Adams Diversified Equity Fund Inc. (NYSE:ADX)
First Half 2016 Earnings Conference Call
July 28, 2016 10:00 AM ET
Nancy Floyd Prue - Executive Vice President and Director of Shareholder Communications
Mark Stoeckle - Chief Executive Officer
Brian Hook - Chief Financial Officer
Good day everyone and welcome to today’s Adams Diversified Equity Fund’s Semi Annual Conference. Just as a reminder, today’s call is being recorded. At this time, I would like to turn the call over to your host for today, Ms. Nancy Prue. Please go ahead ma’am.
Nancy Floyd Prue
Good morning and thank you for joining us. In the room, we have Mark Stoeckle, CEO and we have Brian Hook, our CFO who will be available to take questions. This conference call may contain statements that are considered forward-looking statements within the meaning of the Securities Exchange Act. These statements reflect the Fund’s current views with respect to future events and financial performance. These statements are subject to risks and uncertainties that could cause our actual performance return or investment decisions could be materially different from what we project. We assume no obligation to revise, correct, or update these statements.
Let me remind you this call is being recorded and a replay will be available for two weeks. Details of that replay are in the News section of our website.
Thank you for your interest in Adams Funds and I will now turn it over to Mark Stoeckle for comments.
Thanks, Nancy. Good morning to everyone and thank you for participating in our semi-annual call. This morning, I am going to review our six month results through June, talk a little bit about a few stocks in the portfolio and then open it up to questions.
2016 started off with a significant amount of volatility.
Chinese stocks plunged in January, setting up a significant risk-off trade in US stocks. With this continued into February with the intraday low for the year for the S&P 500 was established at down 11.4%. This someone had flipped the switch, the S&P managed to leg its way back into the black in the remainder of the quarter.
The move back to positive territory was driven primarily by good economic data, as well as the realization that the fed was going to go about the business of increasing rates cautiously. The modest first quarter S&P return was followed up with a bit more return in the second quarter leaving the performance at 3.8% for the first six months.
The Fed June meeting came and went without a move in rates as mixed economic data and the concerns surrounding the UK referendum. Most investors seem to be caught by surprise when they woke up on Friday June 24 to find that the UK voted to leave the EU. That day and the following Monday, the S&P plunged 5.3% as investors tried to get their heads around what the vote really meant for stocks.
Almost as quickly as the market went down, the market rallied 4.9% in the final three days of the quarter, again volatility reared its head in a significant way. The first six months of the year were challenging for active stock picking. Our experience was not much different.
One principal reason for the difficulty was the high correlation to macro-related events. It seems from many companies that the movement in the US dollar mattered more than companies’ fundamentals. This is a very difficult environment for stock selection. What was also difficult during the period was the reverse in trade that happened from the end of 2015.
Recall that we had strong relative performance to other managers in 2015. At that time, we did not see a big sea change in company fundamentals. What we didn’t expect was that many of the very poor performers from 2015 were going to be the darlings of the first six months of 2016.
In fact, the 50 best S&P performers for the first six months were up between 117% and 27%. Of those top 50 companies, only four were in the top docile last year. Said differently, with the uncertainty presented in the beginning of the year, investors flocked to lower quality companies that had underperformed.
This can be seen quite clearly in the materials sector. This year Freeport-McMoRan has performed quite well, but last year, Freeport ranked number 495 out of 500 stocks for performance. This year, it ranks 5 out of 500. Quite a turnaround for a stock that we do not believe has very good company fundamentals.
And that’s a very important point. The lower quality rally that we’ve seen so far this year is an environment where we will struggle. Our emphasis is and always will be on high-quality companies doing good things operationally, at good prices.
With patience, we believe our philosophy will be rewarded. Before moving on to more company-specific commentary, let me say a few things about what we see lying ahead of this, this year. As mentioned before, the Brexit vote was not anticipated by the investing public. If there is one thing we all know, is that investors really dislike the unknown.
With that in mind, it’s hard to get a handle on just what the ultimate exit will look like. It is also looking increasingly like we will not have a resolution to the exit until much later this year and it could bleed over into 2017.
Another issue we have in front of us is this little thing called the US Presidential Election. Now that both candidates have made it through their conventions, the most contentious election in modern history will commence. The rhetoric has been nasty and we don’t expect that to change as we make our way to November.
With the race that is too close to call, we are hoping cooler heads prevail and vitriol subsides. But we will ultimately win the Presidency and House and Senate races will go is anyone’s guess. The rising election uncertainty puts a second unknown in the mix.
