Q1 Commentary (2007)
After a nice start to the year, the broader domestic market endured a sharp sell off in late February and early March before recovering to finish the quarter up slightly for the year. Our performance over this period was mixed and on balance, we modestly underperformed the S&P 500. Needless to say, we are not pleased by these initial 2007 results, but we remain confident about the balance of the year.
Worries about geopolitical issues, concerns over the sub prime housing market, uncertainties over which way the Fed will move on rates (if at all), and recessionary concerns dominated investors’ psyche. These risks and concerns are real, however, their impact on the business fundamentals of our holdings is not very large because the universe of holdings in which we invest is remarkably stable and defensive. Nevertheless, over shorter periods of time like this, even the higher quality companies can be impacted and this is what we believe happened this quarter.
Our research approach is very much bottom up. We want to understand the long term operating and financial strategies of our companies and assess the management talent at those companies to see if they have the abilities to execute on the strategies. Our advantaged research universe is biased on stable, defensive companies that can continue to grow their earnings, dividends and cash flows even during difficult economic periods. Should any of the aforementioned risks actually materialize, we strongly believe that there would not be a meaningful decline in their earnings or enterprise values for our holdings and that the more likely outcome would be that they would use the opportunity to build on their already strong competitive position in the marketplace.
As we enter the earnings season for the first quarter, we are confident that the healthy business trends that we were seeing from our companies in 2006 are still in place. Improving valuations will come as our companies demonstrate their ability to deliver consistent earnings growth and above average dividend increases.To the latter point on dividends, roughly 75% of the portfolio holdings have announced a higher dividend rate for this new year and the average increase from those companies with the higher indicated rate has been well over 10%. We anticipate that by year end, all of our holdings will have increased their dividend this year.
Please note that two corporate actions impacting holdings in the portfolio will be finalized in the first week of April. Altria Group, previously known as Philip Morris, will complete the spin off of Kraft and ADP will also distribute it brokerage division in a tax free distribution. Accordingly, you will see a small Kraft position as a result of the corporate action involving Altria and you will see an even smaller position in Broadridge, resulting from the ADP spin off of its brokerage business. Both of these transactions are similar to the one experienced late last year, when Alberto Culver split its company into two separate businesses, the new Alberto Culver and Sally Beauty. Our philosophy is initially to hold these “stub” positions, while we evaluate the merit of the new stand alone position. Generally, we applaud these types of corporate actions because it shows that management is tightening its focus on those businesses which have the greatest opportunity or advantage.
With one quarter done with and nothing to show for it by way of performance, we are in no way backing away from our expectation of high single to low double digit returns from the portfolio for the full year. We remain encouraged by the fundamental business prospects for our companies and the underlying valuations. The recent myopic focus on macro issues and influences that do not truly pose long term problems to our companies is creating attractive valuations and good buying opportunities. From our perspective, we are overseeing a portfolio with an above average dividend yield, holding companies that are growing their dividends faster than the general market. These companies have superior earnings growth relative to the S&P 500 and yet they trade at a P/E discount to the S&P. All of the companies are financially strong and the majority of them are using the recent market weakness as an opportunity to accelerate their share repurchase efforts. The bottom line is that we like the prospects for higher valuations and look forward to sharing our progress with you in subsequent letters.
