Portfolio Manager's Commentary

Third Quarter 2014

Performance Review

We repositioned the portfolio early in the third quarter, ahead of what we believe to be a forthcoming change in monetary policy in the United States. The shift entailed moderating exposure to small and mid-cap and emerging market stocks, while increasing the allocation to stable and liquid mega and large-cap companies. As the “Fed taper” is expected to conclude by the end of this year, we believe a hike in short-term interest rates is likely sometime after the first quarter, assuming the U.S. economy continues to improve. Federal Reserve Chair Janet Yellen has repeatedly stated that the central bank will press on with monetary stimulus until the U.S. labor market strengthens.  Employment growth has accelerated over the past five years and unemployment has fallen from 10% to 5.9%, converging upon the Fed’s “Natural Rate of Unemployment” target of 5.5%. As the Fed becomes less accommodative and interest rates begin to rise, less speculative and more dependable assets may outperform. Furthermore, we expect a more liquid portfolio to exhibit lower than market volatility, as markets have tended to display greater volatility in rising interest rate environments.

The relative underperformance of U.S. small-cap stocks became apparent early during the first quarter and then again in the second quarter after a short-lived recovery, as the Russell 2000 Index dropped markedly more than the S&P 500 Index. The Russell 2000 Index has lost more than 5% in the year to date, while the S&P 500 Index gained more 5%. The underperformance was broad and indiscriminate, with all small-cap sectors trailing their large-cap counterparts. We expect this relative underperformance to large-caps to continue, as it historically has during most tightening cycles. Emerging markets began to drop in late 2013 on monetary tightening concerns. The MSCI Emerging Market Index rebounded during the first and second quarters, but resumed its decline in early September. The chart below compares the returns of these three indexes—S&P 500 Index, Russell 2000 Index, and MSCI Emerging Market Index—over the last calendar year.

Q3 2014 Bloomberg chart

Source: Bloomberg

We remain committed to holding companies we find to be of the highest quality in terms of both operating fundamentals and environmental performance. The current portfolio continues to exhibit stronger growth and profitability metrics than the MSCI All Country World Index (ACWI). However, the emphasis of late has been centered less on sales and profit growth and more on quality of growth. We have also concentrated on the valuation metrics of the fund relative to the MSCI ACWI.

Selected Fundamentals as of 9/30/14

Portfolio 21: 6/30/14
Portfolio 21: 9/30/14
MSCI ACWI: 9/30/14
Sales Growth:1-Year (%)16.888.969.97
Sales Growth: 5-Year Geometric (%)12.339.548.76
Sales Year on Year Growth: Bloomberg Current Fiscal Year Estimates (%)10.857.896.50
EBITDA Growth: 1-Year Trailing 12M (%)11.3715.405.18
EBITDA Growth: 5-Year Geometric (%)10.189.649.12
Long Term Estimated EPS Growth (%)13.7712.7811.74
Gross Margin (%)46.4046.8543.56
Operating Margin (%)20.3121.2519.65
Return on Equity: Latest Quarter (%)18.9522.0618.64
Return on Equity: 5-Year Average (%)18.0420.6917.68
Long Term Estimated Return on Equity (%)21.8724.1019.89
Return on Invested Capital: Latest Year (%)13.7614.4011.64
Current P/E (x)19.7917.8316.05
Historical 5 YR Average P/E (x)18.4717.3115.08
P/E based on next 12 months (x)16.6015.4114.18
Debt to Capital (x)33.9335.0540.95

The Fund’s emphasis on the highest quality companies has not found favor with the broader market over the past few years. When measured by Return on Equity, MSCI ACWI constituents in the top half and even top quartile have underperformed since the market bottom in March 2009 and over the last three years. Additionally, companies that have reinvested profits into their businesses, as measured by capital expenditures relative to operating cash flows, instead of engaging in stock buybacks or shareholder payouts, have also lagged over the same time frames. The proportion of cash flow used for repurchases has swelled over the last decade while it has slipped for capital investments.

