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Value Equity
Q4 2016 Commentary
Market Review:
U.S. equities posted strong gains in the fourth quarter of 2016, with the S&P 500 returning +3.8% and the
Russell 1000 Value +6.7%. It was a historic quarter in many respects, capped by the unexpected victory
of Donald Trump on November 8th. While stock prices stalled in the weeks heading into the election,
Mr. Trump’s win lifted a cloud of uncertainty and reignited the “risk on” appetite in financial markets
that had begun in the third quarter. This trend, characterized by the significant outperformance of high
beta vs. low beta, cyclicals vs. defensives, and small-capitalization vs. large capitalization, accelerated
sharply with the prospect of fiscal stimulus and more business-friendly government policy.
Figure 1: Post-Election Performance Attribution 11/1/2016-12/31/2016
Source: Strategas Research Partners, 12/31/2016.
By far the largest beneficiary was the Financials sector (+21.1% in Q4), as investors anticipate increased
economic growth, higher trading activity, and a rising interest rate environment leading to higher interest
income for banks. The Industrials sector returned +7.2% for the quarter, largely on Mr. Trump’s pledge
to revamp the country’s aging infrastructure. On November 30th, OPEC reached a deal to cut output by
1.2 million barrels per day while non-OPEC countries, including Russia, agreed to cuts themselves,
leading to strong gains for the Energy sector (+7.3% in Q4). Defensive, higher-yielding stocks suffered in
the fourth quarter, with the Real Estate sector (-4.4% in Q4), Health Care (-4.0% in Q4), and Consumer
Staples (-2.0% in Q4) underperforming the market. Health Care was the only sector down for the full
year, as political pressure on drug prices and uncertainty surrounding the fate of the Affordable Care Act
continued to weigh on the sector.
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Figure 2: Sector Performance Relative to S&P 500*
Financials
U.S. Election
Energy
Industrials
Utilities
C. Staples
Healthcare
*Performance from 8/8/2016 to 12/31/2016
Source: Strategas Research Partners: Technical Analysis Research, Bloomberg, December 2016
At its December meeting, the Federal Reserve increased the target Fed Funds rate by 25 basis points to
between 0.5% and 0.75%, and raised its outlook for three, quarter-point hikes in 2017 from its previous
forecast of two. In her statement, Chair Janet Yellen cited as a reason for the actions “considerable
progress the economy has made”. Indeed, third quarter GDP rose at an annual rate of 3.5%, the
unemployment rate fell in November to a nine-year low of 4.6%, and U.S. home prices have recovered
and surpassed the record reached in 2006. Consistent with the Fed hike and higher prospects for growth,
the bond market sold off heavily, as the 10-year Treasury yield closed the year at 2.45%, up from 1.60%
at the start of the fourth quarter.
Performance Analysis:
The Value Equity composite returned 3.0% net of fees in the fourth quarter of 2016 (Figure 3). The S&P
500 returned +3.82% for the quarter and +11.96% for 2016, while the Russell 1000 Value returned
+6.68% for the fourth quarter and +17.34% for 2016. The sharp rise in stocks this quarter was driven by
the remarkable post-election rally, as the market quickly began discounting the prospect of fiscal stimulus
(e.g., lower taxes, infrastructure spending, repatriation of off-shore cash) and more business-friendly
government policies. The anticipation of stronger economic growth drove inflation expectations higher
and consequently, a spike in long-term Treasury yields and the sharpest 20-day rate of change for bank
stocks since 2009.
The “risk-on” sentiment following the election fueled a rotation into high-beta, cyclical and small
capitalization stocks, which outperformed low-beta, defensive, large capitalization stocks, with the
highest beta quintile outperforming the lowest beta quintile by 1,050 basis points in the quarter. The
composition of the Russell 1000 Value contributed outsized gains for the benchmark in the quarter and
full year. The three best-performing sectors for the fourth quarter, Financials, Energy and Industrials,
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comprise roughly 50% of the Russell 1000 Value, versus only 32% of the S&P 500. Furthermore, the
Russell 1000 Value, with a median market capitalization of $8.2B, benefitted from exposure to small
capitalization outperformance; in the fourth quarter, the lowest quintile of stocks based on market
capitalization in the Russell 1000 Value outperformed the highest quintile by approximately 2,000 basis
points. Small capitalization companies are generally regarded as having less exposure to protectionist
trade policies and a strengthening U.S. dollar than larger, multi-national firms.
