July 8, 2005The financial markets produced uneven returns during the first half of 2005. Concerns over rising short-term interest rates and slowing economic growth kept equity investors in a relatively bearish mood, resulting in modest or no gains for the average investor. However, long-term interest rates remained at much lower than expected levels and provided the stimulus for solid gains in interest rate sensitive assets, such as investment grade bonds and REITs. A rebound in the relative value of the dollar as well as a surge in crude oil and natural gas prices also impacted the decision making process of investors. In contrast to the modest gains of the broad market, Westwood clients enjoyed meaningful returns. Below we discuss why our strategy has worked well thus far in 2005 and why we remain confident that we are appropriately positioned for the remainder of the year.
The year began with concerns over the pace of economic growth in the face of rising interest rates and stubbornly high energy and commodity costs. In addition, investors began to reevaluate their appetite for risk. Westwood had been expecting a decline in economic and earnings growth rates to a more historically normal level of 3% and 10%, respectively, from the 5% and 20% produced in 2003-2004. Furthermore, we believed that these slower growth rates would result in a reduction in investor risk appetite. Therefore, we were well prepared for the transition that began in the first quarter of this year. Our exposure to high quality, attractively valued securities with strong fundamentals allowed us to produce a gain that was well in excess of our benchmark. Also, our belief in the sustainability of the global industrial cycle, fueled by demand from emerging economies such as India and China, led us to find value in the industrial segment of the market. Our holdings in the Energy, Materials & Processing, and Transportation sectors performed much better than the broad market, resulting in superior results for our clients.
The 2nd quarter began with the realization by investors that the Fed would indeed continue its “measured pace” of rate hikes and that inflation had become a legitimate possibility. As a result, the market began to price in the potential for “stagflation”, i.e. slow growth accompanied by rising inflation. Cyclical, economically dependent stocks were sold and “defensive” stocks, such as those in the Health Care and Utilities sectors, became the flavor of the day. The downgrade to junk status of GM and Ford bonds created additional investor angst. However, in early May, market sentiment reversed course when stronger than expected job creation and benign inflation data was reported for the month of April. Investors began to believe that the economy had entered a “Goldilocks” phase, and the market subsequently rebounded, posting a gain for the quarter. The one remaining negative was high oil prices, as crude reached the $60/barrel mark. Again, despite the market’s disdain for cyclical securities early in the quarter, our fundamentally driven approach allowed us to identify attractively valued securities and produce a return for the quarter that exceeded the benchmark. Strong security selection in the Financial Services, Consumer Discretionary, and Energy sectors were the primary contributors to our performance.
A number of headwinds remain in place for the markets as we move into the second half of the year. The Federal Reserve, which raised rates four times during the first half, remains committed to a measured pace of rate hikes, likely resulting in at least two more ¼ point bumps in the Fed Funds rate. Expectations for corporate earnings growth have declined to the single digits, and the recent rally in the dollar will have a negative impact on the earnings of U.S. multinational firms. Finally, there appears to be no near term relief for high crude oil prices. As a result, we continue to believe that a strategy focusing on high quality, attractively valued companies with strong fundamentals remains the most prudent approach. Such securities have historically been the best performers as the economy enters the mid-phase of the economic cycle, and as growth slows and liquidity declines. In addition, we remain convinced that the global industrial cycle will last longer than the consensus expects, leading to gains for firms operating in the Energy, Materials, and Producer Durable segments of the market. Most importantly, valuations remain attractive in these industries. For example, energy companies are trading today as if the price of crude oil was $40/barrel, instead of in the high $50s, and are priced at multiples of cash flow that are significantly lower than historical norms. Free cash flow generation remains very strong for such companies, and investors are now placing a premium on companies that generate strong cash flow and return it to shareholders in the form of dividends and stock buybacks.
Market sentiment has changed drastically at several points during the year, but as patient long-term investors, we remain committed to our rigorous and disciplined investment strategy and will resist the temptation to be influenced by the knee jerk reactions of the masses. By adhering to our investment process, we expect to continue to produce superior risk-adjusted returns for our clients over the long-term.
Thank you for your continued confidence in Westwood and we look forward to serving your investment needs. Please feel free to contact us if you have any comments or questions concerning our first half performance or strategy for the remainder of the year.
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