S C H A F E R C U L L E N Value Equity Q1 2017 Commentary Market Review: C A P I T A L M A N A G E M E N T U.S. equities posted strong gains in the first quarter of 2017, with the S&P 500 returning 6.1% (best Q1 in four years) and the Russell 1000 Value up 3.3%. In many respects it was a continuation of the postelection rally that began last November, as market sentiment climbed in anticipation of the pro-growth economic agenda of the Trump administration. However, there was a significant shift in sector performance from the 4th quarter of 2016 when the reflation trade led Financials and Industrials to outperform. This quarter, Information Technology (+12.6%) led the move higher, fueled by momentum growth stocks in the sector. Improving economic data also benefitted the Consumer Discretionary sector (+8.5%), while Health Care (+8.4%) rebounded after being the only sector down for the full year in 2016. Energy (-6.7%) was the laggard for the quarter, as concerns arose that OPEC production cuts might be offset by rising output from U.S. exploration and production companies. After raising rates 25 basis points in December, the Federal Reserve followed with another 25 basis point hike in March. Fed Chair Janet Yellen cited strong employment figures and rising inflation as two main reasons for the increase. The positive economic data contributed to an unusually quiet quarter in terms of stock price volatility. The VIX index recorded an average closing value of 11.7 for the quarter, the second-lowest quarterly average on record. The S&P 500 recorded a streak of 110 trading sessions without a one percent daily decline (from October 12th through March 20th), the longest such streak since 1985. On the political front, the world watched how Donald Trump would fare in the early days of his Presidency. Given the strong market performance relative to historic election years, optimism ran high many of his pro-growth agendas, primarily tax and regulatory reform, would be certainly implemented. After the Republican controlled Congress failed to garner enough support for its health care bill, questions began to surface about Trump s ability to implement other parts of his agenda. Figure 1: S&P 500 Avg. Performance: 12Mo Following Presidential Open & Re-Election Race 100 = Election Day. Source: Strategas Research Partners, 4/7/2017. 1 of 6
Performance Analysis: The Value Equity strategy gained 5.9% in the quarter, net of fees. The S&P 500 returned 6.1% and the Russell 1000 Value 3.3% for the first quarter of 2017 (Figure 2). Performance in the first quarter was not clearly driven by cyclical or defensive attributes but more so a reversal of post-election sector performance. In the quarter, Large-capitalization, Growth, and High Beta stocks outperformed Small-capitalization, Value and Low Beta stocks. In addition, non-u.s. stocks (+5.3% in local currency, +8.0% in USD) outperformed U.S. stocks in Q1. Figure 2: Value Equity Returns vs. Benchmarks Q1 YTD 1 Year 3 Year 5 Year 10 Year Value Equity (net) 5.9 5.9 16.7 7.1 11.6 6.5 Russell 1000 Value Index 3.3 3.3 19.2 8.7 13.1 5.9 S&P 500 Index 6.1 6.1 17.2 10.4 13.3 7.5 Performance for periods greater than 1 year is annualized Portfolio Attribution: Attribution Effects Value Equity vs. Russell 1000 Value 12/31/2016 3/31/2017 2 of 6 Source: SCCM/Bloomberg, 3/31/2017.
The Industrials sector was the largest contributor to relative performance for the quarter driven by our overweight allocation to the sector combined with strong stock selection. ABB (+11.1%), Boeing (+14.6%), Canadian National Railway (+10.2%) and Siemens (+15.3%) all posted double-digit percentage returns for the quarter, benefitting from improving economic data and expectations of increased infrastructure spending. The strategy s overweight allocation to Health Care aided relative performance as the sector rebounded after being the only sector down for the full year in 2016. The strategy s underweight allocation to the underperforming Energy sector aided relative performance, as the sector declined on concerns of increasing oil supply. Strong stock selection in Consumer Staples aided relative performance, as Kimberly-Clark (+16.8%) and Unilever (+22.0%) benefitted from M&A speculation in the sector. Utilities was the largest detractor to relative performance as the sector benefitted from improved sentiment of high dividend stocks and the portfolio currently has no exposure to this sector. Materials was the next largest detractor to relative performance, as Newmont Mining declined (-3.1%) after returning 90% in 2016. Portfolio Changes: Purchases / Additions Morgan Stanley (MS) was purchased in the strategy. The company has grown its wealth and asset management businesses over the years and may benefit from reduced regulatory burden. The stock trades at 12x 2017 earnings and 1.0x book value. Travelers Companies (TRV) was purchased in the strategy. The company has maintained strong pricing discipline and expects improvement in its consumer auto insurance business over the near-term. The stock trades at 12.8x 2017 earnings and 1.3x book value. Sales / Trims Diageo (DEO) was sold out of the strategy. The stock has performed well as international stocks have risen and bond yields remain low. However, sentiment on the stock has gotten ahead of itself in the nearterm. Kimberly-Clark (KMB) was sold out of the strategy. The stock has performed well as bond yields remain low. However, sentiment on the stock has gotten ahead of itself in the near-term. Xylem (XYL) was sold out of the strategy. The strategy has a number of solid Industrial holdings. Xylem has performed well however the valuation has risen and no longer justifies being held in the portfolio. Vodafone (VOD) was sold out of the strategy. The European wireless market remains highly competitive with Vodafone a likely consolidator. It has proven difficult for the company to monetize its stake it its Indian and South African businesses. Bank of America (BAC) was sold out of the strategy. The stock has performed well post-election given the positive sentiment on bank earnings benefitting from higher interest rates. However, sentiment on the stock has gotten ahead of itself in the near-term. 3 of 6
