Q2 Commentary (2007)
Returns in the second quarter were remarkably generous, despite the modest correction in June. Global economic growth, coupled with interest rates that are still low by historical standards more than offset the pressures from high energy costs, persistent geo-political concerns and the numerous housing related problems.
Performance was good on a relative basis this month and we remain competitive with the broader market for the quarter and year to date periods. To put this performance in perspective, Coho Partners’ philosophy leads us to intentionally overweight such sectors as consumer staples and health care because of their defensive qualities. These types of companies play an integral role in achieving our primary investment objective, which is downside protection. Our exposure to these two areas is about twice that of the market and these sectors underperformed the S&P 500 during this strong up quarter. Stock selection was very good and this enabled us to overcome the drag from our overweight position in these demand defensive industries. This is very good news, because should the market continue to move higher, these companies will keep up and yet if the market were to correct, these companies should provide the type of downside protection that we have come to expect.
Therefore, we are pleased by the pattern of results so far this year and the portfolio is well positioned for the foreseeable future. As we have mentioned in earlier notes, the current private equity trends concern us and we believe they are unsustainable. Moreover, the vast majority of these deals are in highly cyclical businesses, where the success of the investment is contingent upon stable global economic growth. Any disruption to the global macro environment could spell disaster for many of these deals. If this were to happen, our portfolio would probably benefit because it is conservative and defensive.
As is typical, our quarterly letter precedes another earnings season for the majority of our holdings. The outlooks for our companies from the 1st quarter were encouraging and we believe these stable, predictable companies will continue to show solid growth in both earnings and dividends.
At the end of the 1st quarter, we reaffirmed our outlook for the full year, which was that returns for our portfolio should be in the high single to low double digit range. Once again, we see no reason to change from this outlook. We got a disproportionate amount of the full year return this quarter, but as we all know, forecasts over short periods of time are very uncertain. The take away that you should hear is that the market is probably a little ahead of itself and we would not be surprised if the returns in the second half were less generous than they were in the first half. We still are finding opportunities to invest in high quality companies, where we see excellent risk/return characteristics. During the month, the only meaningful portfolio adjustment was a modest trim to our Kaydon position, which was entirely based on valuation.
In closing, the portfolio characteristics that have helped us produce a long term pattern of results that has outperformed the S&P 500 and provided significantly less volatility remain in place. These characteristics are:
- Above average dividend yield and better than market dividend growth.
- Long term earnings growth better than that of the S&P 500.
- P/E multiples that are equal to or less than those of the broader market.
- Companies with well focused operating and financial strategies.
- Companies that are not overly capital intensive.
- Companies with above average profitability.
- Companies that generate meaningful free cash flow, which the managements’ use to enhance shareholder value.
