The markets traversed a bumpier path in 2014 than the prior year. The S&P 500’s double-digit final return of 13.69% should please investors, but the ride surely did not. The market dropped over 5% three times during the course of the year (with a couple additional close calls). The big doozy came in October when the market swoon took us just shy of the much-awaited 10% correction level. Though there had been much angst about the unsustainably low volatility levels earlier in the year, when volatility spiked in October to levels not seen since 2011, concerns only grew. Nothing caused us to question our long-term bullish view so we advocated using the pullback as a buying opportunity.
Opportunity Equity bounced back from our third quarter pullback in the fourth quarter. While we beat the market by a good margin in the quarter, this strength fell short of what we needed to take us ahead for the entire year. We strive to beat the index by a significant margin with consistency, so we are always disappointed when we fail to do so. This is no exception. At the same time, we know with certainty that all active managers, including the best, underperform at times.
Since inception, Opportunity Equity outperformed 10 of its 15 years, by an average of 175 basis points per year.1 After two extremely good years (2012 and 2013), we warned people that the pace of outperformance could not be sustained. We didn’t expect to underperform, but even after lagging in 2014, Opportunity Equity had a cumulative gain of 160% (net of fees) over the past three years, more than doubling the S&P’s 74% cumulative return for the same period.1
Reversion to the mean is a strong and powerful force in the markets. The only good news about lagging the market in 2014 is that the force is now working in our favor, rather than against us. That, combined with our favorable macroeconomic outlook and the solid fundamentals and valuations of our companies, make us optimistic for the outlook this year. We expect market returns over the next few years to be lower than the past few, but we believe the Opportunity Equity strategy’s investments still offer some of the best opportunities available. We expect respectable returns going forward.
Evidence of an improving economy builds. The strength of third quarter GDP growth at 5% surprised many. Job growth in 2014 capped the best year since 1999. Corporate earnings growth remains solid, and dividends have been growing at double-digits. If this continues, it will help the market. Falling oil prices provides a net benefit to consumers that more than offsets any pain for producers. Inflation remains low, easing pressure on the Fed to increase rates significantly. Since rising oil and significant monetary policy tightening typically cause recessions, we still don’t see one occurring for a while. This is good news for the markets, since recessions typically end bull markets. We do believe a Fed tightening could cause a nasty market correction, and we are seeking to protect the strategy’s portfolio from this risk. Historically, this knee-jerk reaction has been a buying opportunity. Lastly, equity valuations are ok, not great, but we don’t believe they are an impediment to stock returns.
We like the broad positioning of the Strategy’s portfolio (housing, financials, technology and airlines) even more lately. We think this year will prove out our bullishness on housing. Many people we speak to vocally disagree with us (which we like, as it indicates what’s priced into the stocks). Our bullish view centers on demographics, and the need for more housing stock. Birth rates, household formations and demand have been hindered by the economy, but they have all bottomed and clearly started up. Supply constraints and credit availability created headwinds in 2014. Both remain, but are improving on the margin. Indeed, Raymond James recently upgraded their entire homebuilder coverage to outperform, saying Obama’s FHA price cut marks a “rare visible moment that marks a key inflection point which forces investors to take notice.” Rarely does the government make improving a particular industry a top objective.
New orders should see significant improvement year-over-year. Overall activity levels still languish near prior recession lows. We need big volume growth to meet estimated underlying demand creation, then even more to fill the hole that’s been created. You can buy the homebuilders for below-market multiples on this year’s earnings and we expect them to grow earnings double digits for as far as the eye can see.
We’ve taken down our weight in financials over the past few years as conditions have normalized. It remains our second largest sector exposure (after consumer discretionary, where the builders sit), and we’ve concentrated in our favorite areas. Mortgage insurers and the mega-cap banks make up the bulk now. We think both have significant upside. Mortgage insurers represent a significant piece of the future solution to private capital funding housing lending. They benefit from the housing dynamics we discussed previously, plus they trade at significant discounts to the market, while growing well above market rates for the foreseeable future. A similar valuation and growth case can be made for the mega banks. We expect companies like JP Morgan, Citigroup and Bank of America to generate significant amounts of excess capital that will eventually be returned to shareholders.
