January 17, 2014 The Key Conclusions from this note: Fund Positioning

January 17, 2014
Reflections at Year-End and what is Important for US Stocks in 2014
The Key Conclusions from this note: Fund Positioning
It is important to be mindful of the macro backdrop given its significance on day-to-day market fluctuations. At present, in
the absence of any one sector of the stock market being uniformly inexpensive with improving fundamentals, we believe
the best strategy is to focus on those individual companies whose profit growth and efficiencies will increasingly
stand out as the business cycle matures further. These stocks should distinguish themselves from the broad market
through organic growth from innovation, pricing power and their global reach. US companies such as Google, Johnson &
Johnson, UPS, Schlumberger, Proctor & Gamble, BlackRock, Starbucks, PepsiCo, Verizon, Citigroup, and Coca-Cola all
exhibit these attributes. Combined with this portfolio component in a barbell approach, there remain selective companies
in the US that continue to harvest growth in earnings and continue to enhance operations by streamlining labor forces and
optimizing assets. Namely US companies such as Tyco International, Lam Research, SanDisk, Avon Products, Urban
Outfitters, Juniper Networks, Boston Scientific, NVidia, Sealed Air, Noble Corp., Express Scripts, Cardinal Health, EOG
Resources, HCA, Calpine, Cardinal Health, Network Appliance, Paccar, Microchip, and Devon Energy.
With most of the macro influences deteriorating as 2014 progresses, our Large Capitalization Valuation Sensitive Growth
approach to stock selection with a cognizance of risk management and current bias to mega-size and high quality seems
primed to outperform other investment styles in the US equity market.
Summary
It is easy to be overwhelmed by the chatter surrounding the latest forecasts for GDP or by the actions of the Federal
Reserve given their impact on day-to-day US market movements. However, as equity Fund Managers, we must always
remember that the stock market is simply the aggregation of individual equity investment securities. So, as we assemble
the data from our investable universe, principally the S&P 500 index, what do we currently see?
1. A definitive uptick in operating profit margins and returns on capital, starting in the third quarter of 2013
following a decline since early 2012. This is consistent with the most recent gauges of the economy as tracked by
the ISM Composite Manufacturing Index or PMI;
2. Valuation multiples as well as profit margins and returns on capital on most industrial companies at or near prior
peaks, including those witnessed during the late 1990’s and 2007; and
3. After a significant inventory build-up, there is little evidence of a strong further acceleration in capital spending.
The simple conclusion from this data is that the profit outlook is improving and the re-rating that occurred in 2013, in
anticipation of better earnings in 2014, was partially justifiable. Furthermore, the US stock market should move even
higher in 2014, given the absence of private sector mal-investment, the lack of a negative catalyst from a disappointing
earnings outlook, as well as a “soft-landing” from the impact on valuations from the ability of the Federal Reserve to
navigate away from its liquidity programs.
Investing is rarely this simple. When we dig under the surface we see significant risks from:
1. The transition to sustainable growth in 2014 that would lead to further improvements in operating profit
margins and returns on capital seems at risk. As a consequence, the most recent quarters seeming to be in
hindsight viewed as a “dead cat bounce” akin to the re-acceleration we witnessed in 1999 rather than the 1995-6
analogy some market pundits are describing; and
2. Whilst there have been few signs of private sector mal-investment this cycle, the potential for Federal Reserve
policy to become a more volatile negative influence, due to the significant public sector mal-investment, ($4
trillion in Federal Reserve balance sheet assets and Federal debt levels now near 100% of GDP that would be
crippling under normalized interest rates) can act as the negative catalyst to the increasing likelihood of a
recession in 2015.
The view from a purely bottom-up perspective looks “okay”, despite the elimination of the under-valuation condition that
existed at the start of 2013. Furthermore, when one considers that the foundation for continuing corporate economic profit
growth and confidence is dependent upon the health of the stock market which, in turn, is dependent upon the faith that
US will somehow unwind the unprecedented excess central bank policies and fiscal disequilibrium of the past five years
without disruption, gives us caution as it is unlike conditions seen by any investor, regardless of age or experience.
