David Fleer
Bristlecone Value Partners, LLC
12301 Wilshire Blvd., Suite 320
Los Angeles, CA 90025 USA
Work 1-877-806-4141
www.Bristlecone-VP.com


1st Quarter 2017 Review: Another Positive 3 Months

U.S. stocks continued their march higher during 2017’s first quarter. The S&P 500, an index tracking the 500 biggest companies traded on US stock markets, was up over 6% in the quarter, and is up more than 17% over the past 12 months (including the reinvestment of dividends).

For most of the quarter, investors remained upbeat that a Donald Trump presidency would result in pro-growth policy changes, including changes to the tax code, rolling back of regulations, and infrastructure spending. Doubts emerged after a failed effort to reform U.S. healthcare in late March, which helped pharmaceutical stocks.

Economic data–including employment reports and consumer confidence–was generally strong during the first quarter, contributing to the Federal Reserve’s March decision to raise short-term interest rates for the second time in four months. In its minutes, the committee also indicated that more increases should be expected during the rest of the year. The market shrugged off the impact of higher rates as the move was widely expected and seen as a sign that the economy is strong enough to support the hikes. As a result, bond indexes performed well, and interest rates held relatively steady overall.

Technology and growth stocks in general led the way in the 1st quarter, while value stocks lagged. After posting the highest returns in 2016, small stocks were among the weakest-performing, returning less than 2%. After rising more than 50% in 2016, crude oil prices fell during the quarter, dragging down the energy sector by about 7%.

Looking at international markets, the surprise came from the decline of the US dollar against most currencies (including the Mexican Peso!). The US currency appreciated in the fourth quarter after the election results, as investors reasoned that the new administration’s policies would attract investment to the United States and boost the exchange rate (as would the expected continuing increases in U.S. interest rates). Therefore, the dollar’s weakness in Q1 represented a pullback from the post-election rally.  This currency effect was a major reason why the 1st quarter returns for international funds, including those investing in emerging markets, topped those of their US-focused counterparts.

How Did Your Portfolio Do?
It was another good quarter as our average client’s asset allocation portfolio posted broad-based positive returns with 11 out of our 12 asset classes gaining (your own portfolio results may differ – please refer to your Quarterly Portfolio Review Report). The only exception was the Natural Resources category as energy prices retreated.

Our investment selection outperformed on average in 8 out of these 12 categories during the quarter, and 10 out of 12 during the last 12 months. The table below shows how a model 60/40 balanced (i.e. made up of stocks and bonds) portfolio is allocated, and for each asset category, the benchmark returns through March 31, 2017:

For the past couple of years, as we anticipated higher short-term rates, we made two tactical decisions to protect your portfolio: The first one was, within the US bond category, to allocate about 60% to 70% to more defensive, actively managed bond funds, rather than a broad market index. The second one was to reduce the overall fixed income allocation in your portfolio, and progressively substitute investments in preferred stocks, merger arbitrage funds, and other less traditional asset classes (called “Other Assets” in your reports). Our goal was to find investments that would outperform bond market indexes in a rising rate environment, but would exhibit less volatility than stocks.

As the Federal Reserve kept delaying its first rate hike, it did not pay off for a while. The 4th quarter of 2016 was the turning point: returns from these investments have outperformed the US bond market benchmark by a good margin over the past 12 months. Although we’re not ready for a victory lap yet, it is our expectation that they will continue to do so for the foreseeable future.

Candidly, the extent to which our investments have outperformed their categories’ respective benchmark over the past 12 months is not something that you should expect regularly. Although our goal is to identify investments that will outperform over the long-term, short-term results can be very volatile. As a reminder, during 2015, the same investments underperformed in most categories. Markets are cyclical and can alternate casting a favorable or unfavorable light on our skills in quick succession.

Review of Bristlecone’s Large Cap Value (LCV) Equity Portfolio
(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy depending on the size of the portfolio, and the client’s objectives and constraints)
In our Large Cap Value portfolios, our trading activity remained subdued. We disposed of our long-held investment in Exxon Mobil. We had waited until the New Year to do so in order to defer capital gain taxes for another year. We had originally purchased this company’s shares in 1996, almost 21 years ago, while at a prior firm. Over the years, we added or reduced our holdings depending on valuation, and this investment’s returns significantly exceeded the market’s throughout our ownership. So why sell?

First, during last year’s crash in oil and gas prices, the stock dramatically outperformed its peers. It barely declined while energy prices dropped 50% or more. Consequently, valuation was stretched in relation to its main assets, oil and gas reserves. A second factor was the deterioration of Exxon’s free cash flow (i.e. what is left after all spending). The sobering reality is that it is increasingly more expensive for Exxon to maintain its production, or even grow it. Even if oil prices rebound, we don’t expect the company to generate proportionally as much cash for its shareholders as it did in the past. Finally, we are increasingly uncertain about the value and demand for fossil fuels in 10, 20 or 30 years. When we value a business, we use financial models that project cash flows in the future. Underlying these models is the confidence that the company’s business will not dramatically differ from its recent past. With Exxon, we are not so sure anymore.

