2012 was a year of above average, double digit returns for U.S. equities, with large cap stocks (as measured by the Russell 1000® Index, +16.42%) beating out small cap stocks (as measured by the Russell 2000® Index, +16.35%) by a nose. With regard to style, Value outdistanced Growth by more than 2% for both these Indexes, with most of the outperformance coming in the fourth quarter. The main reason seems to be increasing investor appreciation for improved fundamentals within the financial services sector, which was the top-performing sector in large cap and ranked in the top three in the small cap universe. Along with improved fundamentals, financial services companies seem to be successfully adapting to their new regulatory environment. If the much-improved trend for the group was to continue, it would be a significant positive for the market and the economy.
Concerning the economy, the slow but steady expansion we anticipated did come to pass last year, marked by dramatic improvement in the housing market and grudging improvement in the job market. Those two factors helped push consumer confidence to a four and a half year high. As confidence has improved and the consumer has de-levered, Americans have gotten back to doing what we do best – shop. Given that approximately two-thirds of U.S. GDP is comprised of consumer spending, their confidence and expenditures is key to growth going forward. Interestingly, in the nearly four-year period since the recession trough in 2009, the Consumer Discretionary sector has been the best-performing sector in large cap and in the top three in the small cap universe. Further appreciation in home prices, improved access to credit and steady, if unspectacular, job growth should all help to accelerate this trend as we move through 2013.
Portfolio Positioning
The Diversified Equity portfolio is broadly diversified, with sector allocations resulting from opportunities we identify at the stock level through our bottom-up fundamental analysis and valuation work. During the fourth quarter, the changes in sector allocation were subtle, with Consumer Discretionary exchanging places with Financials for the top spot, followed by Health Care as the third largest sector weight. Year over year, the portfolio saw a significant decrease in exposure to Information Technology, which was the largest sector at year end 2011, Industrials and Energy, with the basis points redirected toward opportunities in Consumer Discretionary and Consumer Staples. While always driven by bottom-up analysis, the changes reflected a shift towards a strengthening domestic economy and the consumer specifically. Financials remained one of the top-three sector weights both years.
Similar to the gradual change in the portfolio’s sector weights, the changes in TAMRO’s three fundamental investment categories occurred in a gradual fashion. The percentage of the portfolio invested in Laggards (restructuring candidates with new or reinvigorated management who have a successful track record that can drive profitability higher) increased during 2012 from 8% to 12% and Innovators rose from 14% to 18%, while the percentages invested in Leaders declined from 78% to 70%.
Fourth Quarter 2012 Attribution Analysis
Stocks moved higher in November and December, helping the Russell 1000 Index recoup October losses and move into positive territory for the fourth quarter. However, weak stock selection caused the Composite portfolio to underperform the benchmark, the Russell 1000 Index. Stock selection in the Technology, Health Care and Financials sectors had the biggest negative attribution impact. On the positive side, the Telecommunication Services, Energy and Industrials sectors contributed to performance on both an absolute and relative basis. An underweight in Technology benefited the portfolio and helped lead to an overall positive sector allocation effect.
2012 Year-End Review - Q&A
with Philip D. Tasho, CFA, Chief Executive Officer and Chief Investment Officer and Timothy A. Holland, CFA, Portfolio Manager
Q: What are your thoughts on the stock market and economy in 2012?
A: It was an above-average year for stock returns across the domestic market cap spectrum. Ultimately, unconventional and accommodative monetary policy trumped investor concerns over fiscal policy, the Presidential election and weakness overseas. The Federal Reserve (the Fed) entered uncharted waters when it announced open-ended quantitative easing through the ongoing purchasing of government securities. Importantly, other central banks globally waded in by mimicking the Fed in word if not deed and the global liquidity cycle continued apace. Meanwhile, the domestic economy continued to expand and the housing and job markets recovered to a point where consumer sentiment hit a four and a half year high. While most investors pulled funds from equity-facing strategies, the savvy money spotted the opportunity. For the year, Finance and Consumer Discretionary were among the top-three performing sectors in both the large cap and small cap segments of the market.
Q: How did TAMRO’s Diversified Equity strategy do last year?
A: In 2012, the Diversified Equity Composite portfolio fell shy of the return for the benchmark, the Russell 1000 Index. The underperformance was due to a slightly negative stock selection effect combined with a negative interaction effect, which was only partially offset by a positive sector allocation effect.
Q: Relative to the Russell 1000 Index, which sectors added or subtracted the most from performance?
A: Of the ten sectors in the Russell 1000 Index, six contributed to relative performance, three detracted and one was basically neutral. The Energy, Consumer Staples and Materials sectors added the most to relative performance, while the Consumer Discretionary, Financials and Technology sectors had the greatest negative impact.
Q: What is your outlook for 2013?
A: With the Federal Reserve indicating it will continue its easy-money policies until unemployment hits 6.5%, subject to inflation limitations, the markets enter the New Year with a significant tailwind and we anticipate ample investment opportunities in 2013. While higher individual tax rates in the U.S. could weigh on sentiment and growth, the offset could be ongoing economic improvement in key emerging markets and perhaps even a stabilization of conditions in Europe. Here at home, we expect the consumer to further find their footing and the overall economy to benefit from improving credit and lending conditions. On balance, the U.S. economy should continue to enjoy a slow and steady expansion, much like we have experienced the last few years. Interestingly, over the four-year period ending December 2012, the broad U.S. equity market (as measured by the S&P 500 Index) has outperformed the fixed income market (as measured by the Barclays U.S. Aggregate Index), with four-year annualized returns of 14.58% and 6.12%, respectively. During this period there has been a large net outflow from equity investments into fixed income securities; maybe this year we could see investors begin to reallocate assets towards equities. The year is off to a strong start, with inflows of over $18 billion into stock mutual funds and ETFs for the one-week period ending January 9, 2013, according to Reuters.
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