Reverting to the simple formula that states:
Stock Market Return = Dividend Yield + Earnings Growth +/- P/E expansion/contraction
Whilst we have increased confidence that earnings growth can be found selectively from our investment universe in 2014,
we also have significant concerns that further P/E expansion can be attained given the potential negative influences on
interest rates and investor confidence, which drive valuation multiples and can overwhelm dividends and earnings growth.
2013: A Year in Review
The past year was disappointing for us. We were, on one hand, part of a very select number of Fund Managers who
believed correctly that 2013 would witness a surprising US stock market surge driven by a re-rating of price to earnings
multiples. We felt this would occur despite the backdrop of disappointing corporate profits and the muted economic
environment. Our company analysis indicated that the declining cost of capital, driven by lower interest rates and
increased investor confidence, as opposed to the growth in operating profits, would drive the stock market higher in 2013
as it did. Where we were incorrect was that, inconsistent with nearly every other historical parallel we analysed, those
most dependent upon stronger economic growth, namely smaller companies, were the key beneficiaries of this re-rating.
They outperformed larger companies significantly. The S&P Small Cap 600 Index outperformed the S&P 500 Index by
more ten percentage points and outpaced the largest “mega”-capitalisation companies, as represented by the Russell Top
50 index, by nearly fourteen percentage points; an area where we had significantly biased our Fund from a stock selection
and portfolio construction basis.
Cyclical and Secular Backgrounds Heading Into 2014
In our view, there are three major cyclical drivers that will influence the stock market in 2014:
1. Economic Re-acceleration: Are the very recent signs of economic re-acceleration set to continue and does it
matter in the face of profit margins near all-time highs already?
2. Pent-up Capital Spending: Is there pent-up demand for capital spending and, if so, what will prompt
corporations to finally spend on capital infrastructure and other value- added growth initiatives?
3. Monetary Policy: What will the Federal Reserve do about its bond tapering and, more importantly, will the
policy interest rate stay at zero and will this impact further the re-rating theme?
Overlaying the cyclical drivers are the two most important secular drivers that will help shape 2014 and beyond:
1. Declining Worker Productivity - Is productivity set to rebound?
2. Demographics - How will the worsening demographic issues in the developed world influence events?
We will attempt to expand on and interpret the available information on the topics above and, hopefully, draw our
conclusions to assist you in your allocations to US equities as well as how the implications and the conclusions will
influence our Fund positioning sector, style and stock-wise.
Cyclical
1. Economic Re-Acceleration
One of the foremost reliable gauges of the economy, the ISM Composite Manufacturing Index or PMI, is sending the
most positive signal now regarding an improvement in the economic outlook for 2014. After giving signals of
slowdown, if not escalating recession risks, between the summers of 2012 and 2013, in recent months, the PMI has seen a
prominent jump to levels not seen since the spring of 2011. While the strong PMIs in recent months haven’t consistently
shown up in the hard economic data, such as GDP, and it is yet to be seen whether this rebound will translate into a longer
term capital investment acceleration or it will be a shorter term mid-cycle inventory led bounce that may pay off if those
items are eventually sold, but will be problematic if not. In fact, looking at third quarter GDP, over 63%, or the largest
proportion in over ten years, was due to inventory stockpiling.
As for the consumer, disposable personal income growth remains tepid as, relatedly, do retail sales evidenced by the most
lackluster shopping seasons in recent years with average holiday spending expected to decline for the first time since
2008. Another potential driver, growth in governmental spending and investment is decelerating. Lastly, net exports for
the US will have a hard time growing unless there is de-rating of the US dollar. Given these conditions, we see the
sustainability of the recent positive pickup in economic activity being almost wholly dependent upon whether business
capital investment increases significantly in 2014.
2. Pent-up Capital Spending
Despite the headlines, we find only scant evidence of a great US manufacturing renaissance outside the chemical industry.