Figure 3: Value Equity Returns vs. Benchmarks
Value Equity (net)
S&P 500 Index
Russell 1000 Value Index
Q4
YTD
1 Year
3 Year
5 Year
10 Year
3.0
3.8
6.7
11.5
12.0
17.3
11.5
12.0
17.3
6.3
8.9
8.6
12.3
14.7
14.8
6.1
7.0
5.7
Performance for periods greater than 1 year is annualized
Portfolio Attribution:
Attribution Effects –Value Equity vs. Russell 1000 Value 9/30/2016 – 12/31/2016
Source: SCCM/Bloomberg, 12/31/2016.
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The Energy sector was the largest contributor to relative performance for the quarter. Our strategy’s
strong stock selection helped drive excess returns in the sector with ConocoPhillips Chevron, and
Halliburton each up double digits. Relative performance was also aided by our underweight allocations in
the Utilities and Real Estate sectors as we have no exposure to either of these underperforming sectors.
Superior stock selection in Consumer Discretionary and Information Technology contributed to
absolute and relative performance for the quarter.
Financials was the largest contributor to absolute performance; however our underweight allocation to
this top performing sector hurt relative performance. Our overweight allocation to Health Care, an
underperforming sector, was a drag on relative performance for the quarter. The Industrials sector was
also a drag on relative performance for the quarter driven by the rally in more cyclical industries
benefitting from the prospect of infrastructure spending. Stock selection within Materials,
Telecommunications and Consumer Staples hurt relative performance for the quarter.
Portfolio Changes:
There were no portfolio changes during the quarter.
Market Outlook:
The current expansion, which began in early 2009, is entering its eighth year and is now the 2nd longest
bull market since 1928 at over 94 months in duration and up over 220%. With U.S. GDP growth barely
mustering 2%, financial markets have rocketed higher on unconventional monetary policy in the form of
ultra-low (and even negative) interest rates and quantitative easing. Now, the prospect of fiscal stimulus
and deregulation, has revived animal spirits in hopes that the new Administration’s policies will revive
growth and inflation. However, the market appears to be looking past potential challenges ahead: the
Administration’s ability to transform broad themes into concrete policy proposals; the willingness of
Congress to support drastic increases in infrastructure spending or any rollback of federal regulation; and
the amount of debt Trump’s proposals would add to the country’s already historic debt burden (currently
107% U.S. Government Debt to GDP, the highest since President Truman in the 1940’s).
Trump’s initial priorities are repealing the Affordable Care Act (ACA) and implementing tax
reform. With a Republican Congress and Senate, the new administration has a favorable chance of
lowering the statutory tax rate (while removing some tax deductions) and facilitating the repatriation of
offshore cash. Lower corporate taxes would boost cash flow and earnings, and could fuel M&A, share
repurchases and dividend payments. Capital investment may also pick up if companies believe end
market demand and capacity utilization will improve. GOP House leader Paul Ryan has floated a
territorial-based tax plan, including a border-adjustable tax proposal, which would tax the gross value of
any imports but would not tax the exports of American companies. This new, destination-based
consumption tax system has significant, far-reaching implications for corporate profitability, currencies,
and trade deficits with numerous other financial implications yet to be fully understood. In addition, the
new administration views infrastructure and Defense spending as key tools for injecting growth into the
economy. However, the country’s large budget deficit and massive debt levels, as well as the budget
reconciliation process, are considerable hurdles for passage of fiscal spending packages. Moreover, these
spending programs, given their relatively small size, are unlikely to significantly boost GDP growth.
The market has already discounted substantial upside from these policies, with expectations for earnings
growth in 2017 and 2018 revised significantly higher. Market sentiment has moved to extreme levels
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with recent Investors Intelligence readings jumping to over 60% bulls and the bull/bear ratio at over 3:1,
both over 90th+ percentile extremes. With equity markets trading at heightened valuation levels, further
appreciation will depend heavily on earnings growth, particularly since P/E multiples have tended to
contract when inflation rises.