However, there are signs that change may be occurring. Higher quality companies actually outperformed in the third quarter. As rate hikes become more widely anticipated, corporate debt issuance will eventually slow off what has been a historically high pace. This will have a negative impact on stock buybacks, a major source of earnings growth for many companies, and will leave many companies with inflated debt levels. We continue to believe that companies without excessive leverage, reinvesting in their businesses at rates higher than their cost of capital, will be long-term winners.

Total Return 3/31/2009-9/30/14
Total Return 9/30/2011-9/30/14
Total Return 6/30/2014-9/30/14
Return on Equity (Trailing 12 Months)Top 50%130.86%53.78%-1.99%
Top 25%134.91%55.75%-0.44%
MSCI ACWI139.80%61.15%-2.20%
Return on Invested Capital (Trailing 12 Months)Top 50%131.61%54.52%-1.14%
Top 25%145.46%56.58%-0.14%
MSCI ACWI139.80%61.15%-2.20%
Cash From Operations/Capital ExpendituresBottom 50%122.38%37.66%-4.04%
Bottom 25%130.36%43.57%-2.68%
MSCI ACWI139.80%61.15%-2.20%

Environmental Performance

Climate change negatively impacts the environment, human health, and wellbeing, and poses significant risks to businesses and investors. At Portfolio 21 we are committed to identifying and investing in companies that effectively manage their direct and indirect carbon (and carbon equivalent) emissions. We believe companies with low carbon intensities are more likely to avoid certain future liabilities, such as carbon costs passed down the supply chain, and will be better prepared for changing climate regulations. Moreover, companies with low carbon intensities tend to have reduced energy costs and contribute to the creation a low carbon future.

At the close of this quarter, the Portfolio 21 Global Equity Fund achieved a 56% lower carbon footprint than the MSCI ACWI.1


In an ecologically constrained world, we believe carbon is not the only environmental indicator that will impact a company’s financial competitiveness. Companies around the world must also be cognizant of, and have strategies in place to minimize, their inputs (water and other natural resources) and outputs (waste and pollutants). Across all economic sectors, companies may achieve an overall lower environmental footprint by reducing inputs and outputs through the use of life-cycle analysis and design. Companies may also make capital expenditures to upgrade their facilities to be more resource efficient. Alternatively, companies can initiate waste optimization (recycling) projects that will result in an overall lower environmental footprint.

As of September 30th, Portfolio 21’s global mutual fund achieved a 48% lower environmental impact than the MSCI ACWI.2


These metrics demonstrate the effectiveness of Portfolio 21’s inclusion of environmental research in portfolio management. For more information on Portfolio 21’s impact as it compares with our benchmark, please see our latest Global Equity Fund Environmental Impact Report.

Performance Attribution

The largest performance detractor during the third quarter was related to currency, as the fund is overweight foreign assets, particularly European currency denominated equities. The dollar extended a four-year high as improving economic data fueled speculation the Federal Reserve is moving closer to raising interest rates, while the euro hit its lowest level against the greenback in over a year after the European Central Bank surprised markets by cutting a key benchmark rate and announcing a bond purchasing program meant to bolster Europe’s tepid recovery. In fact, all major currencies depreciated against the dollar during the period. Weak performance of international equity markets relative to U.S. equities amplified the negative impact. Despite the currency and country allocation drag, security selection within Europe and Asia had a positive contribution to returns over the period.

Beyond currencies and countries, sector allocation and performance influenced fund returns during the third quarter. Portfolio 21, and fossil fuel free investors in general, benefited by being underweight the Energy sector, as it was the worst performing economic sector over the period. Oil prices suffered the biggest quarterly decline in more than two years as ample supply shielded the market from the risk of disruption from conflict in the Middle East. Security selection within the Consumer Discretionary, Materials, and Telecommunication sectors had a positive contribution to performance. Contrarily, overweighting the industrials sector and poor relative performance of stocks within the Consumer Staples, Technology and Healthcare sectors inhibited fund returns.

Performance Leaders

Nike: A strong earnings announcement capped a big quarter for the footwear and apparel company. Nike’s stock was up over 23% on improved margins and strength across all geographies, reaffirming its status as a growth company. The company’s strong brand and continued innovation have allowed it to follow a premium pricing strategy even in its very competitive industry. Nike has long shown leadership in environmental sustainability and this commitment has also benefited the company’s bottom line. The company’s Flyknit technology is an example of innovation combining with environmental awareness to drive revenue.