The bottom line is that business capital investment is the only potential driver for sustainable growth. Despite record
corporate profits, companies have taken advantage of the historically low interest rates to borrow as well as to use their
substantial cash hoards increasingly to buy back stock rather than to reinvest in their own businesses. In fact, over sixty
percent of free cash flow for US companies has been directed towards dividends and share repurchases in 2013, the
highest proportion since 2009. Furthermore, the ratio of capital spending to sales for all S&P 500 Index industrial
companies stands at 6.2%, consistent with the ten year average but well below the level of the 1990’s and levels for us to
become “strategically longer-term bullish.” While manufacturing utilization levels have risen sharply from the 2008
lows, recent trends have slowed and company commentary during the third quarter gave no indication of material pickup
in the future.
Without some type of technological innovation that can drive returns on investment higher or a change in US tax policy
that prioritizes investment away from other uses of cash flow, such as an investment tax credit or accelerated tax
depreciation for new equipment purchases, we believe a large capital spending surge led by corporations to drive the
economy further is unlikely in 2014. Also, given the complete failure to direct the original mammoth Economic Stimulus
Act of 2008 into productive value-added projects with a multiplier effect, versus transfer payments to the States and oneoff tax rebates, the political appetite to undertake a genuine government directed infrastructure program in the US is near
zero. The Bush Troubled Asset Relief Program (TARP) and the Obama stimulus combined were some $1.5 trillion
injected into the American economy. Nearly six years after his inauguration and after the Government shutdown and the
botched healthcare.gov website launch, President Obama just does not have the pull in Congress to do anything of
significance. Indeed, the Democratic, never mind Republican, caucus does not trust him. This means that they do not have
the votes to make these plans happen. Consequently, without a change in corporate tax incentives or a genuine
infrastructure policy, the most important pillar of a self-sustaining, virtuous US recovery - investment in future growth
through capital spending - will be missing as long as the Fed's intervention policies in the economy provide shareholders
with a far quicker way of generating returns by using excess cash flow to buy back stock and boost dividends and there is
a lack of high payback innovation that incentivizes companies to invest in capital projects regardless of interest rates.
Technological innovations are usually easy to see in the hindsight, but a guidepost to future innovation certainly emanates
from venture capital spending. Aside from the investments into the biotechnology sector which seem to be paying off,
recent concentration of investment into technology, namely social networking, seem to be abating somewhat but
“lifestyle” rather than “business” technology still dominates due to the success stories of Facebook and Twitter amongst
others, so our hope for the next business changing development as seen in the 1990’s such as the connected PC
environment or enterprise resource planning (ERP) solutions, dampens our enthusiasm for an investment led growth
resurgence.
3. Monetary Policy
The failure of US fiscal policy has caused the dependency on unprecedented and massive monetary easing and allowed
the US financial sector to heal distinct from the tremendous restructuring undertaken by business and consumer focused
corporate America. That said, companies cannot sustain the pace of profit margin improvement without top line growth
and it is unlikely that monetary policy will suddenly gain the value in transmission to the real economy (as opposed to
financial assets), when it has not in the past five years. The vast bulk of the Federal Reserve’s bond purchases have
made their way right back in the form of bank reserves deposited at the Federal Reserve.
A significant issue not widely discussed is the fact that the Federal Reserve is likely to taper its bond purchases simply
because the amount of debt issuance by the US government is falling and, if the Fed maintained its current rate of
Treasury bond purchases, it would essentially be monetizing all the federal government’s new deficit financing. The US
dollar’s reserve currency status has been the only fact to allow this not to have the normal inflationary impact that it has
had on other countries that have pursued this type of debt monetization program. To us, the more important lever is what
the Fed does with the policy rate, now at essentially zero and negative in real terms. Our forecast is that it will continue to
pursue a policy of negative real interest rates and perhaps introduce other non-traditional stimulus measures to advance
the rate of employment growth and until a higher rate of inflation (greater than three percent) is well entrenched into the
economy which is the only way to somehow allow it to unwind a $4 trillion balance sheet as well as avoid a meaningful
interest rate rise and risk a recession meaning that monetary policy may contribute to an increase in market volatility just
when expectations are the exact opposite.
