Third Quarter 2011
Many national equity markets entered into a bear market over the period as volatility spiked on worries over economic growth and sovereign debt issues. The macroeconomic environment is hostile and it may get nastier still. The U.S. recovery is faltering two years after the biggest slump since the Great Depression. Economic data is suggesting slow growth and many are concerned the slowdown could last years rather than months.
Fund Performance
Portfolio 21's third quarter performance matched that of the MSCI World Equity Index. Fund returns were inhibited by a higher-than-benchmark allocation to foreign markets, while performance was enhanced by a higher allocation to defensive economic sectors and companies.
See Portfolio 21's complete standardized performance. Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling 877-351-4115.
Performance data quoted does not reflect the 2.0% redemption fee on shares held less than 60 days. If reflected, total returns would be reduced.
Equity Markets
Stocks fell in the third quarter, dragging the MSCI All Country World Index to its biggest quarterly loss since 2008. Many national equity markets entered into a bear market over the period as volatility spiked on worries over economic growth and sovereign debt issues. The macroeconomic environment is hostile and it may get nastier still. The U.S. recovery is faltering two years after the biggest slump since the Great Depression. Economic data is suggesting slow growth and many are concerned the slowdown could last years rather than months. The Federal Reserve said it saw "significant downside risks" in the U.S. economy and outlined a plan to replace $400 billion of short-term debt with longer-term Treasuries to spur growth. The sovereign debt crisis in Europe appears to be spiraling out of control. The European Financial Stability Facility (EFSF) was created last year to assist debt-troubled euro zone nations. European leaders continue to debate the scale and scope of bailouts. The original funding (EUR440 billion) is undoubtedly not enough. The EFSF is attempting to solve the excessive debt problem with more debt that will be "guaranteed" by Europe, but bailing out the offenders may not make for an effective disciplinary action. An additional concern weighing on investors' minds is the state and path of the Chinese economy. There is increasing market concern about China and a few cracks are starting to appear in its economic growth.
The S&P 500 index lost more than 13% in the third quarter on fears that a wave of European debt defaults would topple Europe into recession, which would hit a U.S. economy already at risk of falling into a double-dip recession. The losses came against the backdrop of recent weak economic data, the U.S. losing its triple-A credit rating, and the inability of lawmakers to address worries that another recession may be on the way. The Federal Reserve's efforts to support the economy, including holding its benchmark rate at virtually zero since December 2008 and expanding its balance sheet to a record $2.9 trillion, have done little to reduce the unemployment that has hovered around 9% since April 2009, or to revive the housing market.
Foreign stocks performed even worse. Sovereign debt worries plagued European stock markets. The EURO STOXX 50 Index sank 23% in euro currency terms. In U.S. dollar terms the index lost nearly 30%. The German and French indices ended the quarter down around 25% as a slow response from politicians to the growing crisis continued to unnerve traders. Persistent squabbling over financial policy has been a major obstacle to achieving a lasting solution to Europe's debt crisis. The challenge is how to reconcile national interests with the need to leverage common economic goals in the most efficient way. The FTSE 100 Index dropped 13% as the outlook for the British economy weakened so quickly that the Bank of England signaled it was ready to pump in more money, potentially as soon as October. Japan's Nikkei 225 Index fell 11% as exports fell due to slower economic growth and a stronger yen. Consumer spending also remains weak and unemployment is on the rise. Moody's lowered Japan's rating to Aa3 from Aa2, citing large deficits and the buildup in government debt.
The much-heralded decoupling by emerging markets was absent during the third quarter. There was no place to hide. Brazil's Bovespa Index depreciated 16% after economists raised their forecast for inflation and lowered their forecast for economic growth this year. Chinese stocks sank to an April 2009 low in the third quarter on concerns that growth is slowing due to the government's measures to dampen inflation and slumping external demand for the country's exports. Stocks in India also fell on slowing economic growth and accelerating inflation.
It seems that international investors expect the world economy to relapse into a recession, with more than one in three forecasting a global economic meltdown within the next year. After all, fiscal tightening in a deleveraging economy isn't expected to produce growth. However, the fiscal and monetary reforms needed in the U.S. and overseas to sustain this advance have little chance of happening. The International Monetary Fund predicted "severe" repercussions if Europe fails to contain its debt crisis or if U.S. policy makers reach an impasse over a fiscal plan.
The crux of the mainstream bullish argument for stocks put forth by many investment strategists is that stocks are inexpensive based on standard measures such as price-earnings ratios as well as the equity-risk premium. Both measures depend on corporate earnings forecasts, which are open to uncertainty. P/E ratios will not protect equity prices where there are significant cuts to earnings. Corporate profit margins were terrific in 2010 but have become less so this year. Labor costs are surging, which is slashing margins and trends in productivity have deteriorated. We may be at a tipping point at which companies no longer can pass on cost increases in a low-demand world. Earnings projections for U.S. companies are just beginning to be scaled back, acknowledging more of a chance that the country will again fall into a recession.
World Currencies
In general, currency market valuations are driven by inflation in the long run and the ebb and flow of risk aversion in the short run. Over the past quarter investors have been trying to determine which currency is least unattractive.
