Employee Spotlight
This month we recognize Sylvia Fry, Senior Vice President, Chief Compliance Officer.

Business Council Award
Read about Andrea McMahon’s involvement with the University of Nebraska at Omaha Business Council.

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David Spika appeared May 8, 2013 on CNBC’s ‘Squawk Box’ program in an interview with anchors Joe Kernen and Becky Quick.

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Volume 18, Issue 5
April 2013

The Issue for International Fixed Income

With central bankers around the globe reiterating their commitment to maintain low interest rates until unemployment falls and economic growth stabilizes, the environment remains supportive of fixed income securities. However, in this low rate environment, to find attractive total returns, investors need to consider looking beyond the domestic fixed income market. International bond markets are extremely diverse and offer investors access to economic or market environments that have the potential to provide attractive returns. In this month’s letter we discuss the reasons why investing in foreign bonds is a logical evolution for fixed income portfolios and the opportunity they currently present.

Greater Opportunity Set

Approximately 75% of the world’s sovereign debt and 64% of total bond market capitalization exists outside the U.S. By adding exposure to foreign bonds, investors significantly increase their opportunity set, thereby expanding the diversification and the ability to limit risk and improve returns by focusing on the countries with the most attractive economic and interest rate cycles. Expanded investment opportunities also allow active foreign bond investors to have an advantage over those who focus solely on U.S. government bonds. Specifically, the ability to manage currencies allows for additional risk control and return enhancement.

Add Diversification

Investing solely in domestic fixed income securities is no longer sufficient to achieve the desired level of global diversification for many investors’ portfolios. International bonds are a viable asset class with the potential to help reduce portfolio return volatility in a manner similar to the diversification benefit expected from international equities. A diversified approach to fixed income securities representing various issuers, countries and currencies can help vary investor portfolios in many ways, as global fixed income has historically exhibited lower correlations to other major asset classes. Plus, different countries typically produce different levels of investment return at different times, so it can be to a bond investor’s advantage to look outside the U.S. for additional sources of return and seize the best opportunities available among various countries, sectors, and issuers.

Investing in an International bond portfolio also can help diversify away from interest rate, political and economic risk that may exist in any particular country, including the U.S., as focusing on a single market’s economic and interest rate cycle to generate returns may actually increase an investor’s risk rather than returns. While investors in international bond markets are exposed to interest rate, political and economic risk of many different markets, the primary factors driving international prices are somewhat uncorrelated to the same factors in the U.S. markets, thus diversifying the risks.

Global Bonds Have More Ways to Generate Returns

International fixed income portfolios not only have the potential to earn return from compounding nominal yields but additionally from currency management. Currency provides an additional investment opportunity on top of the standard factors for bond investors. A country’s bond market may produce average performance in local currency terms in a given year, but a cheap and appreciating currency can provide investors with an additional source of return. Investing in the right countries, coupled with currency appreciation, offers return potential usually far in excess of any one domestic market. Such a strategy can also provide an additional, uncorrelated alpha source to a multi-asset class portfolio. Additionally, in a domestic only portfolio, dollar weakness will exist as fear of inflation and as U.S. government debt levels increases. A portfolio of international  bonds denominated in foreign currencies can help protect the purchasing power of U.S.-based investors during these periods.

 Appeal of Developed and Developing Country Investments

The recent economic shifts make investing outside of the U.S. and other major developed -country bond markets, such as Japan and the Eurozone, even more compelling from a risk perspective. Many smaller developed and developing markets have adopted free market policies and are poised for economic growth and prosperity, as they modernize and expand their financial systems. Many developing countries were not impacted by the financial crisis to the extent that developed markets were, providing access to economies that are in fundamentally better shape than many developed markets. A large number of developing economies have achieved pre-crisis economic activity, which has led to strong currency markets. Central banks and governments in these nations have become more fiscally responsible in recent years by reigning in inflation, building reserves and strengthening their economies. This has led to improved credit quality (as shown in the chart above) and liquidity, lowering borrowing costs, underpinning the ability of these countries to withstand volatility in global growth and financial markets.

