Investments are based on fundamental and detailed research and analysis, with particular emphasis on stocks with low absolute and relative P/E ratios:
- From a starting universe of the 1,250 largest U.S. equities, we methodically identify the least expensive based upon absolute P/E and P/E versus a company’s historic norms.
- The opportunity set of approximately 250 are subjected to our “value check” process which confirms valuation attractiveness.
- We then conduct thorough fundamental research on the resulting list of 80-100 companies, which typically includes visits and conversations with company management, competitors, customers, analysts, etc.
- We develop our own earnings, cash flow, and balance sheet models and cross check our own normalized estimates with company management and also with Wall Street analysts.
- We prepare detailed valuation models to develop price objectives.
We sell a stock if the company fails to meet our fundamental performance objectives or when it reaches our price target.
Period: Q4 2012
Portfolio date: 31 Dec 2012
No. of stocks: 40
Portfolio value: $1,448,339,000
|Stock||% of portfolio||Shares||Recent activity||Reported Price*|
|hist||STT - State Street Corp.||3.15||971,800||Reduce 10.14%||$47.01|
|hist||TXN - Texas Instruments||3.08||1,441,300||Add 0.03%||$30.94|
|hist||AIG - American Int'l. Group||3.04||1,247,500||Add 50.52%||$35.30|
|hist||COF - Capital One Financial||2.96||739,900||Add 3.48%||$57.93|
|hist||GOOG - Google Inc.||2.95||60,300||Add 10.04%||$709.37|
|hist||BAC - Bank of America Corp.||2.94||3,670,600||Reduce 5.85%||$11.60|
|hist||C - Citigroup Inc.||2.92||1,069,300||Reduce 16.36%||$39.56|
|hist||SNY - Sanofi Aventis||2.90||886,800||Reduce 13.08%||$47.38|
|hist||MSFT - Microsoft Corp.||2.88||1,560,800||Add 7.28%||$26.73|
|hist||PFE - Pfizer Inc.||2.86||1,653,800||Reduce 7.86%||$25.08|
|hist||UNH - United Health Group Inc.||2.78||742,300||Add 7.64%||$54.24|
|hist||LIFE - Life Technologies Corp.||2.77||816,900||Reduce 6.10%||$49.08|
|hist||NVS - Novartis AG||2.76||630,900||Reduce 13.39%||$63.30|
|hist||GE - General Electric||2.74||1,888,100||Reduce 9.42%||$20.99|
|hist||DD - Du Pont (E.I.)||2.70||869,200||Add 16.41%||$44.97|
|hist||BG - Bunge Ltd.||2.70||538,700||Reduce 5.97%||$72.69|
|hist||SCHW - Charles Schwab||2.67||2,692,600||Reduce 8.02%||$14.36|
|hist||IVZ - Invesco Plc||2.65||1,473,200||Reduce 6.58%||$26.09|
|hist||AON - Aon Corp.||2.63||685,900||Add 34.02%||$55.60|
|hist||FLEX - Flextronics International Ltd.||2.61||6,075,800||Add 10.43%||$6.21|
|hist||CVS - CVS Caremark Corp.||2.60||777,600||Reduce 5.89%||$48.35|
|hist||CAH - Cardinal Health Inc.||2.58||906,100||Reduce 5.23%||$41.18|
|hist||MMC - Marsh & McLennan||2.58||1,084,900||Reduce 2.88%||$34.47|
|hist||DVN - Devon Energy Corp.||2.56||712,500||Add 23.81%||$52.04|
|hist||CMCSA - Comcast Corp.||2.53||982,100||Reduce 6.61%||$37.38|
|hist||TMO - Thermo Fisher Scientific||2.48||563,500||Add 1.53%||$63.78|
|hist||AES - AES Corp.||2.41||3,255,700||Reduce 6.56%||$10.70|
|hist||LUV - Southwest Airlines||2.39||3,379,000||Reduce 7.31%||$10.24|
|hist||RSG - Republic Services||2.37||1,168,600||Buy||$29.33|
|hist||TWX - Time Warner Inc.||2.32||701,800||Reduce 10.71%||$47.83|
|hist||PG - Procter & Gamble||2.30||491,500||Reduce 9.05%||$67.89|
|hist||WLP - WellPoint Inc.||2.27||539,300||Buy||$60.92|
|hist||LOW - Lowe's Cos.||2.21||901,200||Reduce 8.16%||$35.52|
|hist||OI - Owens-Illinois Inc.||2.09||1,422,700||Add 6.82%||$21.27|
|hist||WFT - Weatherford International Ltd.||1.96||2,532,200||Reduce 10.18%||$11.19|
|hist||BP - BP plc||1.91||662,800||Buy||$41.64|
|hist||AMAT - Applied Materials||1.89||2,393,400||Reduce 24.08%||$11.44|
|hist||SYY - Sysco Corp.||1.55||709,800||Reduce 41.50%||$31.66|
|hist||NEM - Newmont Mining Corp. (Hldg. Co.)||1.55||483,900||Buy||$46.44|
|hist||ADI - Analog Devices||0.77||263,600||Reduce 59.76%||$42.06|
* Reported Price is the price of the security on the portfolio date. This value is significant in that it indicates the portfolio manager's confidence in the stock at that price and suggests at least some level of undervaluation and/or margin of safety.
