I am delighted to be able to report that Polygon has just celebrated its tenth anniversary. They have been extraordinarily rewarding years for me and have vastly exceeded my expectations and, I believe, those of most of our clients as well. On a risk adjusted basis we have been able to consistently outperform global financial markets, while taking less risk, which is basically as good as it gets for investment managers. As a result, the firm has been privileged to serve a small, but growing number of investors, who have had the confidence to entrust their asset to our stewardship. I remain extremely grateful for their trust and support.
One development which deserves special mention is that Diane Hallock Winder is joining us as a Director. Diane most recently served as a Senior Vice President at Merrill Lynch, while previous roles include Assistant Director of Barclays’ private bank and writer for the Economist Intelligence Unit (EIU). A graduate of the University of California at Santa Barbara with a Masters from the Johns Hopkins School of Advanced International Studies, Diane has lived in Europe, Africa and the Middle East and speaks fluent French. She will be a valuable addition to the Polygon team, helping across a range of areas, including client communication and compliance.
We are coming off a strong year in which portfolios invested in Global Growth, our primary strategy, achieved an average return of 12.7%. This is consistent with our average annual performance of 11.51% since inception (in both cases after fees and taxes). It compares very favorably with our custom benchmark (70% S&P 500 and 30% Barclays US Aggregate Bond Index) which had average returns of 7.63% over the same period, not to mention the MSCI World Equity Index which averaged an 8.31% p.a. return over the ten years. Furthermore, we are off to a strong start in 2013, with Global Growth up approximately 6%.
Our asset allocation had an equity bias in 2012, with stock exposure hovering around 75% for most of the period, with the remaining 25% of the assets invested in bonds and alternatives. In a year when global markets were almost uniformly up (the Dow gained 7%, Europe increased by 16% and emerging markets were up by 14.5%), this was the correct strategy.
In terms of geographic distribution, North American equities were the largest component, accounting for 40% of total assets. All of our biggest positions were up, with exposure to pharmaceuticals and financial institutions proving particularly helpful. We did manage to cleverly build a small position in Hewlett Packard which declined an eye watering 45%, but has rebounded by 41% in 2013. Europe averaged about 10% of the portfolios and all of our positions, except Shell (-6%) were up (European small cap 31%, Daimler 30%, Novartis 11%, and Total 7%). The portfolios continued to be overweight in both Asia (15%) and emerging markets (10%). The outstanding performer was Samsung, up 61%. Other substantial positions included: ETF’s in China up 19%, Africa up 26%, and emerging market small caps up 24%. Lastly, our fixed income and alternative allocations were generally remunerative. Both emerging market and high yield bond positions demonstrated substantial gains of 17 and 13.5 percent, respectively, for the year. The non US real estate fund gained 29%, while the commodity positions were essentially a wash.
From a global macroeconomic perspective, I believe we have weathered the worst of the storm, and feel reasonably positive about the current environment. However, definite head winds remain, particularly in the aftermath of the debt crisis in Europe and the US. In the US there are a number of strong positives which are likely to propel markets forward in the medium term. These include: the rebound in housing, which is already starting to have a strong spillover effect on industries ranging from banking to manufacturing, and our growing energy self sufficiency, which is expected to create three million new jobs in the US by 2020. Lower energy prices have also contributed to the rising competitiveness of American workers, whose wages only increased by 25% over the last ten years, while Chinese workers’ wages have gone up by over 100%. This so called “re-shoring” of jobs is also beginning to have a significant impact on overall employment in the US. For the first time since 1998, the economy has seen two consecutive years of growth in manufacturing jobs. All of these factors have combined to create a more positive psychological environment and, concomitantly, a more buoyant consumer who, with a significantly lower debt burden, is starting to spend money again.
Simultaneously, the US corporate sector has made great strides, with net margins, profitability and corporate cash all at near record levels. While equity valuations remain muted, though not cheap, both in terms of price to book and price to earnings ratios, stocks appear to be reasonably priced. Furthermore, financial flows into equities have been negative for fifty out of the last sixty months. As a result, over 500 billion dollars has flowed out of stock funds and twice that amount has been plowed into bond funds. However, in the last two months the trend has started to reverse itself. Should this pattern carry on it would clearly be a major positive for equities.
Before getting too euphoric, it is worth keeping in mind the seemingly intractable politics of Washington and the government’s attendant inability to deal effectively with the budget, tax, and deficit morasses. Though we continue to muddle through, and have seen our debt to GDP ratio drop from over 11% to close to 5% over the last several years, one is tempted to say that this is due to happenstance rather than well thought out policies –“the genius of incompetence” as a friend of mine once put it. Until, and unless, our politicians get their act together, which is not in my foreseeable future, the US will struggle with the economic inefficiencies and impaired performance which this kind of political risk entails. In particular, though it has been quiescent so far, given the amount of monetary stimulus the FED has generated, the specter of inflation cannot be too far off. This in turn strengthens the argument for real assets and magnifies the risks of longer term bonds.
Elsewhere in the world, Europe continues to be a cause for concern in both the economic and political spheres. The probability of 17 fractious governments managing their economies on a coordinated basis is slim, and with expectations of little or no GDP growth in 2013 the investment environment is far from ideal. However, stock prices appear to have fully discounted these problems, and prices, in comparison to either the US, or relative to historic values, look appealing. For instance, some of the major car companies are currently trading at price to earnings ratios which are half of their ten year averages. Dividend yields are also attractive. Major multinationals like Total are paying a dividend of 5%, yet have a current PE of less than 10. Likewise, Daimler is paying a current dividend of 3.6% with a PE of 9. In addition, many of these companies derive half or more of their revenues from outside Europe, but their securities are priced as though they are exclusively being sold into the European market. The emerging markets and Asia remain our favorite areas. If one looks globally, perhaps the most important long term trend is the growth of the middle class consumer in the third world. In countries like India, Brazil, China and even Africa, literally 100’s of millions of people are beginning to reach the tipping point where they can afford to purchase major consumer items like cars, washing machines, and TVs. This has huge implications, not only for their economies but for the international companies supplying them. While the relationship between economic growth and stock market returns is much debated, over time, investing in economies like China and India, not to mention smaller developing countries like Turkey and Chile, with trend line growth rates in the 5%-10% range, is an attractive proposition. Certainly that was the case in 2012 and we believe it will continue to be in 2013. China, in particular, looks interesting, with valuations having fallen to levels not seen since the Asian crisis of the late 1990’s.
Lastly, exposure to bonds and alternatives continue to be an important component of our risk control process. Although bonds are certainly not without risk (especially long dated ones), their relatively low correlations against stocks remain attractive. Fixed income securities in local emerging market currencies look interesting at the moment and offer higher yields than European and US bonds — in countries with better macroeconomic characteristics. Real estate and commodities also provide useful diversification, and the former, in particular, has the potential to generate handsome, real returns. Though we have not been active in private equity or in hedge funds recently, all of these uncorrelated asset classes remain a potentially important part of our investment tool kit.