The Japanese and U.S. currencies were the best performers during the third quarter. The yen climbed toward a record high against the dollar and most other currencies as investors sought shelter from fears over euro zone and U.S. government debt. The dollar advanced as a sell-off in global equities weighed on risk appetite and drove demand for the U.S. currency, which is perceived as a potential safe haven. Demand for U.S. assets rose as investors pursued liquidity, even though the Federal Reserve has pledged to keep its benchmark interest rate near zero through mid-2013 and Standard & Poor's cut the nation's credit rating from AAA.
The euro dipped to below $1.36 as European policy makers continued to tussle over measures to tackle the threat of a Greek default. Other European currencies fell in sympathy. Investors have doubts about whether Greece will implement austerity moves fast enough to get a sixth payment from last year's EUR110 billion bailout. Many contemplated that the euro's existence may require members to leave the 17-nation currency region. Greece and perhaps Portugal may decide financial stability and the bailouts aren't enough to compensate for the continued austerity and bet it would be easier to write down debt, spur exports, and improve competitiveness with a cheaper currency.
Emerging market currencies finally reacted to global risk aversion, reduced liquidity, slower growth, and contagion of the European crisis. The Brazilian real, the South African rand, and the Mexican peso declined double-digit percentages against the U.S. dollar. Major Asian currencies depreciated to a lesser extent.
Economic Sectors
Average correlations between the ten major sectors of the S&P 500 approached 100% in the third quarter from around 80% just three months ago. That's the highest level of such common price action since the financial crisis. These high correlations may plague markets through the end of the year, since they are fundamentally caused by worries over European financial market solvency.
All of the economic sectors lost value in the third quarter. Economic sectors with defensive characteristics declined the least, with the utilities sector ahead of the pack.
Utility stocks are considered potential safe havens and offer nice dividends. Many sport yields of at least twice that of 10-year Treasuries. Portfolio 21 is overweighted in utility stocks, however, the group underperformed due to a higher allocation to European and Brazilian positions. Healthcare stocks didn't do too badly over the period and fund stocks performed in line with their global peer group. Healthcare companies typically exhibit a higher degree of earnings stability and many sport juicy dividend yields too. The peak-to-trough fall in drug-sector earnings during the previous downturn was just 7%.
Cyclical economic sectors were the worst performing group during the third quarter. The financial services, materials, and energy sectors topped the list on the downside. Concerns that the credit crisis in Europe may threaten to spill over into U.S. banks pressured Wall Street, sending shares of major banks to their historical lows. Banks are suffering from worries about possible write-downs of euro zone debt and less profitable lending due to the U.S. Federal Reserve's new measures to lower longer-term interest rates. Profit estimates for financial services companies have been slashed. Combined first-half earnings at the fifteen largest U.S. banks by assets dropped 17% from a year earlier, led by a decline at four of the six biggest on a drop in trading revenue and net-interest-margin compression. Second-half earnings reports may be even bleaker. Portfolio 21's exposure to the financial services sector is half that of the MSCI World Equity Index and Portfolio 21 financials outperformed. Not having direct exposure to European banks helped fund performance.
Not having direct exposure to much of the commodities and energy sectors also enhanced fund performance. Commodity-related stocks plummeted amid concerns that the euro zone sovereign debt crisis will derail the global economic recovery. Copper prices have plunged, far exceeding the pullback in stocks. The selloff is particularly significant given that the metal is used in everything from iPads to indoor plumbing and electrical wires. Oil prices fell on increasing supply and a weaker demand outlook. The International Energy Agency reduced its oil demand estimate for 2011 and 2012, citing lower economic growth. However, the agency still forecasts oil demand to be marginally higher than current supply next year.
Individual Stocks
Some Portfolio 21 stocks appreciated in the third quarter. China Mobile, the world's biggest phone carrier by users, gained after posting a rise in second-quarter profits that beat analysts' estimates after data traffic rose on demand for smartphone games and videos. The stock was also driven higher by confirmation of an alliance with Apple that might lead to an iPhone for China Mobile's fourth-generation high-speed wireless data network. Shares of Google rose after the owner of the world's largest search engine reported sales and profit that topped the Street's expectations, a sign that the company is benefiting from efforts to expand in mobile and display advertising. IBM, the biggest computer services company, climbed after it reported sales that beat analysts' estimates and lifted its profit forecast amid buoyant demand for software. Roche gained on encouraging data on dalcetrapib, a drug in late-stage development that raises "good" cholesterol. A handful of other fund stocks rose during the period including Cisco, Severn Trent, and National Grid.
Some Portfolio 21 stocks declined significantly in the third quarter. Johnson Controls fell after analysts questioned third-quarter profit margins on record sales. NetApp dropped after the maker of data storage products reported first-quarter sales that missed analysts' estimates. Accor slumped as analysts reduced industry revenue per room metrics for 2012 to near zero. Itron declined on belief that organic growth for electronic meters will turn negative following the end of stimulus driven demand. Metal recyclers Schnitzer Steel and Sims Metal Management dived along with falling scrap prices. Other fund stocks that underperformed during the period include Ormat, SolarWorld, Mitsubishi Electric, Electrolux, and Bank of New York Mellon.