Lastly, crude oil has been on quite a roller-coaster this year. The beginning of the year saw a major move down when crude traded below $30 for the first time since 2003. As quickly as it went down, it started its spent to just over $50. The recent move towards $40 has again caused some consternation.
Our view is that the longer-term supply and demand will fall into better balance allowing for crude to go well into excess of $50. A significant number of rigs have been laid down in the last 18 months which has begun to take out some supply. In addition, there has been an enormous number of worldwide development projects that have been put on hold or canceled.
Fund managers, Jim Haynie, Cotton Swindell and I believe that these facts – given these facts, it is only a matter of time before favorable supply and demand balance allows for a rebound in crude prices.
I will now move on to the portfolio. There are few stocks that we really like that have trailed this year, because of deals that have yet to close. Several of them are in the healthcare sector, which has covered for us by Steve Crain. We own two managed care companies, Cigna and Aetna.
Both are currently in the midst of M&A transactions. Cigna with Anthem and Aetna with Humana. We own both stocks before the deals were announced and we like for their fundamentals with or without a deal. The Justice Department has taken a lot of time evaluating both deals and that has weighed on the stock prices.
Recently, the Justice Department announced that they would sue to block the deals. Notwithstanding that, we feel very good about the operational prospects for both Cigna and Aetna and firmly believe that we will ultimately be rewarded for owning each of them. It’s just going to take longer than we imagine.
Another healthcare stock involved in the deal is Allergan. They are selling their generic business to Teva Pharmaceuticals. The market has been waiting patiently and just yesterday it was announced that Justice Department has approved the transaction.
It is a $40 billion deal that we believe puts Allergan in great position to pay down debt, repurchase shares, and do what they do very well which is make acquisitions. Notwithstanding the fact that Allergan has underperformed so far this year, with the deal now being approved, the market can put the unknown behind and focus on the outstanding opportunities that lie ahead for Allergan.
During the first half of the year, we took a new position in Goldman Sachs. The attractiveness of Goldman started with the fact that it had a very attractive valuation. Jeff Scholar, our Financial Services analyst, identified that Goldman rarely trades below book value and it’s historically - and historically that is proven to be an opportunistic time to own it.
We believe that Goldman is best-in-class capital markets company. In addition, their business model has evolved into a recurring fee revenue model with their asset management and investment banking businesses growing from 12% of revenue in 2010 to 20% and 21% respectively. Therefore, 41% of current revenue is asset and capital light, fee-oriented and higher relative return on equity.
As I said in the beginning, we focus on high-quality companies doing good things operationally at good prices. Goldman Sachs is a prime example of that.
In technology, we added to our position in Adobe. Adobe is a high-quality technology company. They are dominant in 70% of their business which is related to Photoshop and Acrobat and the remaining 30% of their business, they are the largest player in a fragmented market.
The recent transition to the cloud increases Adobe’s visibility of its business model. This transition also improves margins as direct selling is more cost-efficient than selling through partners and distributors. We believe Adobe can continue to dominate in a market that continues to expand.
Most investors don’t usually talk about utilities, but it’s a sector that was one of the best performing in the first six months. I thought you would find it interesting. We recently swapped one Michigan utility for another. We sold our position in CMS Energy Corp. and purchased DTE Energy Company.
Both are similar business models, but our analysts Greg Buckley identified the fact that although historically they traded very closely to each other, CMS had outperformed DTE by a significant margin over the past year. In addition, Greg identified that the two had historically traded at similar valuations, but DTE had grown to a 12% discount to CMS.
We believe there were similar businesses in a compelling valuation in performance difference selling CMS and buying DTE was a wise decision for our shareholders.
I want to now review a few things about the Fund that I believe are very important. First, we remain committed to a minimum yearly distribution of at least 6%. In fact, since we made that commitment in 2011, we have exceeded the minimum each year. We understand the importance that many of our shareholders place on this distribution and we’ll continue to honor our commitment.
As it relates to the distribution, we feel it is important that our shareholder remember that our stock or Fund it should be viewed as a total return vehicle, meaning, you just can’t look at the price return of the stock, you must factor in the distribution – distributions in order to get a proper understanding of your total return.
Lastly, it’s important to me that you know, that we have a very good team here at Adams. In addition to having a strong infrastructure and accounting and compliance, we have assembled a very good investment team. We have strong portfolio management augmented by very good fundamental sector analysts.
