From the stock market lows in 2009 until midyear 2010, the more economically leveraged stocks had largely outperformed less economically-sensitive, “higher quality” stocks. As a result, many high quality businesses (i.e. those with more consistent revenues, earnings and economic returns) were trading at very attractive valuations. During this time, we took advantage of the disconnect between the attractive fundamentals and discounted valuations and purchased a number of these businesses at attractive valuations.
Now, as the economic recovery sputters, investors have flocked to these high quality companies and, as a result, many of these stocks have outperformed the broader market. Given the inherently stable nature of these businesses, and the fact that many pay attractive dividends, we are pleased to be participating in the relatively stronger returns, especially in light of the relatively lower risk assumed.
With the stronger returns over the past two years, many of these businesses are now trading at more full valuations. As such, we have been harvesting gains in some of these stocks, especially where they have grown to be sizable positions in portfolios, and redeploying the proceeds into new areas where we believe the market has presented new attractive opportunities: Housing (Potlatch Corp and DoubleLine Total Return Bond Fund), Information Technology (EMC Corp) and Healthcare (via European-based company Sanofi SA).
As a leading owner of timber in the U.S. and a major supplier to the U.S. housing market, Potlatch Corp (PCH) is a business we have been interested in for some time. Our constructive view of a gradually improving U.S. housing market and some important recent strategic decisions by PCH management gives us confidence that PCH’s business will benefit in the years ahead.
Our investment in PCH offers a combination of offensive and defense characteristics. It is defensive because the company has recently right-sized the business and the dividend (~3.5% yield*) to the current recovering housing environment. PCH is offensive because it will directly benefit from a stronger housing market as more home construction and re-modeling activity drives increased demand for PCH’s wood products. In addition, there is strong investor interest in timber assets and the stock is inexpensive relative to recent private market land transactions.
Importantly, we do not expect a quick, robust or smooth recovery in housing. Given the broader investment climate, we have been patient and disciplined in our interest in PCH, waiting for both the cut in production and dividend to match the current housing environment and for the market to give us an opportunity to purchase PCH at a sufficient discount to our conservative view of fair value.
DoubleLine Total Return Bond Fund (DBLTX/DLTNX) is a Fund that invests primarily in mortgage securities. We view this as a fixed income investment opportunity offering an attractive current yield with the potential for higher total return opportunities. DoubleLine is positioned to benefit from our thesis of a gradually improving housing market over the next couple of years with a portfolio of mortgage debt that is trading at levels reflective of the ongoing concerns over household balance sheets and future income growth.
Our investment in Doubleline also offers a combination of offensive and defense characteristics. It is defensive because the fund is comprised of high quality mortgages with a relatively short duration and it pays a current yield hovering around 7%*, and the underlying portfolio is trading at a discount to par value. DoubleLine is offensive as a direct beneficiary from the gradually improving housing market and employment picture, which should benefit the underlying value of its mortgages.
EMC Corp (EMC)
is a leading global provider of information storage systems and virtualization software with an 80% majority ownership of VMware. During the second quarter of 2012, EMC stock was weak (down over 20%) due to broad-based weakness in Technology stocks as well as lackluster earnings from one of its main competitors, providing us the opportunity to initiate an investment at a discount to our estimate of fair value.
EMC has grown free cash flow in the mid-teens over the past four years and should be able to continue to grow in the years ahead. Future revenue growth will be driven by global data growth, which is projected by the research firm IDC to be 40% per year through 2020. In addition, fast growing high margin software revenue is an increasing portion of EMC’s business. The company has a strong balance sheet and an excellent track record of capital allocation decisions.
is a diversified global leader in healthcare based in Paris, France. The ongoing financial crisis in Europe combined with some patent expirations, have created significant volatility for SNY’s stock. However, only 27% of revenues are derived from Western Europe, compared with 60% from the U.S. and emerging markets, and the company has a strong pipeline of new drugs in development – which are the key future value drivers of the stock.
We have taken advantage of the broad selloff in European stocks and purchased Sanofi at an attractive valuation. The company is approaching the end of its patent cliff and is positioned for accelerating earnings growth and improving returns on equity. In addition, SNY has an underappreciated pipeline, with eighteen new product launches expected over the next four years. The company also pays a solid current dividend (~4% yield*) that has the potential to grow meaningfully in the years ahead.
Initiating some of these investments at the time we did seemed contrary to the general mood of the markets. However, as legendary investor Sir John Templeton once remarked “If you want to have a better performance than the crowd, you must do things differently from the crowd.” We have been pleased with many of our contrarian investments in high quality stocks over the past few years and are optimistic that recent investments offer similar opportunities for the years ahead.
*Yields provided are as of the date posted.