At this stage of the cycle, the Federal Reserve would be raising interest rates and the stock market drivers of return would
be away from further expansion of valuation multiples and a focus on the delivery of profits as previously accommodative
conditions tighten. There seems little to no justification for Fed support of the private sector or the continuing low level of
yields. That said, a sustained and large rise in interest rates is politically unacceptable and will negatively affect the US
budget deficit. On the assumption that the US has balanced budgets forever but the government pays “normalized interest
rates”, interest payments would be ~ 30% of annual federal government spending. In other words, normalized interest
rates would produce an uncontrollable US debt service budget item that would sharply increase U.S. budget deficits and
the national debt. The Federal Reserve will be required to keep its policy rates low to maintain the public sector malinvestment. In other words, the Federal Reserve is likely to succumb to political pressure and will allow a higher rate of
inflation to become imbedded into the economy before it begins to increase the Federal Funds rate in any meaningful way.
The impact from this on the private sector will be disruptive and contribute to increased volatility in interest rates and
higher inflation expectations.
Secular
Declining Worker Productivity
The most powerful force that extended the disinflation-driven bull market of the 1990’s was the peace dividend followed
by and, more importantly, the increase in computerization and the internet leading to a significant increase in labor
productivity. None of these forces seem to be in force today.
Increases in productivity are responsible for the increase in per capita living standards and it is a simple fact that the
fundamental drivers of economic growth are increases in population plus productivity. The big question is whether the
rampant use of social media and personal connectivity hinders productivity? As so many people are in this constant
whir of socializing—accessible to each other every minute of the day via mobile devices, instant messaging and socialnetworking sites. The obvious question that needs to be answered is: How much work can 'hyper-socializing' employees
really accomplish if they are holding multiple conversations with friends, or are obsessively checking Facebook? Perhaps
I’m showing my age and biases but will entrepreneurs and innovators lead us from the wilderness into a new age of
productivity or are they too busy tweeting about what they just had for lunch?
Demographics – We are getting older – promoting human reproduction to ensure national growth
In a number of industrialized countries, including the US, on the assumption that fertility remains at or close to present
levels, populations will start to decline and, in some cases, do so quite rapidly in the near future. The impact of this on
developed societies is that the combined demand for goods and services will decrease and increasing pension liabilities
that can be crushing in terms of taxation on younger workers will be an issue and, potentially, a source of unrest and
political disruption. Japan, the pathfinder of this phenomenon as it embraced Western family planning even before Europe
and the US, shows the debilitative impact from an aging society and need to resort to new radical inflationary
macroeconomic policies to combat its ill effects. Russia, on the other hand, has introduced its annual "day of conception"
worker holiday as a desperate gesture to increase Russia’s struggling birth rate. No developed world country is immune
from this significant problem which is just starting to be felt. With regard to near-term relevance to Federal Reserve
policies, we see that the US Civilian Labor Force Participation Rate has dropped below a level that we last saw thirty
years ago, when women began to join the workforce in earnest. A large part of the current fall in the unemployment rate
from 10.8% to 7.0% has been due to this “dropping out” of the labor force, either due to discouragement, early retirement,
or public assistance best evidenced by the fact that more persons have joined the rolls for social security disability
payments than full-time private sector payrolls since 2009. This collapse in the civilian workforce participation rate and
increase in the numbers of person on government dependency since the recovery began in June 2009 has never happened
before during previous recoveries. Productivity and the growth in average hourly wages have fallen significantly as
inflation has slowed and competition for jobs domestically and from overseas limiting consumer consumption as
evidenced by the latest drop in consumer spending being consistent only with past recessions.