Sector % analysis
Articles & Commentaries
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.
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.
The Sound Shore Fund ended June 30th with a net asset value of $32.12 per share, after an income distribution of $0.164717 on June 20th. The second quarter total return of -4.86% was below the Standard & Poor’s 500 Index (“S&P 500”) and the Dow Jones Industrial Average (“Dow Jones”), which returned -2.75% and -1.85%, respectively. Year-to-date 2012, the Sound Shore Fund has a total return of 9.34% versus 9.49% for the S&P 500 and 6.83% for the Dow Jones.
We are required by the SEC to say that: Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than original cost. The Fund’s 1, 5, 10, and 15-year average annual total returns for the period ended June 30, 2012 were -0.99%, -2.01%, 5.28%, and 5.41%, respectively. As stated in the current prospectus, the Fund’s annual operating expense ratio is 0.94%. For the most recent month-end performance, please visit the Fund’s website at www.soundshorefund.com.
Capital markets in the second quarter of 2012 were somewhat reminiscent of the third quarter of 2011: Concerns about Europe’s banks and the global economy drove US Treasury rates to new lows and kept stock markets in check or worse.
After a strong first quarter, Sound Shore returned a modest portion of its 2012 gains in the second. Semiconductor leader Texas Instruments was symptomatic of several of our industrial detractors for the period as prospects for a slowing economy outweighed the company’s competitive successes and strong balance sheet. Additionally, lower rates caused net interest margin concerns for a few of our financial holdings, including Citigroup and Metropolitan Life.
Meanwhile, fuel supplier Sunoco, our best contributor for the quarter, bucked the declining trend in energy after agreeing to be acquired by Energy Transfer Partners. We started our position in Sunoco in early 2010 when the stock was priced at less than 4 times cash flow and below book value. Though consensus viewed Sunoco as a pure play refining and marketing company, our research concluded that the bulk of the company’s value was in its well-positioned logistics and steel coking segments and that new management was committed to unlocking that value through restructuring. Over the interim 30 months, the company transformed itself into a high growth fuel transporter and retailer as it sold, spun off, or closed its non-core and unprofitable businesses. Pro forma for its actions, Sunoco had strong free cash flow, net cash on its balance sheet, and an attractive business mix all of which appealed to Energy Transfer. We sold the position in May after a total return of over 50%.
Other strong second quarter performers included cable service provider Comcast, a long term holding, and integrated gas provider EQT, a position we restarted in the first quarter of 2012. Comcast benefitted from solid internet subscriber trends, while EQT advanced after the successful spin out of its midstream gathering and processing segment into a publicly traded MLP.
At 12.7 times forward four quarter earnings, the S&P 500 is at a meaningful discount to its long-term average of 15.9 times and incorporates a fairly dour outlook for the economy and earnings. As the globe’s long term financial deleveraging continues, start and stop markets like those we have seen since 2009 seem likely to prevail. Moreover, the relatively better performance of US stock markets versus global peers reflects, in our opinion, the attractive valuations for many US companies that are well positioned for the current environment. Sound Shore continues to research and invest in low P/E (absolute and relative to norm), out of favor stocks where company-specific drivers will build value, even in a challenging economic backdrop. At quarter end, our holdings’ forward four quarter price earnings multiple of 10.7 times was at a compelling discount to the market and to their norms.