Some of the higher growth technology names were hit hard last year. Investor patience for lofty valuations and little progress towards profits understandably waned. This rout provided us the opportunity to add significantly to names we thought were wrongly penalized, like Amazon (where we added some long dated call options), Priceline and Coupons.com.
We appreciate your continued support and confidence. We promise to continue to work hard in an effort to generate attractive returns on your behalf.
Market Commentary
The S&P 500 Index climbed 13.69% this year, posting double-digit gains for a third year. The Dow Jones Industrial Average followed suit, rising 10.04% for the year, with the Nasdaq Composite surpassing both, closing out the year with a rise of 14.83%. Nine out of the 10 sectors in the S&P 500 posted positive returns at year-end, with Utilities and Health Care gaining the most with returns of 28.98% and 25.34%, respectively. On the other hand, Energy and Telecommunication Services did the worst posting returns of -7.79% and 2.99% respectively. Large-caps outperformed mid-caps, which beat small-cap names. Specifically, the large-cap Russell 1000 Index returned 13.24%, edging ahead of the Russell MidCap Index’s 13.21% gain for the year. The small-cap Russell 2000 Index posted 4.90% returns. Value stocks slightly outperformed growth stocks with the Russell 1000 Value rising to 13.45% compared with the Russell 1000 Growth Index’s rise of 13.05% over the year. Stocks outperformed bonds, with the Barclays U.S. Aggregate underperforming most equity benchmarks with a 5.97% return. However, long-dated U.S. Treasuries outperformed the S&P by at least 1000 bps, with the Barclays Long-Term Treasury Index rising 25.1%. Gold continued to decline in 2014, decreasing by 1.50%. The U.S. Dollar Index had its strongest year since 1997, increasing 12.79%, while oil prices fell 45.9%. IPOs finished out the year strong with $231.7 billion in proceeds and 376 firms completing IPOs, making this year the highest since 2010. Major developed countries ended the year with positive gains, with the United States being the top country with a rise of 13.69% followed by Canada with an increase of 8.35%. India was the strongest BRIC country, gaining 26.41%.
The stock market picked up speed in the fourth quarter after the largest correction in two years. The Nasdaq Composite led the charge with a 5.76% quarterly gain while the Dow Jones Industrial Average gained 5.20% and the S&P 500 rose 4.93%. The market started the quarter down, continuing the pullback that began at the end of September, but the market quickly regained momentum through the rest of the quarter reaching record highs as people continued to buy the dips. In October, the Fed finally ended QE3 but maintained the “considerable time” language in reference to the start of rate hikes. Seven out of the 10 sectors in the S&P 500 posted positive returns for the quarter, with Utilities and Consumer Discretionary gaining the most with 13.19% and 8.74% returns, respectively. Energy and Telecommunications performed the worst with returns of -10.68% and -4.16%, respectively.
Strategy Highlights
During the fourth quarter of 2014, Opportunity Equity generated a total return of 7.37% (net of fees).1 In comparison, the Strategy’s unmanaged benchmark, the S&P 500 Index returned 4.93%.
Using a three-factor performance attribution model, security selection and sector allocation contributed to the strategy’s outperformance, which was partly offset by the interaction effect. American Airlines Group Inc., United Continental Holdings, Delta Air Lines Inc., Intrexon Corp, and Fiat Chrysler Automobiles NV were the largest contributors to performance, while Genworth Financial Inc., Netflix Inc., Sberbank-Sponsored ADR, Pandora Media Inc., and Zulily Inc. were the largest detractors.