TJX: After a rare earnings miss in the first quarter, investors were wondering whether the growth engine at TJX was slowing. The second quarter’s results put those fears to rest and the stock ended up over 12% for the quarter. The world’s largest off-price retailer posted strong numbers and affirmed its large growth opportunity in international and digital while continuing to execute at a high level across all current business lines. Due to its scale, management skill, and business model, we believe TJX is in a position to perform well regardless of macro-economic cycles. Bolstering its leading position is the company’s improving environmental, social, and governance (ESG) profile focused on energy efficiency in its stores and logistics efficiency in its carrier network.

Performance Laggards

Jeronimo Martins: It was another tough quarter for the Portugal-based grocer; its shares were down 26%. Intense competition and deflation in Poland, where Jeronimo generates 70% of its revenue, have slowed the company’s growth and weakened margins. However, it remains the price leader in Poland, has continued to take market share, and is in a better financial position than its competition. Management has shown the ability to adapt and innovate. A new plan for Polish stores will be unveiled in November while the company’s recent expansion into Columbia is tracking ahead of schedule. Jeronimo also has a competitive advantage over rivals on the ESG front as it continues to focus on local sourcing, healthy products, and eco-packaging.

Elekta: Disappointing quarterly results led to a 16% slide in the shares of the radiation oncology company. Weaker software sales led to a decline in margins as investors once again showed concern over the lumpiness of Elekta’s earnings. The company remains the technological leader in the field and with a new CEO focused on improved cash flow, a new gamma knife product, and a possible game changing MRI guided linear accelerator on the horizon, multiple catalysts are possible for the stock price. Elekta also holds a decided ESG advantage over its main competitor, Varian, due to its focus on product life cycle.

New Positions

We added American Express (AMEX) and UPS to the portfolio in the third quarter. AMEX provides charge and credit card products, travel services, network services, stored value products, loans, and other products and services to businesses and individuals. The company issues cards to consumers and engages in merchant acquiring and processing globally. The addition of AMEX to the Global Equity Fund improves the diversification and fundamental characteristics relative to the ACWI.  AMEX has a high correlation to the S&P 500 Index and the S&P 500 Financials Index and exhibits superior growth and profitability metrics when measured against the sector and benchmark, including higher margins, Return on Equity, and Return on Invested Capital.

We consider AMEX a low impact service company. As a service business, the company’s environmental footprint is minimal due to its business model and structure. AMEX’s direct environmental impact stems primarily from its data centers, which handle the company’s data traffic and transaction processing. To minimize the company’s impact, AMEX has established a 10% greenhouse gas reduction goal by 2017, from a 2011 baseline. Additionally, in 2012, 29% of the company’s electricity was derived from “green power,” compared with none just four years earlier.

United Parcel Service (UPS) is a logistics company that provides global package delivery and supply chain management services. It offers logistics services to the global market, which include transportation, distribution, forwarding, ground, ocean and air freight, brokerage, and financing. The company operates its business through three segments:  U.S. Domestic Package, International Package, and Supply Chain & Freight. The U.S. Domestic Package segment provides time-definite, money-back guaranteed, small package delivery services and also offers a spectrum of U.S. domestic guaranteed ground and air package transportation services. The International Package segment offers a wide selection of guaranteed, day and time-definite international shipping services. The Supply Chain & Freight segment consists of forwarding and logistics services, UPS Freight business, and financial offerings through UPS Capital.

UPS aggressively addresses the company’s largest environmental impact areas and recognizes energy efficiency and reduced carbon dioxide emissions as a business opportunity. The company recently launched Orion, a proprietary information technology system that applies an advanced algorithm to customized map data to provide delivery drivers with optimized route advice. Launched in 2013, Orion is expected to save 1.5 million gallons of fuel and avoid 14,000 metric tons of carbon dioxide emissions in 2014.