Reconciling the Cyclical & Secular Trends
As we enter 2014, despite a bottom-up optimism we are less enthusiastic about the prospects for further sizable
gains in US stocks as a whole relative to what we believe is a very bullish consensus. This is due primarily to the
negative macro circumstances being unlike any evidenced in the past and the lack of confidence in the ability of
public officials to manage their unwinding, without creating a more volatile investment landscape for companies to
operate in successfully. While we see a modestly improving growth outlook for operating profits through early 2014, we
do not foresee the cost of capital declining as was the case in 2013 and, more importantly due to high valuation levels,
investor confidence is likely to erode as the improving tone of economic growth falters and companies as a whole
disappoint in terms of lofty profit expectations as the year progresses. In fact, nearly every Wall Street Strategists’ report
that we have read recently fixates on justifying expanding valuation multiples and a further re-rating in the context of a
secular bull market that began in 2009 with little passing thought to what will drive aggregate company-level economic
profit creation and market value added in 2014. As a natural contrarian, it is important for us not to reflexively adopt a
posture away from consensus but identify how we think the major investment themes and drivers reconcile to our
conclusion and, most importantly, what inferences can we draw from the overall picture we get from the substantial
bottom-up information we gather on a constant research basis from the stocks within our investment universe. The
“goldilocks” environment of two percent growth with no inflation will continue for the very near-term, but we expect
increasing concern as the year progresses and we think higher inflation in 2014 and a recession in 2015 is a growing
possibility. Our Large Capitalization Valuation Sensitive Growth approach to stock selection with a cognizance of
risk management seems primed to outperform other investment styles under the current circumstances.
Thank you as ever for your support and interest in the Fund.
James Abate, MBA, CPA, CFA
Fund Manager
Managing Director & Chief Investment Officer
Centre Asset Management, LLC
Disclosures
The statements and opinions expressed are those of James A. Abate are as of the date of this report. All information is historical and
not indicative of future results and subject to change. Reader should not assume that an investment in the securities mentioned was or
would be profitable in the future. This information is not a recommendation to buy or sell. Past performance does not guarantee future
results.
Investors should consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. To
obtain a prospectus containing this and other most current information regarding the fund, please go to our website
www.centrefunds.com or call 1-855-298-4236. Read the prospectus carefully before you invest.
Important Risk Disclosure: There is no assurance that this investment philosophy will consistently lead to successful investing. An
Investment in the Funds involves risk, including loss of principle.
Centre American Select Equity Fund is distributed by ALPS Distributors, Inc. Centre Asset Management, LLC and ALPS
Distributors, Inc. are not affiliated.
Top 10 Holdings (as of 03/31/2014)
Google Inc Class C
Microsoft Corp
Johnson & Johnson
Apple Inc.
PepsiCo Inc
Schlumberger Ltd
Verizon Comm.
Comcast Corp
3M Co
Biogen Idec Inc
4.73%
3.66%
2.97%
2.91%
2.35%
2.25%
2.19%
2.01%
2.01%
1.94%
For the most current holdings information go to http://www.centrefunds.com/holdings.php?cusip=261782106
Definitions
S&P 500 Index - The S&P 500 Index is the Standard & Poor’s composite index of 500 stocks, a widely recognized, unmanaged index
of common stock prices. You cannot invest directly into an index.
ISM Composite Manufacturing Index – An index based on surveys of manufacturing firms by the Institute of Supply Management.
The index monitors statistics such as employment, production inventories, new orders and supplier deliveries. The index is widely
followed and is considered a good indicator of overall economic condition of the country.
PMI Index – Purchasing Managers Index is an index that serves as an indicator of economic health of the manufacturing sector. The
PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
Re-rating - When the market changes its view of a company sufficiently to make ratios such as PE substantially higher or lower
Dead cat bounce – A temporary recovery from a prolonged decline (bear market), followed by the continuation of the decline (bear
market).
S&P 600 Small Cap Index – The S&P 600 Small Cap Index is the Standard & Poor’s market cap weighted index that covers a broad
range of small cap stocks in the United States.
Russell Top 50 Index – The Russell Top 50 Index measures the performance of the largest 50 companies in the Russell 3000 index.
Free Cash Flow – The cash flow that the company generates after covering it makes the necessary investment/outlay for operating
assets and capital expenditures.
Bullish – A stock market trend/movement characterized by rising prices
GDP – Gross Domestic Product
P/E – Price/Earnings ratio
DRX 000269 Exp 12/31/14