Trading Activity
We engaged in transactions during the third quarter to better position Portfolio 21 for the future amid intensified market volatility. We sold Johnson Matthey to reduce exposure to falling metal prices and a slowdown in global manufacturing and we sold Reed Elsevier on competitive threats and a lack of growth conviction. We sold our position in Westpac Bank; with loan growth slowing and bad debts growing, there are better opportunities elsewhere than this Australian bank. We sold Apogee. In the current market and economic environment we are focusing more on solid companies with stable and/or improving business fundamentals. We also sold Volvo in order to pare down fund exposure to Swedish industrials, as well as the krona.
We trimmed several fund positions on strong stock performance and redeployed the proceeds into more undervalued stocks. We trimmed our position in Scottish & Southern Energy partly on a nice run-up in the stock and partly to cut fund exposure to the utilities sector. We trimmed our position in Henkel. The stock had doubled in value over the past two years, but the company is facing some headwinds, including higher raw materials prices and slowing manufacturing demand.
We retooled the fund's transport positions. We sold PostNL, Deutsche Post, and Mitsui O.S.K. Lines. PostNL was the mail and logistics arm of TNT, which was recently broken off into a separate company. As a stand-alone company, PostNL's core business is a slow grower at best. Deutsche Post's express unit (DHL) has exhibited inferior performance in terms of growth and profitability. We reinvested the proceeds in some more recently approved companies in the transport space that have better growth prospects and are more profitable, such as FedEx and Expeditors International.
We initiated a position in Cree. Shares were more than cut in half on slumping growth and profits. The company is grappling with weakness in the LED lighting market, pricing pressure, and excess inventories. Nonetheless, we believe that Cree is well positioned to prosper as the industry shifts toward high-efficiency LED lighting. Cree has invested massive sums in R&D to establish its sector-leading position. Moreover, the company will be transitioning to more efficient manufacturing production which will enable it to improve its expense structure. We also established positions in Danone and Deere & Co. Danone shares have already had a decent run this year but the stock has been unloved for some time. The company is #1 or #2 globally in its four categories (fresh dairy, baby food, beverages, and clinical nutrition) and is growing faster than its competition. We feel all four lines fit well in a sustainable future and that Danone's ESG (environmental, social and governance) performance is strong across the board. Deere & Company has been, and continues to be, a leader within the agricultural equipment sector. Food, agriculture, and agricultural equipment are essential goods/services and will continue to be in demand independent of the sovereign debt or ecological crises.
We selectively waded back in to the solar sector with SolarWorld after taking profits in SunPower. The company is integrated, which gives SolarWorld tight control over its supply chain and enables the company to manage against fluctuations in polysilicon and panel prices. We also like that SolarWorld has become a brand name for residential solar, particularly in Germany and the U.S., the two largest solar markets.
Finally, we also added to some existing Portfolio 21 positions. We purchased more Samsung, the undisputed market leader in flash memory and DRAM. The company has gained significant traction in the lucrative and fast growing smart phone and tablet market segments, but recent weakness on intellectual property concerns and competitive threats have provided an opportunity to buy more shares. We bought additional shares of Cosan on optimism over sugarcane production in Brazil. We also added more shares of Sabesp to the fund. Sabesp is a play on infrastructure in Brazil, with growth being driven by demographics and sustainability trends. We purchased more shares of Ameresco as the company's budget-neutral solutions make economic sense for addressing aging infrastructure in North America. We also bought additional shares in Electrolux, Schneider Electric, Ecolab, MTR Corporation, and Waste Management on weakness.
The information provided herein represents the opinion of the Portfolio Manager of the Fund and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.
Past performance does not guarantee future results.
Holdings are subject to change and are not recommendations to buy or sell any security. See complete fund holdings information.
The MSCI All Country World Index is a market-capitalization-weighted index composed of over 2,000 companies, and is representative of the market structure of 48 developed and emerging market countries in North and South America, Europe, Africa, and the Pacific Rim. The index is calculated with net dividends reinvested in U.S. dollars. The S&P 500 Index is a broad-based unmanaged index of 500 stocks, which is widely recognized as representative of the U.S. equity market. The Dow Jones EURO STOXX 50 Index is a market capitalization-weighted stock index of 50 large, blue-chip European companies operating within euro zone nations. The FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. The Nikkei 225 Index is the leading and most-respected index of Japanese stocks. It is a price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange. The MSCI World Index is a capitalization weighted index that monitors the performance of stocks from around the world. The Bovespa Index is an index of 50 leading stocks traded on the São Paulo Stock, Mercantile & Futures Exchange. One cannot invest directly in an index.
Moody's and Standard & Poor's are ratings companies that assign a rating to a company's or country's debt based on its analysis of the issuer's credit worthiness. The highest rating given is AAA and the lowest is C.
The Price-Earnings ratio (often abbreviated as P/E) is the current market price of a company share divided by the earnings per share of the company.
Correlation is a statistical measurement of the relationship between two variables, such as securities or market sectors.
