Quality Growth Equity Management Quarter Ended September 30, 2016 5 Houston Center 1401 McKinney, Suite 1600 Houston, TX 77010 Tel: (713) 853-2359 Fax: (713) 853-2300 [email protected]www.GarciaHamiltonAssociates.com Awards/rankings may not represent client experiences and are not indicative of future performance. Go to www.garciahamiltonassociates.com/awards/ for additional information on each award. Presented By: Curt Rohrman, CFA Partner, Director of Equity Investments
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Quality Growth Equity Management · full year earnings will decline for the first time since the financial crisis, with 2016 estimates 1.5% below 2015. Market valuations at 17.5x
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Quality Growth Equity ManagementQuarter Ended September 30, 2016
Ruby@GarciaHamiltonAssociates.comwww.GarciaHamiltonAssociates.com Awards/rankings may not represent client experiences and are not indicative of future performance. Go to www.garciahamiltonassociates.com/awards/ for additional information on each award.
Presented By:
Curt Rohrman, CFAPartner, Director of Equity Investments
Invest in companies with above-average sustainable growth and/or accelerating growth and an ability to beat earnings expectations over time.
Buy quality companies. Various quality rankings and other metrics which demonstrate quality are evaluated carefully before a stock is added to the portfolio.
Primarily use our proprietary screening process and bottom-up work to determine relative sector weights. Portfolio constraints exist to ensure sufficient diversification to control risk.
3rd Quarter 2016 Quick Take
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The Market Stocks finished with decent returns during a low-volatility quarter. Strangely, low-quality and small-capitalization
stocks led, even while mega-cap technology stocks (Apple, Microsoft, Google) posted strong gains. For the quarter, the S&P 500 Index increased 3.9% including dividends. The Russell 1000 Growth Index rose 4.6%.
Global growth remains anemic. The U.S. Federal Reserve is walking a tight line: deferring a second interest rate hike, yet trying to convince the public that economic improvement is underway.
Earnings estimate cuts continued, reflecting the disappointing global economy. Third quarter earnings might be 1.9% below year ago levels, marking the sixth consecutive quarter of lower year-to-year profits. In all likelihood, full year earnings will decline for the first time since the financial crisis, with 2016 estimates 1.5% below 2015.
Market valuations at 17.5x forward earnings are at the upper end of historical ranges.
The Portfolio The portfolio gained 3.9% in the quarter, 70 basis points shy of the benchmark Russell 1000 Growth Index.
The shortfall is attributable to 177 basis points of low-quality headwinds as stocks rated “A+” or “A” actually declined during the period. Stock selection was good, providing 216 basis points of positive performance.
Our market outlook is somewhat cautious, with U.S. Federal Reserve dictating stock market direction near term.
The portfolio remains conservatively positioned with a meaningful overweight in high-quality stocks.
-5%
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S&P 500 3Q 2016
Aug
ust
Sept
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3.85%
3.84%4.52%
9.05%
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3%
6%
9%
12%
Russell Top 200 Russell Midcap Russell 2000
Performance by Capitalization 3Q 2016
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3rd Quarter 2016 Equity Market Commentary
Sources: Bloomberg, Russell Investments
4.58%
13.75%
3.48%
16.18%
0%
6%
12%
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3Q16 Trailing Twelve Months
Growth vs. Value
Russell 1000 Growth Russell 1000 Value
Stocks posted attractive gains for the quarter, with the S&P 500 Index up 3.9% including dividends. Investors sought an unusual mix of equities:low-quality stocks, small capitalization stocks, and mega-cap tech stocks, such as Apple, Google, and Microsoft. U.S. Federal Reserve statementsand actions reflected disagreement among committee members, with a second rate hike pushed out, again. Measures of economic data aroundthe world remained disappointing. Deutsche Bank’s potential impact on global financial markets drew attention late in the period.
o Earnings estimate cuts continued. Reductions have occurred across most sectors, except Technology. For the first time since the financial crisis of 2009, fullyear earnings might decline as 2016 projections are 1% below 2015 levels. Third quarter 2016 earnings are estimated to have decreased 2%, marking thesixth consecutive quarter of down year-over-year earnings.
Returns by market capitalization were linear in the “risk-on” environment, with the smallest indices performing best and the largest lagging themost. A big bounce in selected mega-cap tech names was offset by poor performance among large cap Consumer Staple and Healthcare stocks.
o Stocks offering better yields generally underperformed this period, though more than the mild (14 bp) rise in 5-year Treasury rates would suggest. This shiftfavored small capitalization stocks which often provide no dividend yield.
Growth-oriented indices outperformed Value-oriented styles due to heavier weightings in Information Technology, the best performing sector byfar across capitalization ranges, consistent with a “risk-on” rotation.
o Since the March 2009 stock market bottom, risk factors have dictated returns more than individual company fundamentals and balance sheets.
Information Technology was the most significant contributor to index performance during the third quarter. Attractive trends inTechnology include the shift to cloud computing, increasingly interconnected devices (Internet of Things), and visions of autonomouselectrical vehicles. With that said, roughly half of the sector’s returns can be attributed to mega-caps Apple, Google, and Microsoft, eachof which bounced back after declining 6.7% to 11.8% during the previous (June 2016) quarter.