Market Outlook: The current expansion, which began in early 2009, is now in its eighth year and the 2nd longest bull market since 1928 at over 96 months in duration and up over 250%. The current bull market has been particularly strong with annualized total (real) returns of 18% since 2009. A significant portion of returns in this cycle has come from valuation expansion, with P/E multiples expanding over 70% from 10x earnings at the start of the second leg of the bull market in 2011, while higher earnings have accounted for 28% of the rise 1. With indicators of U.S. long-term inflation levels decelerating and corporate earnings growth relatively muted, the market is focused on fiscal stimulus coming from Washington to deliver further earnings growth, namely corporate tax reform and regulatory relief. In terms of monetary policy, the Federal Reserve continues to embark on its tightening cycle, forecasting three quarter-point rate hikes in 2017, dependent on economic data. Passive strategies have outperformed over the last eight years as over $1 Trillion has flowed into these vehicles while $700 Billion has flowed out of active management. By extension, stocks heavily weighted in passive indices have outperformed; the crowding into passive management, which ignores valuation and risk, is a dynamic we have seen numerous times in history including the Nifty-Fifties, the Portfolio Insurance run and the Dot-Com bubble. Passive investing has become so dominant that nearly 40% of trading volumes occur in the last hour of market trading driven by ETF flows. The Federal Reserve has kept interest rates at historically low levels for an extended period of time driving an unusually long period of low volatility. Correlations have remained high, presenting a challenging environment for active managers to differentiate performance. Active managers have typically outperformed benchmarks in lower return / negative return environments, which have been infrequent over the past eight years. Figure 3: Annual S&P 500 Performance vs. % of Active Managers Outperforming Note: Sorted by Annual S&P Performance High to Low. Source: Strategas Research Partners, 3/31/2017. 1 Goldman Sachs, Global Strategy Paper, March 22, 2017. 4 of 6
A number of research firms have written about the risks of passive investing, highlighting the value of those active strategies which can consistently generate alpha: Sanford Bernstein published a report last year arguing for the role of active management in allocating capital in the economy. Passive vehicles invest in all companies regardless of quality and valuations leading to inefficiencies. As an example of inefficiencies, Robert Baird recently published a report highlighting how large capitalization, cash burning (low quality) companies are trading at a historically expensive valuation levels, worse than the Dot-Com era: Firms that burn cash are very expensive versus history. The aggregate value of firms that burn cash is at levels not seen since the last peak of the dot.com bubble. Firms burning cash today are carrying more debt, burning more cash and are more expensive than they were at the peak of the 2000 stock bubble. It appears to us that passive managers are (by definition) blindly buying market cap weighted indexes which has left high quality, cash generating large cap firms at attractive relative valuations. 2 With the market near all-time highs and broad-based valuations on stocks at elevated levels, we believe investors should be more mindful of risk not less. The S&P trailing price/earnings ratio is currently 21.6x, however the median P/E ratio is 24.2x, significantly higher than the long-term median average of 17x for the S&P 500. The most effective way to manage risk is to adhere to an investment discipline focused on valuation and quality, which is the core tenet of our investment approach. Relative to fixed income and equity benchmarks, the valuation of our portfolio remain attractive. The strategy trades at 15.1x 2017 earnings versus 18.3x for the S&P 500 and 17.2x for the Russell 1000 Value. Best Regards, Schafer Cullen Capital Management, Inc. 2 Baird Kailash Research, The Pernicious Problem with Passive, February 28, 2017 5 of 6
Disclosure: Schafer Cullen Capital Management (SCCM or the Adviser ) is an independent investment advisor registered under the Investment Advisers Act of 1940. This information should not be used as the primary basis for any investment decision nor should it be considered as advice to meet your particular investment needs. The portfolio securities and sector weights may change at any time at the discretion of the Adviser. It should not be assumed that any security transactions, holdings or sectors discussed were or will be profitable, or that future recommendations or decisions will be profitable or equal the investment performance discussed herein. Investing in equity securities is speculative and involves substantial risk. Past performance is no guarantee of future results. Market conditions can vary widely over time and can result in a loss of portfolio value. Individual account performance results will vary and will not match that of the composite or model. This variance depends on factors such as market conditions at the time of investment, and / or investment restrictions imposed by a client which may cause an account to either outperform or underperform the composite or model s performance. A list of all recommendations made by SCCM within the immediately preceding period of not less than one year is available upon request. The strategy depicted in this report has been managed in accordance with the investment objectives of the strategy as determined by the Adviser. The Adviser has selected benchmarks, which in their opinion closely resemble the style of the securities held in the composite or model portfolio of the strategy (e.g. large cap value, small cap value, international, etc.). The securities held in the composite or model are actively managed while the benchmark index is not. Investors should be aware that the Adviser makes no attempt to match the portfolio securities, or the security weightings of the benchmark. The composite or model s performance will be affected greater by the price movements of individual securities as the composite or model is more concentrated, generally less than 100 securities, while a comparative benchmark will generally have between 500 and 2,500 securities where individual security price movements have a lesser affect. An individual cannot invest directly in an index. In the case where this report displays model results, please be aware that such results do not represent actual trading and that results may not reflect the impact that material economic and market factors might have had on the Adviser's decision-making if the Adviser were actually managing clients' money. Model and actual results reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a client would have paid or actually paid (Net of Fee performance) and reflect the reinvestment of dividends and other earnings. Schafer Cullen Capital Management, Inc. makes no representation that the use of this material can in and of itself be used to determine which securities to buy or sell, or when to buy or sell them; SCCM makes no representation, either directly or indirectly, that any graph, chart, formula or other device being offered herein will assist any person in making their own decisions as to which securities to buy, sell, or when to buy or sell them. All opinions expressed constitute Schafer Cullen Capital Management s judgment as of the date of this report and are subject to change without notice. 6 of 6