During the quarter, we also initiated a position in an unusual special situation: New York REIT, Inc. (NYRT). In terms of market size, this investment is at the very low end of what we typically consider for the Large Cap portfolio. It is a Real Estate Investment Trust (REIT), a type of security that invests in real estate properties and trades like a stock (Weyerhaeuser, a timberland company, is another REIT in your portfolio). REITs provide investors with a liquid stake in real estate investments. They receive special tax considerations and typically offer tax-advantaged dividend yields. Our thesis with NYRT is—uncharacteristically for us—very short-term: the company’s management and board was recently overhauled due to poor performance, and the new directors elected a management team with a mandate to liquidate NYRT’s real estate holdings in the next 12 to 18 months and return the cash to shareholders. We bought a small positon as we estimate that the stock price trades at a discount to the liquidation value of this Manhattan real estate portfolio.

Traditionally, upon our track record anniversary at the end of each 1st quarter, we show the Large Cap Value’s portfolio 12-months returns ending March 31, as well as cumulative and annualized returns since inception on April 1st, 2000:

Before discussing the LCV performance, what jumped to us from this table is the low average annual return for the S&P 500 since April 1st, 2000: 4.7%. It is about half of the long-term average stock return since 1928, but even more remarkably, it is also below the average bond returns over the same period (Source: NY University). The reason for this dismal 17-year period for US stocks is that the inception of our performance track record coincided with the onset of the 1st of 3 significant declines in prices.

During the last 12 months, the average LCV portfolio outperformed the broad market by a small margin despite cash levels between 10% and 15% throughout the year. This result, although positive, was clearly not enough to make a dent in the portfolio’s underperformance since 2008.  From inception on April 1st, 2000, there has been three instances of two consecutive 12-months periods of underperformance, and all three happened since 2008. The periods were 2008-2009, 2011-2012 and 2015-2016. This poor streak has been particularly disappointing to us. After being ahead for most of our history and as recently as 2015, the portfolio’s average annual return started lagging the S&P 500’s over a year ago. It raises a legitimate question: has there been structural changes in equity markets recently that make outperformance harder to achieve?

We believe that this is the case to a certain extent, and we see a combination of factors that have been playing out. First, the more investors shift from active to market-weighted index based products, the more the stocks within that index will outperform the alternatives. There is a self-reinforcing phenomenon, which we believe will eventually experience a setback as it did in 2000-2001. Second, the long-term outperformance of a contrarian, value investment process has been widely publicized, and there are more and more professionals researching—and investing in—the same ideas. In other words, it has become harder to uncover mispriced securities amongst the larger companies in the market.

Yet, we are confident that the core principles which served us well prior to 2008, will continue to serve us well in the future:

  • Identify businesses that we understand with long-term competitive advantages run by capable managers;
  • Buy their shares when the stock price is at a discount to our estimate of the value of the business;
  • Hold them for the long-term to minimize gains and transaction costs.

The main reason for our confidence is that markets and prices are set by humans prone to excitement, panic, and other behavioral shortcomings which distract at times from a rational assessment of a company’s intrinsic value. At the same time, we need to continue improving, and draw the lessons of an evolving environment for stock picking to increase the odds of outperforming in the future. Our small size and long-term horizon give us a competitive advantage. We can commit capital or divest faster, without impacting prices as much as the big funds; buy more illiquid and less widely owned names, and exploit periods of market disruption. This is how we can better capitalize on our strengths:

  • Focus our research on companies that are not as heavily owned and researched by big managers and index funds and more likely to yield opportunities. These includes mid-cap names, ideas that are more complex, trade on a foreign exchange, etc.;
  • Focus the portfolio on fewer ideas so that each can have a more meaningful impact when we are right. Historically, we’ve owned up to 45 holdings. Our goal is to lower the number over time to 35 or less.

We enter 2017 with optimism. As we look at the stretched valuations of some of the leading index components (and recent social media companies’ hot share offerings), we feel strongly that opportunities still exist to earn returns in excess of a market-weighted passive strategy. As you know, we eat our own cooking:  all investment professionals at Bristlecone have continued to add to their LCV portfolio since 2008 despite the recent underperformance.

Thank you for your continued trust in our services.


Disclosure Brochure Offer
Securities laws require Bristlecone to make available every year to clients the latest version of our disclosure brochure (Form ADV Part 2A). This form contains important information about our firm, such as services, business practices, potential conflicts of interest, a summary of our Disaster Recovery Plan, and Privacy Policy.

If you receive your 1st quarter statement by mail, a copy is included for your convenience. If you elected to receive your statements through our online portal, the disclosure brochure is available for download on our website by clicking here, but we’ll be happy to mail you a copy free of charge (call 877-806-4141 or email clientservices@bristlecone-vp.com)

You may also find additional information about our firm at our website, and through the Investment Adviser Public Disclosure system at www.adviserinfo.sec.gov. We are also required to adopt a code of ethics and provide a copy of which to clients upon request. The current version is available on our website by clicking here or by contacting our firm at the telephone number or email address listed above.

Please contact us immediately if you have had any changes in your investment objectives or financial circumstances. Any changes could impact how we manage your portfolio and will become part of your client file. You should also contact us at any time during the year if your investment goals and/or financial circumstances change. Should you hold equity securities in your portfolio, you will be responsible for the voting of proxies with regard to those investments. We typically do not vote client proxies unless specifically requested.

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