Fourth Quarter and Beyond

Markets enter the fourth quarter with more uncertainty about global growth and interest rates than in quite some time. With the Fed ready to step back we may be about to find out how much stock valuations have been influenced by the massive liquidity injections over the last five plus years. As assets reprice in the new, less Fed-driven environment, volatility may make its long awaited return. It is our belief that companies grounded in strong ESG and operating fundamentals will be more attractive to investors, providing some safety and some stability as risk becomes more defined.

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 ACWI (All Country World Index) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 44 country indices comprising 23 developed and 21 emerging market country indices. Returns reported reflect the net total return index, which reinvests dividends after the deduction of withholding taxes, using a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties. 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. Russell 2000 Index is an unmanaged index considered representative of small-cap stocks. MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries. The S&P 500 Financials Index is an unmanaged index considered representative of the financials market. An investment cannot be made directly in an index.

Free cash flow is revenue less operating expenses including interest expenses and maintenance capital spending.  It is the discretionary cash that a company has after all expenses and is available for purposes such as dividend payments, investing back into the business or share repurchases.

Standard deviation  is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatility.

Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

Information Ratio is a ratio of portfolio returns above the returns of a benchmark (usually an index) to the volatility of those returns. The information ratio (IR) measures a portfolio manager's ability to generate excess returns relative to a benchmark.

Earnings Growth is a measure of growth in a company's net income over a specific period, often one year. This is not a forecast of the Fund's future performance. Earnings growth for a Fund holding does not guarantee a corresponding increase in the market value of the holding or the Fund.

Earnings per share (EPS) is calculated by taking the total earnings divided by the number of shares outstanding.  EPS Growth and Earnings Growth are not forecasts of the Fund's future performance.

Return on Equity is the amount, expressed as a percentage, earned on a company’s common stock investment for a given period.

Return on Invested Capital is a calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments.

The Price to Earnings (P/E) Ratio reflects the multiple of earnings at which a stock sells.

EBITDA is earnings before interest, taxes, depreciation and amortization.

Correlation is a statistical measure of how two securities move in relation to each other.

  1. Trucost analyzed the holdings of the Portfolio 21 Global Equity Fund, calculated carbon emissions for nine greenhouse gases and then converted those amounts into tons of carbon dioxide equivalents. If companies did not disclose this information, Trucost used its in-house input-output model to create an environmental profile of the company based on data known about its industry and sub-sector. The carbon emissions considered include the company’s direct outputs as well as that of its first tier suppliers, such as electricity. The carbon emissions are then weighted by revenue and the amount of carbon the company contributes to the portfolio is apportioned based on the Fund’s ownership share. All of the companies in the portfolio are added together to provide the total amount of “carbon apportioned” to the Fund. The “carbon footprint” of the Fund is the total “carbon apportioned” normalized by total “revenue apportioned” by each holding. The same calculation was applied to the MSCI All Country World® Index to serve as a basis for comparison. As of September 30, 2014, Trucost covered 97% of the companies held in the Fund and over 99% of those tracked by the index. The remaining companies are not rated or included in Trucost’s model or portfolio analysis. []
  2. Trucost analyzed the holdings of the Portfolio 21 Global Equity Fund in five categories of corporate environmental impacts (Water use, Waste, Land and Water Pollutants, Air Pollutants, and Natural Resource Use) and then converted those impacts into environmental costs (USD) using natural capital cost coefficients. If companies did not disclose environmental impact data, Trucost used its in-house input-output model to create an environmental profile of the company based on data known about its industry and sub-sector. The impacts examined cover a company’s direct outputs as well as that of its first tier suppliers, such as electricity. The environmental impacts are then weighted by revenue and the amount of environmental impact the company contributes to the portfolio apportioned based on the Fund’s ownership share. All the companies in the portfolio are added together to provide the total amount of “environmental impact apportioned” to the Fund. The “environmental footprint” of the Fund is the total “environmental cost apportioned” normalized by total “revenue apportioned” by each holding. The same calculation was applied to the MSCI All Country World® Index to serve as a basis for comparison. As of September 30, 2014, Trucost covered 97% of the companies held in the Fund and over 99% of those tracked by the index. The remaining companies are not rated or included in Trucost’s model or portfolio analysis. []
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