Sectors traditionally considered defensive were a source of funds. A portion of the declines in higher-yielding sectors may be attributed tothe modest rise in interest rates. In addition, investor preference for low-quality stocks hurt the Consumer Staples sector while U.S.Presidential election rhetoric and drug pricing concerns weighed on the Healthcare sector.
September 30, 2016
3rd Quarter 2016 Intra-Quarter Volatility
Portfolio’s High-Quality Stance Was Beneficial During Intra-Quarter Downturns
Period# Trading
Days
Russell1KG
Return
GHAReturn
RelativeOutperformance
% of Index Decline
9/19/14 - 10/13/14 16 -7.02% -5.06% 1.96% 72.08%
8/19/15 - 8/24/15 3 -9.14% -8.39% 0.75% 91.79%
12/29/15 - 2/12/16 32 -11.25% -9.00% 2.25% 80.00%
6/23/16 - 6/27/16 2 -5.13% -4.24% 0.89% 82.65%
Quarter 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16
Russell 1KGReturn
4.78% 3.84% 0.12% -5.29% 7.32% 0.74% 0.61% 4.58%
Only One Down Quarter Over Past 2 Years
Quarterly Returns Have Masked Considerable Intra-Quarter Volatility
Compound annual return for full period September 30, 2014 – September 30, 2016: Russell 1KG = 8.35%; GHA = 6.85%.5
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Sector DiversificationSeptember 30, 2016
Portfolio
R1000G
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Current Portfolio Positioning:
DIVERSIFICATIONDIVERSIFICATION
Source: Thomson Analytics
The portfolio remains significantly overweight high-quality stocks anticipated to produce superior earnings growth over the course of aneconomic cycle. This posture seems appropriate in an environment of slowing economic growth, declining profits and rising valuations. Yet,this environment also makes it increasingly difficult to identify new ideas meeting our investment parameters.
o Holdings rated “A+” or “A” by S&P Earnings and Dividend Quality Rankings comprise 45% of the portfolio, double the benchmark’s weighting.
o Consumer Staples and Industrials are the most overweight sectors. Consumer Staples provide high-quality balance sheets and steady growth in adifficult environment. High-quality Defense stocks account for the Industrial overweight, as military budget funding is set to increase for several years.
o An underweight position in InformationTechnology is mostly attributable to underweights in large benchmark names: Apple, Facebook,and Microsoft.
o Cash positions reflect difficulty in finding high-quality growth companies meeting our investment criteria, rather than a strategic investment decision.
3rd Quarter 2016 Equity Portfolio Commentary
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A+ A A- B+ B B- C NR
Quality WeightingsSeptember 30, 2016
Portfolio
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Current Equity Market Outlook
S&P 500 NTM P/E with Long –Term AverageConsensus S&P 500
Operating Earnings Estimates
Central banker statements are driving market movements, rendering fundamentals virtually irrelevant.
o A viable exit strategy is not clear. Global central bank liquidity programs have driven asset prices higher and interest rates lower. Yet, these programshave long since benefited real economies, and may, in fact, be harming economic activity. The process of removing liquidity is sure to be problematic asfinancial markets unwind positions and discount the prospect of higher interest rates. Current central bank policy seems to be communication-to-the-point-of-confusion in hopes of buying time.
o ChairYellen recently admitted the Federal Reserve would be open to buying equities.This troubling revelation strikes at the heart of capitalism.
• Similar to several previous quarters, September quarter earnings expectations have been revised lower and actual results may surprise positively. Still a quarter away from year end, managements are unlikely to provide forecasts for 2017. Eventually, 2017 expectations are apt to be revised lower.
o Irrespective of corporate earnings, global central banks seem unwavering in their support of stock prices, determined to suppress volatility.
o P/E multiple of 17.5x forward S&P 500 Index earnings borders the high end of the range, consistent with sustained low inflation.
For the quarter, the portfolio underperformed the benchmark by 70 basis points.o All of the shortfall can be attributed to the portfolio’s high-quality position as quality allocation reduced performance by 177 basis points.o Cash holdings limited performance by an additional 27 basis points.
Stock selection was strong this quarter, providing 216 basis points of positive relative performance.o Top performing holdings included Qualcomm (+41bp), eBay, (+17bp) and Edwards Lifesciences, a leader in transcatheter heart valves (+16bp). o High-quality holdings experiencing disappointing returns in the low-quality environment included Walt Disney, CVS Health and Johnson &
Johnson.
Sector allocation reduced performance by 82 basis points, mostly due to an underweight in InformationTechnology.o Positive stock selection in Technology more than offset the underweight position as the sector contributed 6bp to relative performance in total.o Another reflection of the portfolio’s quality bias was an overweight in Consumer Staples, which reduced performance by 26bp.