Relative to the index, the Strategy was overweight the consumer discretionary, financials, industrials and information technology sectors on average during the quarter. With zero allocation to utilities, Opportunity Equity was dramatically underweight this group and more moderately underweight the consumer staples, energy, health care, telecommunication services and materials sectors. In terms of sector allocation, the underweight position in the energy sector, which underperformed the index, contributed the most to the Strategy’s relative performance. On the other hand, the underweight in the consumer staples sector, which outperformed the index, detracted the most from relative performance.
The Strategy initiated seven positions and eliminated 14 during the quarter, ending the quarter with 56 holdings where the top 10 represented 36.6% of total assets, compared with the 17.4% for the index, highlighting Opportunity Equity's meaningful active share of around 96.3%.2
Top Contributors
- American Airlines Group Inc. was up 51.53% during the fourth quarter as lower fuel prices and better-than-expected Q3 metrics helped push the airline higher. American Airlines beat on adjusted EPS by $0.06 during the third quarter as a result of higher cargo and other revenues, along with lower fuel prices. American does not hedge its fuel cost, so it should be a big beneficiary of the drop in oil. American is expected to face some headwinds from their Venezuela capacity cuts, in addition to the $721 million it holds in Venezuelan bolivars awaiting repatriation. During the third quarter, American bought back 2.9 million shares and paid $72 million in cash dividends.
- United Continental Holdings increased over the fourth quarter, rising 42.96%. United Continental also benefited from lower fuel prices and an increase of 7.9% YoY in domestic mainline PRASM in the third quarter. In addition, United beat on adjusted EPS by $0.13 over the same period. While they are not yet returning capital to investors, they are expected to complete their $1 billion share repurchase program within the next three years.
- Delta Air Lines Inc. finished out the fourth quarter with an increase of 36.36%, also benefiting from lower fuel prices. For the third quarter, Delta announced solid results with slightly better ancillary revenue and cost performance. Over the period, Delta bought back $250 million in shares repurchases and returned another $75 million to shareholders through dividends. Delta has completed a new multi-year contract with American Express and is benefiting from its joint venture with Virgin Atlantic.
Top Detractors
- Genworth Financial Inc. had a rough fourth quarter decreasing by -35.11%. Genworth’s third quarter results missed estimates, with EPS missing by $0.13 even adjusting for unusual items. During the period, Genworth experienced $531 million in reserve increases as a result of the company’s LTC (long-term care) claim review that began in the second quarter with additional charges expected. Genworth had promised that the second part of the LTC claim review would be announced during the fourth quarter; however, they have since delayed the results, increasing negative perceptions.
- Netflix Inc. was down -24.29% for the quarter as third quarter performance disappointed. In the third quarter, domestic margins continued to increase but the lower-than-expected US subscriber count worried investors. Over the period, Netflix implemented a price increase while also decreasing total marketing spend. This is believed to have contributed to the lower-than-expected subscriber numbers. Netflix is working to continue to expand its original program offerings in 2015 along with its most recent release in 2014 of Marco Polo.
- Sberbank-Sponsored ADR was down -48.86% for the quarter as third-quarter EPS declined 27% from the second quarter. Although EPS were down, Sberbank announced that ROE was over 14% for the same period. Sberbank suffered from a spike in provisions, as well as the large drop in oil prices and the depreciation of the ruble over the period.
1Since inception, Opportunity Equity outperformed the S&P 500 net of fees for 10 calendar years. A complete record of Opportunity Equity’s annualized one-year performance history can be accessed by clicking here. For important additional information on Opportunity Equity strategy performance, please click on the Opportunity Equity Composite Performance Disclosure. Past performance is no guarantee of future results.
2Active share represents the share of strategy holdings that differs from the benchmark index holdings. The greater the difference between the asset composition of the strategy and its benchmark, the greater the active share.
Contact LMM to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.
Investment Risks: All investments are subject to risk, including possible loss of principal.
The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.
©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.
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