 The global investment landscape has broadened dramatically over the past two decades, encompassing both developed and emerging markets and allowing investors to capitalize on an immense set of investment opportunities that are unconstrained by regional boundaries. A diversified global approach provides investors with the flexibility to pursue the most promising investment ideas wherever they can be found, beyond the limits of a single market or region.

 As mentioned in our year-end letter, Westwood Trust believes that additional Non-Dollar Fixed Income exposure to diversified portfolios is prudent in the current low interest rate environment. We will introduce you to our International Fixed Income strategy later next month.

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Employee Spotlight
This month we recognize Gerald Loo, Vice President, Portfolio Specialist.

Anniversary Celebration
Hear about our 30th Anniversary Celebration!

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Volume 18, Issue 4
April 2013

Media Led by Comcast Best Proving Malone Wrong

April 3, 2013
By Christopher Palmeri in Los Angeles and Alex Sherman in New York

Entertainment companies are proving a safer bet than Liberty Media Corp. Chairman John Malone forecast four years ago, when he predicted some would follow the decline of music labels and newspapers amid online competition.

U.S. media stocks, instead of faltering, produced the best risk-adjusted return since the end of 2011 of the 24 industries in the Standard & Poor’s 500 Index, according to the Bloomberg Riskless Return Ranking. The stocks tied with pharmaceuticals for the biggest improvement from the prior three years, as concern faded that customers would cancel their pay television subscriptions in favor of online services.

Media shares plunged in 2007 and 2008 as advertising cratered and investors fretted that movie studios and cable-television providers would follow the path of music labels and newspaper chains, losing steady customers and advertisers to free or lower-cost content on the Web. Since then, investors have reassessed the prospects for Comcast Corp., Time Warner Inc., News Corp. and their competitors as sales and profits climb with content providers striking additional digital distribution partnerships.

“The stability in the cable industry really came to light through the economic downturn,” said Thomas Lieu, a portfolio manager at Dallas-based Westwood Holdings Group Inc., which owns about 3 million Comcast shares. Revenues and earnings have accelerated in recent years, he said, while “valuation still lags given how solid their performance was 4and continues to be.”

‘Too Late’

The S&P 500 media index, made up of 15 stocks, rose 60 percent from the end of 2011 through the first quarter, topping all groups. Its price swings were below average, leading to a risk-adjusted return of 4.1 percent, according to data compiled by Bloomberg. Pharmaceuticals, including biotechnology and life sciences, had the No. 2 risk-adjusted return, at 3.7 percent. Both industries improved by 2.3 percentage points from the 2008-2011 period.

Bloomberg’s risk-adjusted returns are calculated by dividing the total return by volatility, or the degree of daily price variation. Higher volatility means the price of an asset can swing dramatically in a short period, increasing the potential for loss. The figures aren’t annualized.

Sentiment toward entertainment stocks has brightened since July 2009, when Malone told reporters at Allen & Co.’s annual media industry retreat in Sun Valley, Idaho, “it may be too late” for some companies to survive. “The Internet is moving too fast, too far,” he said.

New Streams

Malone said media companies would suffer if they couldn’t prevent users from gaining access to their content for free.

Cable, satellite and telecommunications companies added a net 31,000 pay TV customers last year as new accounts outnumbered cancellations, according to an April report from Toronto-based Convergence Consulting Group Ltd. Comcast said it would have added video customers last quarter if not for Hurricane Sandy. Internet services including Hulu Plus, Netflix and Amazon Prime pay media companies for content, acting as complements to live TV and providing additional revenue streams.

Since song sharing site Napster emerged in 1999, music industry sales have fallen by more than half to $7.1 billion in 2012, according to the Recording Industry Association of America in Washington. Advertising revenue at U.S. newspapers dropped at a similar rate to $23.9 billion as of 2011, according to the Newspaper Association of America in Arlington, Virginia, whose figures include online sales.

‘Convenient’ Shopping

Cable TV industry revenue more than doubled since 1999 to $97.6 billion in 2011, based on the latest data from the National Cable Television Association in Washington. The average U.S. pay TV bill rose 6 percent that year to $86 a month and will reach $123 by 2015 as companies offering a “convenient, one-stop shop” maintain pricing power, according to market researcher NPD Group Inc. in Port Washington, New York.

