After the struggles of 2008, equity markets witnessed a remarkable turnaround last year, once again demonstrating that cyclicality is not dead. Although correlations across regions and asset classes were again high in 2009, this time they were on the positive side as the Dow Jones Average rose by 22.7%, the Barclay’s Aggregate Bond Index was up by 5.9% and the MSCI World Equity Index increased 31%.
I am pleased to be able to report to you that in 2009 the Polygon Global Growth Composite (see attached disclosure statement which forms an integral part of this presentation) was up 27.58% net of all fees, despite the fact that average equity holdings were generally in the 70% range with the remainder devoted to a mix of non correlated investments including cash, bonds and alternatives. For illustrative purposes a customized benchmark consisting of 70% S&P 500 and 30% bonds would have had a return of 20.30% for the year.
To extend the comparison, since Polygon started at the end of 2002, our Global Growth Composite has achieved average annual returns of 16.53% as opposed to the benchmark’s annualized performance of 6.80%. Similarly, we have out performed the pure equity indices over the seven year period, almost doubling the returns of the S&P 500 (up an average of 8.96%), and beating the MSCI World (up 10.93% p.a.) by a comfortable margin.
Although weightings for emerging markets ranged between 5% and 10% during the course of the year, given their outsized gains they were strong contributors to performance, with India up 86%, while Brazil was up 122% and Chile gained 95%. Overweight positions in Northern Asia were also helpful. Highlights included China, up by 78.3%, and Chunghwa Telecom in Taiwan which increased by 37%. Slightly less exciting was our position in Japan, which nevertheless was up by a substantial 36%.
Our positions in North America (28% of the portfolio at year end) were generally more conservative but included major gains in our Canadian exposure, up 49%, Kinder Morgan up 43% and Legg Mason, up just over 39%. Less pleasing were results from some of our positions in other financial institutions, with Bank of America up 7.2%. On the more defensive side Berkshire Hathaway was up a modest 2.2%, Johnson & Johnson gained 11% and Pfizer increased by 7%. Europe, with a current weighting of 18% in the portfolio, benefited from falls in the dollar and recorded significant increases in many of its positions. Overall our investments in the European markets, as represented by our ETF position VGK, were up 31.4%. In terms of individual stocks Barclays gained 80%, Lafarge increased by 49% and the New Germany Fund, consisting of mid sized companies was up by 52%. Smaller gains were achieved by Shell, up 20%, Sanofi which grew by 27% and Novartis up by 13%.
Our uncorrelated bond and alternative positions showed surprising strength given their generally defensive orientation. The TIPS position was up 11%, while the global real estate fund gained 39%. Our agricultural commodities exposure grew by a hefty 59% with our hard commodities position gaining 41%. Alternative Investment Strategies, a hedge fund of funds, rebounded from a poor 2008 to gain 25%. Our dollar bond positions, all of which were relatively short term in nature, gained marginally, while our Euro denominated bonds benefited from the currency’s appreciation and were up more substantially.
Going forward I believe we are now in a situation where global stock markets may have gotten ahead of themselves, having soared by huge amounts since the lows of March 9. Yet, with the partial exception of the emerging markets, the world’s economies have struggled to regain their bearings after the near disasters of 2008. Having said that, it is important to keep in mind that, contrary to popular opinion, economies and stock markets do not always move together in lock step. In fact, equities and macroeconomic indicators often move in opposite directions for extended periods, though over the long term there is a correlation.
In our view 2010 is likely to see a reversal of this imbalance, with the world economy growing at a 4-5% rate, while equity markets, which have already priced in a very strong economic recovery, pause to catch their breath. Short term this may leave equity markets vulnerable to periodic corrections, particularly if earnings disappoint or if political risk increases, though over the medium term we believe there is still room for them to grow.
In contrast, the real economy is starting to move forward more vigorously. In the US the leading indicators are growing robustly, potentially indicating a V shaped recovery as inventories are rebuilt and the consumer starts replacing worn out goods. Supporting this trend, incomes and spending have both been moving steadily upwards in recent months, albeit from a low level.
With many companies having cut spending substantially over the past year, if it occurs, top line growth will feed into the bottom line quickly. Already in the last quarter we have seen a record number of company results exceeding analysts’ forecasts. As usual, the consumer will be key and any substantial improvement in unemployment will be dependent on his willingness to start spending again.
Another critical determinate of economic growth will be the Fed’s ability to control the massive stimulus and huge amount of debt it has unleashed over the past year. Though inflation remains a medium term concern, as long as capacity utilization remains low and money supply growth is under control, it appears there is some breathing room before the Fed will need to reverse the quantitative easing and low interest rate policies it has maintained over the last year. However, the central issue facing the US economy remains whether or not it can successfully deleverage from years of excess spending.
Emerging markets, especially China, now both the world’s largest exporter and consumer of autos, continue to power forward and are assuming an increasingly important role in the world economy. With strong demographics and economies which in some cases are better managed than their Western counterparts, this is a trend which is likely to continue for many years, though given the very strong rebound of their equity markets, many of which have doubled from their lows in early 2008, we are starting to re- balance and take some profits from those markets. Europe, with less private sector debt than the US, is ostensibly in a reasonable position to move forward, but the disconnect between economic union and political autonomy continues to be a concern as policy makers face a conundrum in dealing with economies with different characteristics that are locked together with the same currency and monetary policy.
In terms of our forward looking asset allocation, we intend to pursue a slightly more defensive strategy than last year when we were fortunate to have started investing more aggressively just as markets hit their lows in early March. Large cap, high dividend stocks in the US continue to appear attractive, with valuations consistent with historic norms and considerably below those of small caps. Sectors which we believe attractive include pharmaceuticals, as well as energy and technology, where we have thus far been underweight. Given current political uncertainties in Europe and a currency which has been trading at close to two standard deviations above its historic norms against the dollar, we intend to be cautious and will probably maintain our current exposure of less than 20% of the portfolio. Again we think big pharma is attractive. With a little more transparency, financials might also become interesting during the course of the year.
With almost 20% of the portfolio invested in Asia, I anticipate reducing our exposure to China which has been very rewarding over the years but has gotten a bit expensive, in favor of Japan which has long been inert but is showing some signs of life. Its smaller companies are particularly attractive on a valuation basis. The search for non correlated assets will remain an important part of our strategy as we seek to apply the lessons of 2008 and identify ways of adding value while controlling risk.
Philip Winder, CEO February 2010