US equity indices were broadly higher in the first quarter of 2012, extending the rebound that started in the latter part of 2011. Markets were helped by solid corporate earnings and better than expected economic trends, especially for US employment and housing.
With macro concerns fading a bit, company-specific factors drove several of our holdings to strong gains. For example, cable service leader Comcast outperformed its media peers and the market after its announced dividend increase and share repurchase both topped expectations. Comcast’s decision to payout a larger portion of its free cash flow provides confirmation of corporate America’s still increasing shareholder friendliness.
Similarly, biotechnology tool maker Life Technologies outdistanced its lagging health care sector to be among our larger contributors. We started our position in Life in the fourth quarter of 2011 after the stock had declined significantly from its peak and was valued at less than 10 times forward four quarter earnings. Our research concluded that Life’s core genomics sequencing, service, and resupply offerings provide stable cash flows, and that significant incremental value from its proprietary bench-top initiative is not yet reflected in the company’s stock price.
While higher interest rates broadly helped financial stocks, our holdings in Bank of America and Citigroup beat the sector due to improving company fundamentals. Bank of America advanced after reporting better than expected improvement in its capital, while Citigroup rose on indications of strong earnings progress into 2012. Both stocks also benefitted from the Federal Reserve’s “stress test” which confirmed their solid equity positions. Even after their first quarter gains, each of these stocks remains priced well below tangible book value.
Our biggest detractors in the quarter were hybrid utilities Exelon and Public Service Enterprise which declined with lower natural gas and power prices. By contrast, it was stubbornly high jet fuel prices that caused margin concerns for Southwest Airlines, which lagged with a modest decline.
For the third year running, we are able to write that, “this March quarter was the S&P 500’s best since 1998.” However, conditioned by the volatile and macro-driven selloffs that soon followed the strong starts of 2010 and 2011, many pundits are calling for another bout of midyear market blues in 2012 due to well-worn concerns about the upcoming US elections, fiscal gridlock, and Europe. With equities still largely out of favor (as evidenced by record equity fund outflows from 2008 – 2011) and the US economy showing gradual improvement, we regard the short term as typically unpredictable. We continue to monitor the global economic issues, but remain focused on our investment horizon which is measured in years, not weeks or months.
Sound Shore remains committed to its 34-year-old investment process: We seek out of favor, attractively valued companies that we conclude will build value through making their own tailwinds. At March 31, 2012, the Fund’s portfolio was attractively priced at 11.3 times forward earnings versus the S&P 500 at 13.8 times, despite better than market projected earnings growth for our holdings.
US equity indices posted only marginal gains in 2011, yet were among the best performing in the world. Behind the slightly positive return of the US stock market there were significant divergences. For example, the downside volatility of the third quarter was almost matched by the strong fourth quarter rebound, up nearly 12% for the S&P 500. As well, the defensive and higher yield utilities sector was up 19% for the year while the financials were at the other end of the spectrum, down -17%. Now in our 34th year, Sound Shore Management, Inc. has seen many challenging markets and, though our performance trailed in 2011, our prior experience is that staying committed to our disciplined value strategy remains the best route to competitive long-term returns for our investors.
The recent environment of solid earnings amidst global economic uncertainty has caused many companies to recalibrate growth expectations. Shareholders have often been beneficiaries of this evolving mindset via increased dividends and share repurchases or other restructuring activities. Sound Shore’s low price earnings investment framework has always included free cash flow and balanced capital allocation as criteria and several of our best contributors for 2011, including Marathon, Lowe’s, and Pfizer, were leaders in this shareholder-friendly trend.
At Marathon, for example, we initiated our position in early 2010 when the integrated oil company was selling at 7 times forward earnings and 4 times cash flow. At the time, we believed the company’s refining and marketing results could prove better than depressed forecasts due to a recent expansion at the company’s largest refinery. After executing on significant improvement through 2010, Marathon announced in early 2011 that it would split into separately traded upstream and downstream companies, further unlocking value. As part of the split, the company used its de-leveraged balance sheet to increase its dividend as well. We sold our Marathon positions as they achieved target valuations during the second half of 2011.