Comcast, the Philadelphia-based owner of NBC Universal and the nation’s largest cable system, had the highest and most improved risk-adjusted return within the media index. The shares gained 81 percent since Dec. 31, 2011, with 19 percent volatility, for a risk-adjusted return of 4.3 percent.

Investors sought safety in the company’s consistent earnings and growing broadband business, said Chris Marangi, a portfolio manager at Gamco Investors Inc., a Rye, New York-based firm managing $36 billion in assets including holdings in Comcast, DirecTV and News Corp. Comcast added 341,000 high-speed Internet and 168,000 telephone customers in the fourth quarter, while losing 7,000 video subscribers, the company reported in its latest earnings release.

‘Both Pots’

The company raised its bet on cable programming by purchasing the remaining 49 percent of NBC Universal from General Electric Co. in a deal completed last month.

“Comcast has its hand in both pots — content and distribution,” Lieu said.

Cablevision Systems Corp., the Bethpage, New York-based cable TV operator, posted the worst risk-adjusted return over the past 15 months, at 0.3 percent, with the smallest price gain and the widest swings. The company spun off its TV networks Madison Square Garden Co. in 2010 and AMC Entertainment in 2011, making it less exposed to improving sentiment about TV networks.

Malone’s Liberty Interactive Corp., which isn’t part of the media index, gained 49 percent and returned a risk-adjusted 2.4 percent since 2011.

Getting Paid

Content creators such as Walt Disney Co. and Time Warner have taken measures since 2010 to ensure they get paid for their programming by requiring that visitors to their websites prove they are pay TV subscribers before they can watch most of their shows. New York-based Time Warner has had the third-best risk-adjusted return since 2011 among major media stocks, and Burbank, California-based Disney ranks fifth.

Movie studios this year are likely to fall 3 percent short of the record 2012 domestic box office sales paced by “Marvel’s The Avengers” and “The Dark Knight Rises,” according to analysts at Barclays Plc.

Even so, international ticket sales have been growing, and film and TV studios are combating declining sales of DVDs by reaching agreements with new video streaming services. Disney signed a deal in December to provide its films to Netflix Inc. for exclusive streaming starting in 2016.

‘Right Price’

“They stepped up and paid the right price,” Disney Chairman and Chief Executive Officer Robert Iger told analysts on a Feb. 5 conference call.

Industrywide revenue from subscription-based streaming services climbed 46 percent last year to $2.3 billion, and digital purchases of movies and TV shows rose 35 percent to $800 million, according to research from Nomura Securities International Inc. That allowed home entertainment revenue at the major studios to hold steady at $18 billion, even as DVD sales and rentals fell.

“Given the past rate of industry declines, this is still a relief for the industry that maybe we have finally turned the corner and should help further improve profitability,” Nomura analysts led by Michael Nathanson said in a March 25 report.

The American Taxpayer Relief Act of 2012

In an effort to avoid the year-end “fiscal cliff,” Congress agreed to and President Obama signed into law the American Taxpayer Relief Act of 2012 on January 2, 2013. The Act extends certain provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (collectively referred to as the “Bush tax cuts”), which themselves were temporarily extended by the Tax Relief, Unemployment and Reauthorization, and Job Creation Act of 2010. Unlike the 2010 extension, the current Act makes permanent certain provisions of the Bush tax cuts while establishing new guidelines for others.

The implications of Act will become more clear through time as progress, or lack thereof, on the spending side of the ledger is debated over the coming months. For now, we review the highlights of the Act on tax rates for 2013:

Individual Income, Capital Gains, and Dividend Tax Rates

A top rate of 39.6% (up from 35% in 2012) is imposed on individuals with taxable income of more than $400,000 ($425,000 for head of household and $450,000 for married filing jointly).

A 20% tax rate will apply to capital gains and qualified dividends that would otherwise fall in the 39.6% tax bracket. For those making less than $400,000/$425,000, the lower 2012 tax rate of 15% remains in effect.

