by their respective Dow Jones indices in local currencies). The offsets to the troubling economic and political backdrop, in our opinion, were the lack of competition from fixed income investments (stock yields exceeded the 10 year Treasury for the first time in over 50 years) and the promises from various central banks to keep flooding the market until private demand for funds recovers, implying interest rates might remain low for the foreseeable future. Additionally, US corporations continued to manage their labor costs well and, while earnings were flat year-to-year, returns on equity remain high by historical standards at 16%. Capital expenditures were held in check, thereby freeing up cash to be returned to shareholders in the form of increased dividends and/or share repurchases.

Our “value” investment process at Sound Shore is somewhat analogous to the market’s performance last year in that we don’t dwell on current headlines and don’t try to predict the unpredictable. Instead, we use the market’s uncertainty towards an out-of-favor stock as an opportunity to investigate whether that company is likely to soon see improving fundamentals through internal management decisions if not economic tailwinds. If we are correct, then the stock should see improving earnings versus expectations and a recovering P/E valuation towards “normal.”

In 2012, your portfolio had 10 previously unpopular stocks that returned more than 30%: Bank of America, Charles Schwab, Citigroup, Comcast, Invesco, Lowes, Sanofi, Sunoco, Time Warner, and Thermo Fisher. In particular, diversified financials Bank of America and Citigroup performed well as both companies benefited from efforts to focus on core franchises, reduce costs, and improve capital ratios.

Equally important as the financials, however, were several companies that benefitted from their management’s more optimal balancing of growth and shareholder returns. Cable service provider Comcast, a long held position, provides a great case study. We started our position in Comcast in 2007 when the company was on the threshold of significant free cash improvement derived from lower capital spending. Over the past five plus years, Comcast has been successful in the telecommunications marketplace, enhanced its portfolio through the acquisition of NBC Universal, initiated a competitive dividend, including an increase of 44% in 2012, and retired over 10% of its shares. Comcast has outperformed the market by approximately 40% and yet its shares still boast a 6.9% free cash flow yield.

Oil service provider Weatherford was the year’s biggest detractor, the result of a temporarily higher 2012 book tax rate and sluggish North American energy markets. Similarly, oil and gas producer Devon declined due to wider than normal price discounts in the US and Canada. Low end valuations for both stocks (Weatherford at 11.9 times forward P/E, Devon at $1.40 per reserve unit) leave room for significant upside as the companies execute as we believe they can.

The new year features its usual share of uncertainty and countervailing trends. Based on P/E the S&P 500 is not quite the bargain it was a year ago, but at 13.2 times is still below its long-term average of 16.0. Additionally, barring reentry into recessionary conditions, equity yields and cash generation seems sufficient to provide support for stocks as competition to fixed income investments.

Sound Shore’s research process includes an average of 700 private management meetings per year and our starting point of researching previously underperforming but sound companies puts us, we believe, in a good position to uncover favorable risk/reward investment opportunities despite the headlines.