Meanwhile, home improvement retailer Lowe’s, a new holding in 2011, hit our valuation screens in late 2010 when the stock was trading well below norm at 11 times forward earnings with a 2.5% dividend yield. We viewed management’s recently changed capital allocation plan, emphasizing lower investment and narrowing the profitability gap to Home Depot, as a significant departure from its past prioritization of store growth. After initiating our position in the third quarter, we benefited from the company’s fourth quarter announcement that its considerable free cash flow would be used to repurchase up to 15% of its shares outstanding per year for a multi-year period.
Similarly, global drug maker Pfizer, a longer term position, started the year valued at 7 times 2011 earnings due to investor concerns about the expiration of its Lipitor patent. Our analysis concluded that the company’s earnings and free cash flow would prove sturdier than expected due to the significant cost cuts and portfolio restructuring moves being taken by new CEO Ian Read. Pfizer shares steadily outperformed through the year as earnings estimates gradually rose and also after the company announced a higher than expected dividend increase and 2012 share repurchase program during the fourth quarter.
Several of our larger 2011 detractors, including General Motors and Citigroup, saw their valuation multiples compress despite improving financial performance. At GM, for example, strong vehicle pricing discipline, cost control, and market share improvement allowed the company to grow 2011 earnings by 29% versus 2010. However, the company’s forward P/E multiple declined to 5 times our 2012 estimate due to concerns about the global economy. Likewise, Citi’s 2011 tangible book value progressed 12% through the year but fallout from Europe’s rocky credit markets cut Citi’s price to tangible book multiple from 1.1 times to 0.5 times. Both GM and Citi are compelling risk-reward opportunities given their low valuations, stable financial positions, and completely new management teams that are successfully executing on focused strategies that are significant departures from their over-diversified histories.
Extended uncertainty in the global economy has depressed equity valuation multiples, which we view as an opportunity for our disciplined value investment framework. Indeed, Sound Shore’s portfolio is valued at 10.3 times forward earnings which compares favorably to both the S&P 500 at 12.4 times and generationally low competitive yields for 10 Year US Treasury Bonds. Since 1978 Sound Shore has been fortunate in the stability of our long-term client base and the commitment of our experienced research team to our one value investment strategy. As in the past, we believe these critical factors should allow us to take advantage of the current confluence of economic uncertainties, investor disdain for equities, and very low valuations.
After a strong first quarter 2011, stocks treaded water in the second due to uncertainty about global growth. As emerging economies fought inflation and the European Union and U.S. worked on debt and deficit challenges, it was the health care, utility, and consumer staples sectors that performed best. In contrast to this otherwise cautious backdrop, small cap stocks continued to outperform large caps and growth continued to outpace value, extending trends from the first quarter, according to data from Standard & Poor’s.
Sound Shore's portfolio was behind the indices during the quarter as signals of a slower economy caused a few holdings to decline. For example, shares of glass bottle maker Owens-Illinois were lower as currency-driven sluggishness in Australian wine exports caused the company to marginally lower its 2011 earnings outlook. Similarly, semiconductor equipment provider Applied Materials and electronics assembler Flextronics pulled back on mixed demand for technology products, partly due to Japan’s slowdown. Meanwhile, despite stable book value per share Bank of America was down due to regulatory and revenue pressures.
On the plus side, global pharma leader Novartis was our best contributor as it benefitted from better than expected generic drug sales and a strengthening Swiss franc. Fellow health care related holdings Baxter International and CVS were also strong performers, as the former advanced after reporting faster than expected gains in its core blood plasma business, and the latter was up following a significant drug distribution contract award. Meanwhile, Visa moved higher after the federal government approved a smaller than expected reduction in merchant debit fees. And finally integrated gas company El Paso, an investment since 2004, outpaced the lagging energy sector after announcing plans to spin off its exploration and production segment.