These tax rates are augmented further by a limited phase-out of itemized deductions and personal exemptions starting at a threshold for individuals of $250,000 ($275,000 for head of household and $300,000 for married filing jointly). This may increase a taxpayer’s effective marginal rate by up to 1.2%.

Finally, the 3.8% Medicare tax on investment income as enacted by the Patient Protection and Affordable Care Act (“Obama Care”) went into effect as of January 1, 2013. This tax applies to the net investment income of an individual whose modified adjusted gross income is in excess of $200,000 ($250,000 for married filing jointly).

Social Security Payroll Tax

As of January 1, 2013, the Social Security payroll tax reverted back to 6.2% for employees (up from 4.2% for 2012). The cap for Social Security withholding is increased to $113,700 (up from $110,100 in 2012).

Further, Obama Care imposes an additional 0.9% Medicare tax on wage, compensation or self-employment income of an individual that exceeds $200,000 ($250,000 for married filing jointly). The additional 0.9% Medicare tax is borne by the employee rather than the employer (though it is subject to withholding).

Gift, Estate, and Generation-Skipping Transfer (GST) Tax Rate and Exemptions

The maximum gift, estate, and GST tax rate has been raised to 40% (up from 35% in 2012). Every individual has a $5 million lifetime exemption (indexed for inflation) from gift and estate taxes. The indexed amount for 2013 is $5,250,000. Every individual has a separate lifetime exemption of the same amount from GST taxes. A deceased spouse’s unused gift and estate tax exemption amount (but not the GST exemption amount) remains “portable.” This means that the surviving spouse may take advantage of a deceased spouse’s unused exemption.

Though not a part of the 2012 Act, the annual gift tax exclusion for 2013 (as indexed for inflation) is $14,000 (up from $13,000 in 2012). This is the annual amount you may give to an individual without using any of your lifetime gift tax exemption.

State and Local General Sales Tax Deduction

The 2012 Act extends through 2013 the provisions allowing tax-free distributions from an individual retirement account to a public charity by an individual age 70½ or older, up to a maximum of $100,000 per taxpayer per year. Distributions to a public charity in January 2013 may be treated as if these distributions had been made on December 31, 2012 (and thus will not count against the 2013 limit). Additionally, a taxpayer may treat distributions to himself or herself in December 2012 as charitable distributions if the taxpayer transferred the amount received to a public charity prior to February 1, 2013.

Conversion of Traditional 401k Retirement Accounts to Roth 401k Accounts

Prior to 2013, only amounts eligible for distribution from a traditional 401k retirement account (i.e., in-service withdrawals of elective contributions after age 59½ or distributions due to disability, severance of employment or retirement) were eligible for conversion to Roth accounts. The 2012 Act allows any amount (regardless of whether it is distributable) in a non-Roth account to be converted to a Roth account in the same plan.

While a “grand bargain” compromise of spending and tax reform remains a long way off, the details of the 2012 Tax Act are now a known factor. At the very least, businesses and individuals are now able to make decisions from a somewhat more informed point of view. As the debate around spending issues unfolds over the next few months, we hope to gain additional clarity on the investment implications of fiscal policy and therefore, make more of the “unknowns” become “known.” Although much work is left to be done, the path to fiscal clarity has now at least been initiated, which is a step in the right direction. Stay tuned. . .

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Multiple Expansion and Earnings Growth

A Powerful Combination

Stock prices over any time period can be influenced by changes in earnings-per-share (EPS), changes in the Price/Earnings (P/E) multiple, or a combination of both.  As shown to the right, the optimal scenario for investors is when earnings are growing and multiples are expanding.  During 2012, the stock market was driven higher largely due to P/E multiple expansion, as corporate earnings grew by approximately 5%. Should earnings growth remain modest in 2013, multiple expansion will once again play a significant role if stocks are to be driven materially higher.