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% Change
Active Weight
Basis Point Contribution Sector Industry Comment
Qualcomm 29.0% 1.82% +41bpsInformationTechnology
Communications Equipment
As the owner of all relevant CDMA technology patents, QCOM receives royalties on virtually every mobile device sold globally and holds a leading share in cellular modem chipsets. After a very difficult 12 month period, the shares rallied on new design wins, resolution of licensing disagreements, and rumors of an accretive acquisition. Offering a 2.7% dividend yield, a solid balance sheet and trading at just 14 times next year’s earnings, the company remains an excellent investment opportunity.
eBay 40.5% 0.45% +17bpsInformationTechnology
Internet Software & Services
eBay is a leading global online marketplace for the sale of goods and services, generally for third party sellers and independent buyers. Beyond the core eBay marketplace, sites include StubHub, Shopping.com, Rent.com, and Half.com. Paypal was spun-off to shareholders during 2015. Recent improvements to the eBay website have ignited sales growth following a difficult period impacted by data breaches, changes to external search engines, and a cluttered website. Recurring rumors suggest international ecommerce companies could acquire eBay.
Edwards Lifesciences is a global leader in heart valves and hemodynamic monitoring. Revenue growth has been robust since the initial approval of the SAPIEN transcatheter heart valve in 2011, a minimally-invasive heart valve replacement alternative to open-heart surgery. Increasing clinical usage and data have proven the superior safety and recovery time of the procedure, expanding approvals to include lower-risk patient pools and international geographies, accelerating revenue gains further.
% Change
ActiveWeight
Basis Point Contribution Sector Industry Comment
Walt Disney -4.4% 2.25% -21bpsConsumer Discretion Movies & Entertainment
Disney is a diversified entertainment company with properties including movie studios, theme parks, cable and broadcast networks, consumer products, and cruise ships. Shares have been pressured on declining network subscriber counts, particularly at ESPN, as viewership shifts to streaming media. Star Wars success makes for tough box office comparisons. Yet, Shanghai Disneyland attendance has exceeded expectations and the acquisition of BAMTech positions Disney for a post-cable world. Share repurchase activity continues.
CVS Health -6.6% 1.76% -21bpsConsumer
Staples Drug Retail
CVS is an integrated health care provider in the United States, focused on improving outcomes and reducing costs through 9,600 retail locations, 1,100 walk-in Minute Clinics, 75 million pharmacy benefit management (PBM) members, and 1 million dedicated senior pharmacy care patients. The long-term, high-quality holding has been pressured on fears of drug price cuts, increased competition for PBM contracts, and sluggish front-end sales. Trading at just 13 times next year’s earnings, valuation is now near the financial crisis lows.
Orbital ATK -12.7% 0.69% -18bps Industrials Aerospace & Defense
OA designs and manufactures aerospace and defense products for the U.S. government, allied nations, law enforcement agencies and commercial space customers. Formed with the merger of Orbital Sciences and ATK, products include launch vehicles, propulsion systems, structures, and ammunition. During the quarter, OA disclosed accounting issues related to at least one government supplies contract and a delay in financial statement filings for the duration of an investigation. The shares were sold from the portfolio.
What Did Not:
What Worked:
3rd Quarter 2016 Equity Portfolio Commentary
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September 30, 2016
Current Equity Market Factors
Factor Position
Sentiment Sentiment indicators continue reflect a balance between bulls and bears.Neutral
MonetaryReal and nominal levels of growth in the monetary aggregates remain stable near historical averages. Neutral
Valuation Our Valuation Model for the S&P 500 continues to suggest stocks are undervalued. Positive
EconomicOur Liquidity Model remains at relatively low levels.The current reading is consistent with 1.5% growth in GDP. Neutral
EarningsEarnings revisions remain negative on balance and aggregate consensus estimates suggest no growth over the next 12 months. As a result, our outlook for earnings is negative. Negative
Inflation Despite growing concerns of deflation, longer-term expectations remain very stable. Neutral
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Sentiment is Neutral
Source: Investors Intelligence
Last Updated: 9/30/2016
Market Factors
Sentiment indicators continue to reflect a balance between bulls and bears.
12
The Monetary Environment Is Neutral
Sources: St. Louis Federal Reserve, Bloomberg
Last Updated: 9/30/2016
Market Factors
Real and nominal levels of growth in the monetary aggregates remain stable near historical averages.
13
Valuation is Positive
Sources: Thomson Financial, Bloomberg, GH&A Research
Last Updated: 9/30/2016
Our Valuation Model for the S&P 500 continues to suggest stocks are undervalued.
Market Factors
14
The Economic Outlook is Neutral
Sources: Bloomberg, GH&A Research
Last Updated: 9/30/2016
Our Liquidity Model remains at relatively low levels. The current reading is consistent with 1.5% growth in GDP.
Market Factors
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Earnings are Negative
Sources: Thomson Financial, Barron’s, GH&A Research
Last Updated: 9/30/2016
Earnings revisions remain negative on balance and aggregate consensus estimates suggest no growth over the next 12 months. As a result, our outlook for earnings is negative.
Market Factors
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Inflation is Neutral
Sources: Bloomberg, GH&A Research
Last Updated: 9/30/2016
Despite growing concerns of deflation, longer-term expectations remain very stable.