As Polygon enters its second decade, we are privileged to have a loyal and growing client base. 2013 was a record year for us, both in terms of growth and total assets, but we continue to carefully monitor the size of our client base so that we can emphasize the personal service and individual attention which we believe is an important part of our value added.
We are coming off another strong year, with our primary strategy, Global Growth, having produced an average return of 14.5%. This compares favorably with our long term average annual performance of 11.8% in the eleven years since inception (net of fees). It also compares very favorably against our custom benchmark (70% S&P 500 and 30% Barclays US Aggregate Bond Index).
Our asset allocation in 2013 was weighted towards equities, with stock exposure in the 75% to 80% range. The remaining 25% was invested in bonds and alternative investments. This proved to be a good strategy for 2013, with most global stock markets moving strongly upwards, other than those of the emerging economies (of which more later). In particular, the developed countries did well, led by Japan and the US, both of which were up in the 25%-30% range. On average, European equities gained 16%, while emerging markets lost 5% (all in dollar terms). Other asset classes were less fortunate, with commodities, and many debt markets, showing declines.
In the US, where we have the most significant exposure (averaging 40%), virtually all of our major equity positions saw gains (NB: all portfolio performance numbers cited exclude dividends). Our overweight pharmaceutical positions were well rewarded, with Pfizer up 22%, Merck up 26% and Johnson & Johnson up 31%. GE, Morgan and Wells Fargo all increased in the mid-30% range, while our two energy related positions, Exxon and Halliburton, were up 17% and 46% respectively.
Our equity investments in Europe, where we had about 15% of total exposure, were slightly less rewarding, though Mercedes increased by an even 50%. In terms of other significant holdings, our Pharma position (Novartis) was up 27%, while Nestle was up 13% and Unilever increased by 8%. Our portfolios continued to be slightly overweight in both Asia (10%) and emerging markets (10%), which, given market weakness in the developing countries, detracted from overall performance.
Our fixed income and alternatives exposure certainly did part of their job, acting as a diversifier and bringing the volatility or standard deviation of our portfolios down substantially. However, in an environment of rapidly rising equity markets, the downside of that lack of correlation was poorer relative returns. Our commodity positions declined, though our REIT’s and MLP’s gained substantially. Most of our fixed income positions were either flat or slightly up, as the bank loan fund gained 4%, the high yield position was up 6%, and the Goldman Sachs preferred increased in value by 6%.
Going forward, in contrast to last year, we feel equity markets are likely to face more headwinds, despite continued improvement in the global economy. Valuations, while not exorbitant, are certainly not cheap, with the US market having risen by almost 200% since its lows of March 2009. In fact, three quarters of the gains in US stocks recorded in 2013 were due to expansion of the price to earnings ratio (PE), not earnings growth. With their recent substantial declines, emerging markets are potentially the primary exception to this view, despite their disappointing results in 2013. Europe falls in between the US and the developing countries in terms of their opportunity set.
In the US, stocks are trading at very close to their average multiples on both a price to earnings and a price to book basis. Dividend yields are at the top of their historic range compared to bond yields, which suggests that income oriented investors will continue to use defensive stocks as bond surrogates as long as interest rates stay low. However this also represents a significant risk should interest rates kick up, as we believe likely. Partly as a result of this rotation away from bonds, for the first time in years US equity mutual funds saw inflows ($350 billion vs. an $80 million outflow) from bonds. However, it should be kept in mind this comes against a back drop of five successive years of flow out of stocks and into bonds, which totaled over $1 trillion.
While it is becoming increasingly difficult to find value in US equities, there are some positives in the US from a macroeconomic point of view, as both the corporate sector and individual households repair their balance sheets from the ravages of 2008-09. At $77 trillion, net household wealth is at an all time high, as is corporate cash. Another positive factor for the US going forward will be the declining drag of reduced government expenditures on the economy as the federal government deficit improves to roughly 3% of GDP.
Nonetheless, it is becoming harder to find bargains in US equities, with so many stocks having recorded substantial gains in 2013. Two themes we think will have legs in 2014 are investments in technology and branded luxury goods. Technology stocks have had relatively few gains over the past several years as they have been out-paced by more conservative securities. In addition to this relative undervaluation, US tech equipment has been aging, as companies have been reluctant to invest in replacing it because of economic uncertainty. With the economy looking stronger, corporations flush with cash (and coming under increasing pressure to spend it) and the average age of US equipment at a record high of 5.5 years, the potential for a rally in tech stocks is substantial.
Another sector we like globally is luxury goods. As income stratification becomes more of a reality in the US, it is becoming clearer that not only the top one percent, but the top 10%, are the beneficiaries of a number of trends. The ever more dominant role capital is playing in the economy and the concomitant decline of labor in importance all feed into the growing spending power of the upper class. Similarly, the global rise of the consumer in emerging markets, particularly China (though somewhat tempered by recent anti corruption drives), should help propel luxury goods producers forward.
A number of these companies are based in Europe, where firms such as Richemont, Dior and Burberry have long been amongst the market leaders but continue to lag in performance, with current valuations averaging about 10% below historic averages. In general, Europe, which at long last is beginning to shake off the lethargy of the last few years, is looking hopeful, as valuations remain reasonable compared to the US. Like their counterparts in the US, European corporates are sitting on a mountain of cash (currently approximately $1 trillion), and are coming under increasing pressure to either spend it or return it to shareholders—via dividends or share buy backs, either of which would be a clear positive for equities.
From our perspective, emerging markets, particularly in Asia, look the best value globally. Following last year’s declines, most of which were caused by currencies depreciating against the dollar, as opposed to falls in equities, the recent sell off has made these markets more attractive. Currently, emerging markets as a whole are trading at a discount to PE ratios in the US of 20%—in contrast to previous years where they often traded at a premium. In addition, countries like Korea and China are trading at discounts to their historic PE’s of up to 40%. PE ratios in Asia excluding Japan are currently at 11, one standard deviation below their 10 year average. Similarly, the price to book ratio in China is 1.1, equivalent to approximately half its long term average. While one cannot ignore the political problems of developing countries like Turkey, Thailand or Argentina, nor the current account deficits that several of these countries are facing, the fact remains that, both in terms of demographics and economic growth, emerging markets have great economic prospects, which over time should translate into market gains.
We continue to see fixed income securities primarily as a defensive asset class with limited upside. However, given expectations of only modest gains in stocks in 2014 and the diversifying benefits of bonds, they should not be ignored. Sectors such as high yield bonds, bank loans and preferred stocks continue to offer the best value and provided reasonable returns for us in 2013. However, despite the current respite, the potential for interest rates to creep up, as they did in 2013, when the rates on 10 year treasuries rose from 1.9% to 3%, still exists. As a result, we are keeping our bond exposure on the low side and maturities short, to minimize the interest rate risk.
As regards alternatives, we continue to believe that real assets, especially real estate, both US and global, are a useful diversifier as well as a potential hedge against inflation. In 2014, we will look to increase our exposure to this asset class. In contrast, commodities, which represent approximately 2% of the portfolio, look less interesting in light of slowing growth in countries such as China, which have been huge consumers of them. During the course of the year we will opportunistically look to tactically reduce, but not eliminate, our commodities exposure.