History has shown that changes in the P/E multiple can be a powerful force in driving stock returns.  Despite meager earnings growth in 2012, the stock market appreciated by 16%, due in part to expanding multiples.  Since equity investors hate uncertainty, rising P/E multiples have historically been associated with greater levels of confidence in economic growth, the political/regulatory environment, and macro-economic issues. As the uncertainty surrounding European debt issues, the Fiscal Cliff, and U.S. elections gradually faded throughout 2012, the market experienced P/E multiple expansion.   Much of this uncertainty was diminished as the result of central bank easing efforts, such as the Fed’s Open Ended Quantitative Easing and the ECB’s bond buying program (also known as OMT, or Outright Monetary Transactions).  As a result, multiple expansion occurred due to the perceived lower risk associated with these uncertainties, which in turn, resulted in improving confidence. As we have moved through the often bumpy recovery from the 2008 Financial Crisis, the vast majority of stock market gains has resulted from earnings growth, while continued macro uncertainties constrained investor confidence.  The multiple expansion driven gains of 2012 marked a departure from this trend.  Now the question is: will we see more multiple expansion or will earnings results be the primary driver of market performance in 2013?

Multiple Expansion – A Brief Lesson

Earnings growth and P/E expansion often do not occur simultaneously, and the impact on the market has varied.  For instance, during the 1950s, earnings grew less than 4% per year, but it was one of the best decades for stock price performance.  In contrast, the 1970s, driven by an acceleration in inflation, saw the fastest earnings growth in the past 60 years but was one of the worst decades for stock market investors. The bull market of the 1980s represented a period when earnings multiples doubled, while the 1990s saw multiples double again; however, earnings of the underlying businesses climbed only about 6% per year, while stock prices appreciated nearly 14% annually due to multiple expansion.  Of course, this over exuberance led to an overvalued market (the P/E multiple eventually reached approximately 30x in contrast to today’s level of approximately 14x), which was then followed by a severe market correction in the 2000s. 

4th Quarter 2012 Earnings Summary

A lot has been made about the slowdown in U.S. economic growth during the 4^th quarter of 2012, but this period was burdened with uncertainty around the Fiscal Cliff, the effects of hurricane Sandy and a drought in the Midwest.   These took a bigger toll on consumers and businesses than expected, but overall, 4^th quarter earnings reports have reflected better growth rates than expected as corporate executives focused on cutting costs and took advantage of record-low borrowing rates.

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Market Performance
Concerns about the Fiscal Cliff, and the resulting impact on the economy if no agreement was reached, drove sentiment during the 4^th quarter.  As a result, the broad stock market suffered a slight loss for the period.  Despite signs that global growth is improving, investors remained generally pessimistic given the potential impact of the roughly $700 Billion in tax hikes and spending cuts that were scheduled to occur if legislators had been unable to reach a compromise that offset or postponed these actions.  Even an announcement by the Fed that its bond buying program (aka QE) will be increased to $85 Billion/month was insufficient to offset the negativity of investors.  In addition to QE, the Fed announced that the federal funds rate is anticipated to remain near zero until at least mid-2015 and that these accommodative measures will remain in effect until there is “substantial” improvement in the labor market.  The Fed is hopeful that its actions will result in stronger housing prices, an increased demand for stocks and other risk-based assets, and ultimately, stronger consumer spending.  Such a result would likely create better job growth and help the Fed make progress on its mandate of full employment.

In addition to the expansion of QE, which amounted to the Fed replacing Operation Twist with direct purchases of U.S. Treasuries, the FOMC committed to maintaining a zero fed funds rate until the unemployment rate falls below 6.5%, as long as inflation is below 2.5%.   This likely equates to a rate hike occurring no sooner than mid-2015 and is a signal that the Fed is fully committed to meeting its mandate of full employment.  As a result, investor demand for securities that can produce growth and income should continue for the foreseeable future.

Economic data generally improved over the course of the quarter.  Home prices, job growth, auto sales, and consumer confidence all rose, while consumer debt service fell to lows not seen since the early 1980’s.  On the other hand, spending during the Christmas season was disappointing, and many blamed it on Fiscal Cliff fears.  However, the consumer has been very resilient in the face of much uncertainty, and consumer spending is poised to be a key driver of economic growth once the Fiscal Cliff issues are resolved.