Similar to last summer, midyear 2011 markets seem to reflect great uncertainty about how macro factors will unfold. As uncertainty often yields profitable investment opportunities, Sound Shore remains diligently focused on identifying inexpensive stocks with strong earnings and cash flow prospects that are likely to beat low expectations. Our bottom-up based portfolio currently has a forward four quarters price/earnings multiple of 11 times versus 14 times for the S&P 500 and should be well positioned going forward.
Indeed two of our best contributors for 2010, Smith International and Genzyme, were acquisition targets. Oil services provider Smith, which gained 62% after agreeing to be acquired by Schlumberger, was a position we started in 2009 when it was trading below norms on earnings and cash flow and at book value. Our research concluded that Smith’s new senior management team and its industry leading positions in drill bits and fluids appeared poised to produce better than consensus earnings through 2012. Schlumberger, the global leader in oil service, apparently came to the same conclusion and purchased the company to bolster its presence in resurgent North American energy markets. We sold our Smith shares as the stock achieved our target valuation in the first quarter.
Meanwhile, drug developer Genzyme, which we profiled in last year’s annual letter, attracted interest from several potential suitors due to its unrivalled rare-disorder product pipeline and attractive valuation. Genzyme hit our screens in early 2009 when the stock had dropped to an all time low valuation of less than 13 times earnings and under 10 times cash flow following a contamination issue at one of its manufacturing facilities, a not uncommon occurrence in biotechnology. Our review of the company’s pipeline indicated sum-of-the-drugs revenue and earnings growth that was well above sell-side analysts’ expectations that were fixated on the near-term impact of restoring its idle facility. After our initial third quarter 2009 investment, we used the stocks’ subsequent volatility to add to our position so that when, in July 2010, pharma giant Sanofi-Aventis announced its acquisition interest, Genzyme was our biggest holding. Although a transaction had not occurred as of year-end, we sold our shares in the fourth quarter after the stock had achieved our target valuation.
Citigroup was another strong 2010 performer as it outdistanced the lagging financial sector. We built our position in Citi during the latter part of 2009 when the shares were selling for a significant discount to tangible book value and were also depressed by a poorly executed partial sale of the U.S. Treasury’s holdings. In addition to its compelling valuation, we believed Citi’s strong consumer bank, low relative mortgage exposure, and prospectively over-reserved balance sheet could drive better than forecast earnings. During 2010, Citi outperformed as financial results and the complete U.S. government exit from its shares were both ahead of schedule.
On the takeaway side, Apollo Group and Exelon were among our biggest detractors. Apollo, the leading for-profit education company, was lower due to concerns about federal rule changes regarding funding eligibility at its schools. Apollo, valued at less than 10 times 2011 consensus earnings, is likely to emerge a winner in the changing industry environment as it is the only for-profit school system already meeting proposed new requirements for gainful employment. Meanwhile, power generator Exelon declined due to lower natural gas prices and slower than expected demand recoveries in its Midwest and mid-Atlantic markets. Typically, Exelon’s best in class nuclear electric fleet commands a significant valuation premium per megawatt versus coal and natural gas, but due to the severity of the recent economic cycle that premium has all but disappeared. Our view is that management’s efforts to add capacity and cut costs has the potential to yield better than expected earnings power in the next 12-24 months and, following that, differentiated pricing of its unique portfolio of power assets should recur.
Sound Shore’s bottom-up, fundamental research process should be well positioned for the current market environment. Following the big cyclical snap-back from March 2009 to April 2010, company-specific drivers of stock performance appear to have regained relevance which we believe could continue in 2011. Meanwhile, even with S&P 500 earnings poised to set an all-time high in 2011, stocks are almost 20% below the peak levels achieved in 2007 and 2000. The large flow of funds away from stocks and into bonds during the past 24 months has helped to keep equity valuations reasonable to attractive. As well, we are optimistic about our holdings which we estimate have above average earnings growth prospects but, at year-end were valued at 11.7 times 2011 consensus earnings versus 13.6 times for the S&P 500.
After slogging through the dog days of summer, stocks advanced broadly in September lifting the third quarter to solid gains. Better than expected global economic signals and reasonable equity valuations more than offset investor concerns about the rotating devaluation of “old guard” currencies.
