In the fourth quarter of 2012, Prudent Value’s model portfolio returned +1.8% net of fees while the S&P 500 Index (SPX) returned -0.3%. For the calendar year, Prudent Value’s model portfolio returned +4.8 net of fees while the S&P 500 Index returned +16.0%. Prudent Value’s under-performance relative to the S&P 500 index is due in large part to the portfolio’s large cash and fixed income positions, though we remained active in equities as well.
Last year marked a strong year for equities following a lackluster 2011. Bonds overall performed well with emerging market debt (+18.1%) and U.S. corporates (+10.6%) leading the rally.
It’s been a little over four years since Lehman Brothers’ failure that contributed to the global financial crisis. After a precipitous fall in the S&P 500 through March 2009, the index has performed remarkably well in my opinion.
So well, that if you had purchased the S&P 500 Index ETF (SPY) at a high of $157.52 in October 2007 and decided to vacation in a remote island until the end of 2012, you would have never guessed that the world had gone through the worst financial crisis since the Great Depression.
This would not cross your mind because your SPY investment would be down about 9.5% and much less after including dividends. On a less encouraging note, there was untold havoc on businesses, families, real estate, states, cities, municipalities, schools, and the list goes on and on. The question now is will the real economy grow fast enough to absorb the current excess capacity in labor, property, plant, and equipment?
Because strains in our economy pose significant downside global risks, it is hard to believe Congress will not act in the best interest of promoting a thriving global economy. In this vein, I believe it is reasonable to expect Congress to cushion the fall by extending some of the tax and spending initiatives or adopting all or parts of the National Commission on Fiscal Responsibility and Reform plan (aka the Simpson-Bowles plan).
A balanced deficit reduction plan over the long-term, coupled with open-ended quantitative easing (QE) and debt restructuring, is conducive to a sustainable public sector and a growing (albeit slowly) private sector in my opinion. In other words, there would be a certain amount of austerity, a certain amount of debt restructuring, and a certain amount of printing of money.
When done in the right mix, I do not believe it would produce too much deflation or too much depression. There would be slow growth, but it would be positive slow growth. At the same time, ratios of debt-to-incomes would go down. This right mix is referred to by hedge fund manager Ray Dalio as a “beautiful deleveraging.” In this beautiful deleveraging and open-ended QE ($85 billion per month of unsterilized bond buying by the Federal Reserve) environment, we remain active buyers of equities.
In the fourth quarter, we initiated five new equity positions. These investments fall into the technology and financial services space. In technology, our largest investment was in Apple (AAPL). AAPL designs, manufactures, and markets smartphones, tablet devices, computers, and portable digital media players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications.
Apple’s products and services include iPhone, iPad, Mac, iPod, Apple TV, a portfolio of consumer and professional software applications, the iOS and OS X operating systems, iCloud, and a variety of accessory, service and support offerings.
AAPL also sells and delivers digital content and applications through the iTunes Store, App StoreSM, iBookstoreSM, and Mac App Store. AAPL sells its products worldwide through its retail stores, online stores, and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers, and value-added resellers.
Our largest new purchase in financial services was Markel Corp. (MKL). MKL is a diverse financial holding company serving a variety of niche markets. Examples of niche markets that MKL has targeted include: wind and earthquake exposed commercial properties, liability coverage for highly specialized professionals, horse mortality and other horse related risks, personal water crafts, high-valued motorcycles, aviation and energy related activities.
MKL’s market strategy in each of these areas of specialization is tailored to the unique nature of the risk, coverage and services required by insureds. In each niche market, MKL assigns teams of experienced underwriters and claims specialists who can provide a full range of insurance services. MKL’s financial goals are to earn consistent underwriting and operating profits and superior investment returns to build shareholder value.
On December 19, 2012, MKL announced a merger with Alterra Capital Holdings Limited (ALTE) by offering ALTE shareholders cash and stock valued at approximately $3.13 billion. Following the merger, MKL’s existing shareholders will own approximately 69% of the combined company on a fully diluted basis, with ALTE’s shareholders owning approximately 31%. ALTE is an insurance holding company offering specialty insurance and reinsurance products complementary to MKL’s products.
In 2012, the top three performing U.S. sectors were communications (+24.39%), consumer cyclical (+24.39%), and financial services (+24.32%). The worst three performing U.S. sectors in 2012 were equity precious metals (-8.73%), equity energy (-1.08%), and natural resources (+0.95%).
The top two performing regions in 2012 were India (+27.49%) and Europe (+20.90%). The worst two performing regions in 2012 were Japan (+11.37%) and Latin America (+12.60%). While we do review market performance from time to time, our primary focus is to find great businesses run by shareholder-oriented management.
Our favorite investments are what we view as undervalued wide economic moat businesses. Wide economic moat is a type of sustainable competitive advantage that a business possesses that makes it difficult for rivals to wear down the business’s market share and profits. To learn more about Prudent Value, please click here.
The investments discussed are held in client accounts as of January 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