Energy-related commodity prices were relatively flat over the course of the quarter, but gasoline prices at the pump fell, which had a positive impact on consumer sentiment and spending.  Metals prices, such as gold and copper, fell during the quarter as the positive impact of QE liquidity dissipated.

Domestic Equities

The rotation out of safe havens such as Utilities and Consumer Staples continued as investors sought more reasonably valued securities in economically-sensitive sectors.  As a result, the Producer Durables and Materials & Processing sectors produced gains during the quarter.  The best performing sector, however, was Financial Services, as banks rallied on the Fed’s expanded QE, the housing market continued to improve, and the realization that capital levels are now more than adequate.  Technology stocks were the worst performers during the quarter, as investors remained concerned about weakened PC demand and corporate capital spending in the face of a possible Fiscal Cliff failure.

In the U.S., the S&P 500 gained during the year despite a slightly negative quarter as politics overshadowed economics.  Following a close presidential election, the focus turned towards the “fiscal cliff” and possible implications on an already fragile economic recovery and debt-burdened consumer.  The Chicago PMI in December showed improvement from new orders and inventories, while the housing recovery remained on track as pending home sales increased for another consecutive month in November.  

Global Equities

Global equity markets ended on a positive note for the quarter as investor risk sentiment improved.  Economic data from China continued to show evidence of a broad recovery, dispelling fears of a hard-landing, while growth in the U.S. remained on track even as negotiations regarding the “fiscal cliff” triggered near-term uncertainty.  Europe, Japan, and Emerging Markets led the advance, while commodities were generally weak for the quarter, particularly in precious metals and agriculture.  

Although Europe is expected to dive deeper into recession before any signs of a recovery, equity markets in the region seemed to be assuaged by recent policy responses and rhetoric from authorities to support sovereign finances and implement fiscal reforms, resulting in one of the best quarterly and annual performance since 2003.  Greece outperformed during the last quarter despite missing fiscal and growth targets in its restructuring program, while Portugal, Spain, Italy and France outperformed core economies such as Switzerland, Germany, and Belgium.  The Nikkei was lifted by expectations of a more aggressive monetary policy under new leadership in Japan, while depreciation in the yen against the U.S. dollar during the year is expected to be positive for competitiveness.  Asia posted a broad advance across all country markets in the last quarter, driven primarily by China as rising activity in the construction and service sectors, added to signs of a strong recovery in real GDP growth for 4Q12.  Emerging economies of Thailand and Philippines were among the best performers, and South Korea was also positive.

Among the major sectors, Financials, Consumer Discretionary and Industrials led gains amid an improvement in economic outlook, while Telecommunication Services, Information Technology, and Energy lagged. 

Fixed Income

As was the case in the previous quarter, Treasury yields finished the year largely unchanged in the final quarter of 2012.  Providing some support to the bond market was the Federal Reserve’s decision to increase the amount of quantitative easing in 2013, which served to offset the ever-present uncertainty on the political front.  Outside of the Treasury market, risk assets were not held back by Washington’s inability to address the issues at hand as credit spreads tightened sharply in the fourth quarter.  A steady stream of better than expected economic reports, along with diminishing concerns over the European debt crisis also contributed to investors’ willingness to take on more risk.  Faced with near insatiable demand and historically low yields, corporations continued to issue debt at a record pace in the fourth quarter.       

With interest rates little changed, overall returns for the Investment Grade Fixed Income universe were only modestly positive for the fourth quarter.  As was the case for all of 2012, the Credit sector once again outperformed.  Benefiting from the strong demand for risk assets, long duration corporate bonds in the Financial sector were easily the top performer for the period with a gain of over 3%.  Lower rated bonds also outperformed, gaining almost 2%, compared to a flat return for the AAA rated portion of the market.  While they still managed to post a positive return for the year, long-duration Treasuries declined by 1% for the period and were the worst performing sector for the second consecutive quarter.    

We hope you had a Happy New Year, and we look forward to discussing your portfolios with you.

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Employee Spotlight
This month we recognize Mark Easterbrook, Director of Research.

Wellness Committee Happenings
Learn about our Workout Party and other spring events.

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