Although the health care sector underperformed the market during the quarter, two of our best contributors were drug makers Genzyme and Pfizer. Bio-pharma developer Genzyme’s gain of 39% followed Sanofi-Aventis’ announced interest in acquiring the company, while Pfizer was up 20% following better than expected earnings driven by cost control. Similarly, asset manager Invesco gained 26%, outperforming the lagging financial sector as its net funds flow topped both forecasts and peer group results due to improved product performance. Other outstanding contributors included AES, Coca Cola, eBay, and Texas Instruments.
Bank of America was the biggest detractor for the third quarter, down 9%, due to concerns over new financial regulations. We believe Bank of America, trading at tangible book, should continue to consolidate its market share gains and reclaim double-digit returns on equity. Applied Materials, which declined 3%, was also one of the poorest performers. Applied Materials, a leading technology supplier to the global semiconductor industry, is selling at the low end of its historic price to sales ratio and 10 times estimated earnings despite better than estimated market earnings growth through 2012 and a dividend yield of 2.4%.
There is much fretting about equity markets currently due to sovereign stress and the possibility of a US and/or worldwide “re-recession.” Long-term investors, however, should also keep in mind that the S&P 500’s forward P/E multiple of 13.0 times, according to Thomson Baseline, is reasonable when compared to the 15-year median P/E of 17.0 times and also attractive versus the limited competition from interest rates. As well, corporate America’s financial health, unlike that of households and most governments, is in aggregate very strong.
We anticipate the unpopular, yet higher quality stocks we have favored are poised to resume their outperformance particularly if economic concerns continue. Sound Shore’s process remains focused on locating and investing in companies that we believe have market or better financial prospects which are priced at a discount to historic norms and the market. Currently our portfolio’s aggregate forward four quarter P/E multiple and 2011 earnings per share growth are estimated at 10.6 times and 21%, respectively, based on consensus estimates, both of which compare favorably with the S&P 500.
The rebound in equities that began in March 2009 continued during the first quarter of 2010. Investor optimism about corporate profits and balance sheet strength more than offset emerging concerns regarding record fiscal deficits in the US and many other countries. For the period, industrial and financial stocks performed best, as they have since the market’s bottom, while utilities and telecommunications were the only sectors in negative territory.
Sound Shore’s best contributors included Smith International, Baker Hughes, and Valero, energy holdings which well outpaced their lagging sector. Drill bit maker Smith was a significant gainer after it agreed to be acquired by larger rival Schlumberger, while its oil service peer Baker Hughes benefitted from better than expected pressure pumping trends at its recently acquired BJ Services segment. Meanwhile, oil refiner Valero, which was higher after unexpectedly announcing the potential sale of its Delaware facility, also benefitted from improving fuel profit margins. Financial institutions Citigroup and Bank of America were also strong performers as both confirmed stable to improving profitability in their core lending and capital markets businesses.
Global utility AES was the biggest detractor for the quarter as its share price dropped with declining power prices and also due to its sale of new shares to the China Investment Corporation. AES remains a full position given its reasonable valuation of 11 times 2010 earnings and 6 times cash flow and its differentiated growth pipeline that appears poised to add significantly to earnings through 2013. Also, mobile semiconductor company Qualcomm was down after it lowered its outlook for royalty related revenues. However, our research indicated minimal long term earnings and cash flow impacts from this factor and we expect Qualcomm to benefit from the global growth in smart phone demand due to its patented technology.
After the market’s spectacular and broad gain off last year’s bottom, many of its valuation metrics, including price/earnings, price/book, and price/sales, are close to regaining their long term averages, according to Thomson Baseline. Sound Shore has always demurred from making shorter term market predictions, and instead has focused on owning out-of-favor stocks that we believe over time will be good investments and potentially more rewarding than owning the market indices. During this past ten year period ending March 31, 2010, a $10,000 investment in the Sound Shore Fund would have grown to $15,884, while a comparable investment in the S&P 500 would have declined to $9,365.
With the ten year return for the S&P 500 negative and in the lowest decile of returns since those of the Great Depression and with bond yields around historic lows we remain optimistic about future equity returns. We expect to see greater differentiation between companies based upon franchise strength and the potential to build value. Sound Shore’s investment process should be well positioned given its focus on quality businesses at out-of-favor valuations and rigorous company research.