QUARTERLY COMMENTARY
Cornerstone Investment Partners, Concentrated 30
3rd Quarter 2014 Performance Summary:
Following a rewarding 2013 and a strong first half of 2014, the market continued its remarkable run
during the third quarter, with the U.S. markets, as measured by S&P 500 Index, ending the quarter up
by more than 1.1%. This marks the seventh straight quarter of gains for the index. Records show
that S&P 500 has risen for seven consecutive quarters only a few times in the last 40 years. However,
factors including slower-than-expected current US economic expansion, low dispersion in stock
returns, and continued geopolitical unease have made 2014 a hard year for active fund managers.
Since the beginning of 2014, the most attractively valued stocks based on our proprietary valuation
methodology performed the worst, while expensive stocks performed best on average. To provide
perspective, over the whole 27 years of our model’s recorded history, there have been only five times
when the most attractive stocks underperformed the least attractive stocks for three consecutive
quarters. In all of those cases, the subsequent 12 month performance was marked by a reversal,
where the most attractive stocks outperformed the least attractive stocks significantly. Generally
speaking, the five-year bull market has put the overall market close to fair value. Nevertheless,
Cornerstone believes that we are able to find value in those companies that have shown long-term
profitability, and we continue to identify attractive opportunities within our universe. Further, with
global interest rates remaining at staggeringly low levels, in our view, U.S. stocks are the best game in
town, and the case for actively managed and concentrated equity portfolios remains compelling.
Overall, the S&P 500 finished the 3rd quarter up 1.1% as 7 of the 10 sectors within the index were in
positive territory. Health Care (+5.5%), Information Technology (+4.8%), and Telecommunication
Services (+3.4%) were the three best performing sectors. In a reversal from last quarter, Energy (8.6%), Utilities (-4.0%), and Industrials (-1.1%) were three sectors within the index that detracted
from the overall performance. For the period, the Cornerstone Investment Partners Concentrated
30 Portfolio underperformed the overall market.
Attribution
The top contributing sectors for the quarter in the Cornerstone Investment Partners Concentrated
30 Portfolio were the Information Technology and Financials sectors. Additionally, our absence
within Utilities and Materials continued to help drive relative performance as these sectors
underperformed the overall market. Our overweight position in Information Technology and our
stock selection in Financials helped drive our performance.
Bed Bath & Beyond (+14.7%) was the best-performing stock in the portfolio during the third
quarter. After being one of the top underperformers for the last two quarters, investors were poised
to reward the Company for good news, and its second quarter results handily beat Wall Street
estimates due to strong comparable store sales of 3.4%. Additionally, the Company continued to use
its high free cash flow to return money to shareholders, buying back $1 billion of its stock during the
quarter, and authorizing an additional $3 billion of future share repurchases. While the Company
remains under some competitive pressure from other formats, we believe that the market does not
fully appreciate the Company’s long-term stability, high free cash flow, and experienced management
team.
EMC (+11.5%) was also one of the strongest stocks during the quarter, and the best performer
among our Information Technology positions. In July, activist fund Elliott Management announced
it acquired a 2% position in the Company and recommended that EMC split up its federation (either
by spinning-off its majority position in fast-growing virtualization company VMWare or selling the
legacy storage business to a competitor.) Later in the quarter, news reports emerged that EMC was
exploring a sale of all or part of its business, including discussions with Hewlett-Packard. While those
talks have reportedly stalled, EMC remains one of the most attractive investments in our 800-stock
universe.
Intel (+13.5%) continued its positive momentum from the second quarter, when it was the bestperforming stock in the Concentrated 30 portfolio. During the third quarter, positive trends in the
PC market helped increase investor confidence in the name and Intel’s second quarter results
demonstrated continued strength in that segment to go along with its fast-growing datacenter unit.
Additionally, the Company confirmed its ability to continue advancing chip technology versus its
competitors.