We have a team that takes a long-term view and look for high-quality companies doing good things operationally at good prices. I feel very good about our prospects of delivering good investment results over time for our shareholders.
With that, operator, I would like to open it up for questions.
Thank you. [Operator Instructions]
As we are waiting for questions. I thought it might be interesting to talk a little bit about interest rates and how they have affected the financial services sector. As many of you probably know, financials did not performed well in the first half of the year and a lot of that has to do with the fact that, frankly, banks and large financial institutions with low interest rates are finding it very difficult to make money, especially, the very large and mid-cap banks. It’s an issue that they have had for quite some time and one that we do not see is going to go away any time soon.
One of the ways that we have structured the financials portfolio – because of that is we are overweight insurance, mostly in property and casualty and we also are overweight diversified financials, companies like BlackRock, the Goldman Sachs that I mentioned and Intercontinental Exchange.
We think that banks will continue to have headwinds, because of the low interest rate. We don’t anticipate that the Fed will likely do anything until December at the earliest. So we think that those headwinds are going to continue.
Nancy Floyd Prue
Okay Mark. The first question comes in it’s talking about our largest holdings especially in Technology, several of your largest holdings and for the Funds are in technology. Could you talk about Microsoft or Alphabet and tell us what you like about that sector and in particular those stocks?
Yes, sure. Good question, because we do have a significant weighting in technology. Technology is one of the few areas where you can actually find in addition to healthcare, where you can actually find good growth. One of the things that we actually like about Google or Alphabet is, low to mid-teens long-term revenue growth and stabilizing margins.
So, from a – sort of from a financial perspective, they continue to be very attractive. They have a very strong position in mobile and video as we all know and a very attractive valuation.
The one thing about Google that it’s kind of interesting is if you look at last year, last year Google did very, very well. And this year it’s gotten caught up in that reversion trade that I talked about in the very beginning of the call where a lot of good, high-quality companies have been ignored this year.
Performance this year ranks 402 out of 500 stocks. We continue to like the prospects going forward. We think this reversion trade will subside at some point. We believe it should subside in the near future. And again, continue to like the long-term mid-teen’s revenue growth and the very attractive valuation given the underperformance this year.
Nancy Floyd Prue
Operator, do we have any other questions waiting?
Not at this time. [Operator Instructions]
Nancy Floyd Prue
Okay, we do have one other one that came in about energy prices. Mark, you’ve talked about some of the things that affected the energy market and that is also a strong performing sector during the first six months. What do you see for oil prices or energy in the back half of the year?
We continue to be very favorable and as I mentioned a little earlier, the supply and demand imbalance right now is – really should be favoring, in the near-term it should be favoring higher oil prices. The number of rigs that have been laid down is significant both in the United States and globally.
We have begun to see some of that show up in supply, which is very attractive. That coupled with good solid demand. We think it gives us a good feeling going forward. The other thing that I mentioned, the numbers that we have seen of worldwide projects that has been either deferred or put on hold is upwards of $500 billion.
And although you won’t see the effect of that in 2016 or 2017, you start getting into 2018 and 2019 and the fact that those projects have gone offline will also have a significant impact on supply. So, we like the supply and demand imbalance. We think that – excuse me – we like the fact that the supply imbalance will be in favor of higher oil prices as we look out over the horizon.
I do think we need to have some patience with energy. It has been volatile. As I mentioned, it started off the year going down under $30, it went up to $50. It’s now a little under $42 this morning. I think we have to have some patience, but we do believe as portfolio management team, when we look out over the horizon, we think that oil prices at the balance of this year and looking out at 2017 will be significantly higher.
Nancy Floyd Prue
Okay, we have one more question coming in. The shareholder is asking just for a clarification about the 6% distribution. Will you find it difficult to provide a 6% distribution even with low interest rates?
We will not. Again, it’s something that, when we made the commitment in 2011, we looked at a variety of different scenarios and how it might be difficult or easy to get to that 6% number. And we did factor in interest rates. So, as we manage the portfolio, we feel very comfortable even in a low interest rate environment of honoring the commitment of the 6%. And as I mentioned, even in the last couple of years with interest rates low, we’ve actually exceeded that. So, we feel quite comfortable with that commitment.
Nancy Floyd Prue
Okay, there has been no other questions posed from the audience. We will bring the conference call to a close. But please feel free to contact me if you think there is some questions after the call and we look forward to speaking with everybody again after the yearly results.
Thank you very much.
Thank you. And again, that does conclude today’s conference. We thank you all for joining. You may now disconnect. Thank you for calling.
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