Figure 4: Average S&P 500 LTM P/E by CPI Y/Y Tranche (1950-Current)
Source: Strategas Research, January 2017.
The Federal Reserve forecasts three quarter-point rate hikes in 2017, dependent on economic data.
Economic expansions can remain in place for years, but they often end when central banks fear
overheating and raise interest rates to cool economies. Post World War II, the Federal Reserve has
embarked on 12 rate hike cycles in an attempt to engineer soft landings; however, it has only been
successful once (in the mid-1990’s), while the other 11 instances have resulted in recessions and equity
bear markets (Gary Schilling Insight, January 2017). The following charts demonstrate that stable,
defensive sectors have outperformed in the past seven rate hike cycles since 1970.
Figure 5: Sector Performance After Fed Hikes
Source: BCA, January 2017.
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As rates move higher off recent historic lows, financial conditions are already tightening. Higher interest
rates increase borrowing costs, reduce consumer spending and often slow economic growth. Sharp jumps
in yields have preceded several market crises.
Figure 6: S&P Current and Historical Valuations and SCCM Exposure
Source: Cornerstone Macro, January 2017.
With the market near all-time highs and broad-based valuations on stocks at elevated levels, we believe
investors should be more mindful of risk, not less. The most effective way to manage risk is to adhere to
an investment discipline focused on valuation and quality, which is the core tenet of our investment
approach.
Relative to fixed income and equity benchmarks, the valuation of our portfolio remain attractive. The
strategy trades at 14.0x 2017 earnings versus 18.2x for the S&P 500 and 17.5x for the Russell 1000
Value.
Best Regards,
Schafer Cullen Capital Management, Inc.
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Disclosure: Schafer Cullen Capital Management (SCCM or the “Adviser”) is an independent investment advisor registered
under the Investment Advisers Act of 1940. This information should not be used as the primary basis for any investment
decision nor should it be considered as advice to meet your particular investment needs. The portfolio securities and sector
weights may change at any time at the discretion of the Adviser. It should not be assumed that any security transactions,
holdings or sectors discussed were or will be profitable, or that future recommendations or decisions will be profitable or equal
the investment performance discussed herein. Investing in equity securities is speculative and involves substantial risk.
Past performance is no guarantee of future results. Market conditions can vary widely over time and can result in a loss of
portfolio value. Individual account performance results will vary and will not match that of the composite or model. This
variance depends on factors such as market conditions at the time of investment, and / or investment restrictions imposed by a
client which may cause an account to either outperform or underperform the composite or model’s performance. A list of all
recommendations made by SCCM within the immediately preceding period of not less than one year is available upon request.
The strategy depicted in this report has been managed in accordance with the investment objectives of the strategy as
determined by the Adviser. The Adviser has selected benchmarks, which in their opinion closely resemble the style of the
securities held in the composite or model portfolio of the strategy (e.g. large cap value, small cap value, international, etc.). The
securities held in the composite or model are actively managed while the benchmark index is not. Investors should be aware
that the Adviser makes no attempt to match the portfolio securities, or the security weightings of the benchmark. The
composite or model’s performance will be affected greater by the price movements of individual securities as the composite or
model is more concentrated, generally less than 100 securities, while a comparative benchmark will generally have between
500 and 2,500 securities where individual security price movements have a lesser affect. An individual cannot invest directly in
an index.
In the case where this report displays model results, please be aware that such results do not represent actual trading and that
results may not reflect the impact that material economic and market factors might have had on the Adviser's decision-making if
the Adviser were actually managing clients' money.
Model and actual results reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that a
client would have paid or actually paid (Net of Fee performance) and reflect the reinvestment of dividends and other earnings.
Schafer Cullen Capital Management, Inc. makes no representation that the use of this material can in and of itself be used to
determine which securities to buy or sell, or when to buy or sell them; SCCM makes no representation, either directly or
indirectly, that any graph, chart, formula or other device being offered herein will assist any person in making their own
decisions as to which securities to buy, sell, or when to buy or sell them.
All opinions expressed constitute Schafer Cullen Capital Management’s judgment as of the date of this report and are subject to
change without notice.
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