TRW Automotive (+13.1%), a position we initiated during the second quarter, had strong
performance behind speculation (and eventual confirmation) it would be acquired by German auto
parts maker ZF Friedrichshafen. ZF, which is owned by the Zeppelin foundation, has offered
$105.60 per share for TRW to expand into the faster-growing active safety market and become the
world’s second-largest auto parts maker.
Norfolk Southern (+8.9%) was the best-performing stock in the Industrial sector during the quarter.
Investors rewarded the company for its strong position in energy-related transport, (crude oil and
frac sand), merchandise and intermodal operations, along with increased confidence that recent
service issues were shorter-term in nature. In addition, improvements in US manufacturing
investment by both domestic and foreign companies are expected to support further growth.
Overall, the sectors that detracted from performance during the second quarter were the Industrials,
Health Care and Energy sectors. Our overweight position and stock selection within the Industrials
sector, our underweight position and stock selection in the Health Care sector, and our stock
selection in the Energy sector (which had two of the best performing stocks last quarter) helped
drive underperformance.
Mattel (-20.5%) was the biggest underperformer in the portfolio during the quarter and has been so
throughout 2014. Revenues in the Barbie brand and Fischer-Price have recently been weak, which
drove second quarter results well below Wall Street estimates. Additionally, while Mattel has
historically controlled Disney’s girls-related products, it lost future rights to items based on the hit
movie Frozen to Hasbro beginning in 2016. However, American Girl continues to perform well and
Mattel acquired Mega Blocks to expand in the fast-growing construction segment. While there are
changes in the highly competitive toy space, Mattel’s size and scale should allow it to continue to be a
market leader well into the future.
Ensco (-24.5%), a position we entered during the second quarter, was also a large underperformer
during the third quarter. The offshore drilling industry is entering a period where rig supply is
expected to exceed demand, leading to reduced day rates for most segments of the market, and
market valuations for peer companies have declined. However, Ensco is well positioned in the
significantly more stable edges of the industry, with a high quality fleet of newer ultra-deepwater and
jack-up rigs that should allow it to retain a better revenue base than peers throughout the dip and
perform better coming out of this period. Ensco’s fundamentals and embedded characteristics
remain strong, and we see this dip as a short-term overreaction compared to a long-term business
cycle shift.
Cummins (-14.0%), which had performed well through the second quarter, was an underperformer
during the third quarter. While Cummins beat Wall Street’s estimates during its second quarter due to
strong North American sales, the Company did not increase guidance as much as analysts expected.
However, Cummins has an internationally diversified business driven both by global economic
growth and secular increases in required emission standards.
Parker-Hannifin (-8.8%), was another Industrial name that underperformed due to concerns over
international economic growth. While the Company’s earnings were up over 15% versus last year
with strong performance in North America, Wall Street consensus estimates for the quarter and 2015
guidance were slightly higher as operating margins in the international business declined. Although
the Company expects “generally stable macroeconomic conditions,” and is finalizing a recent costcutting effort, we believe the market is mispricing the stability and growth potential of the Company.
Chevron (-7.8%) was the next-biggest detractor in the energy sector during the quarter. Oil and
natural gas prices both declined nearly ten percent between June and October amid lower
expectations for global growth and increased production of North American onshore assets. As one
of the five oil and gas supermajors, Chevron is not immune from volatility in the broader price of
energy commodities, which impacts its potential revenue stream. However, the Company has one of
the highest levels of earnings per barrel among its peers and a strong diversified collection of assets.
Portfolio Activity
Other than standard additions and trims, during the third quarter, we did not enter or exit any names
in the Concentrated 30 portfolio.
Concluding Portfolio Commentary
To drive sustainable performance, we remain focused on our philosophy and process. Within the
800 stock universe from which we select candidates for investment, approximately 380 stocks still
remain undervalued in our estimation, with the median stock price trading near our estimate of its
fair value. As disciplined investors, we continue to stick to our investment philosophy, which is
simple, sensible and has proven its worth over the long term. We believe that volatile periods, when
stock prices diverge from the companies’ fundamental values, create compelling opportunities for
long-term performance.