Thornburg U.S. Equity Strategy

2nd Quarter 2019

Connor Browne, CFA
Connor Browne, CFA
Portfolio Manager and Managing Director
Robert MacDonald, CFA
Robert MacDonald, CFA
Portfolio Manager and Managing Director
Portfolio managers are supported by the entire Thornburg investment team.
JULY 23, 2019

The S&P 500 Index returned 4.3% during the second quarter, with low volatility stocks leading the way, growth stocks just behind and value stocks lagging. The Thornburg U.S. Equity Strategy had a disappointing quarter, up just 1.86% (net of fees). For the first half of 2019 that puts the strategy up 16.56%, a good absolute return, though trailing the index return of 18.54%.

What We See
The two most interesting things we see today are the wild outperformance of low volatility stocks, especially over the last year, and the associated underperformance of value stocks.

Chart 1 is a look at the valuations of companies that are expensive versus cheap, on a trailing P/E basis.

Chart 2 shows the forward P/E spread of the S&P 500 Value Index stocks versus the overall market.

Chart 3 shows the valuation of low volatility stocks versus the overall market. Notice how tight valuations were back in 2013 and into 2014.

To frame the current environment, we must discuss interest rates. As of this writing, the U.S. 10-year Treasury sits just above 2%, down from 3.25% last fall. Globally, record amounts are invested in negative yielding bonds today (approximately USD 13 trillion). By one measure, global interest rates are at 5,000 year lows.1

Many investors use discounted cash flow (DCF) or dividend discount models (DDM) to value their equity investments. Both are highly dependent on two variables, the projected constant growth rate in perpetuity and constant cost of equity capital. As the risk-free rate declines, so does the cost of equity capital. Funny things begin to happen as investors apply forever low risk-free rates into their valuation models. The implied P/E valuation for businesses that are projected to grow, forever, can go almost parabolic. This may explain some of the valuation discrepancy that we’re seeing in growth and low volatility companies relative to the rest of the market.

Interestingly, as the discount rate declines, the portion of valuation driven by cash flows further out in the future increases. From Bernstein, “If the overall discount rate (WACC) falls from 10% to 5% in a very simple DCF then the proportion of the net present value accounted for by cash flows more than 5 years in the future rises from 70% to 95%.” Bernstein takes pleasure in highlighting that, based on their data, “people are really bad at forecasting anything 5 years ahead.”

Investors, especially factor ETF investors, seem to be using a shortcut to figure out which companies will grow fast, forever. They have been plowing money into S&P 500 low volatility ETFs, which simply track the performance for the 100 least volatile stocks in the S&P 500 Index as measured by trailing 12-month standard deviation. It also happens that these ETFs have performed well, of late, and according to Empirical Research Partners, “Most of the flows that go into ETFs each month are directed into products that rank in the highest two quintiles of three-month past performance.” So perhaps that’s what’s going on? Empirical Research Partners further points out that since 2011, there has been a nearly 2% annualized difference between the dollar weighted return in low volatility ETFs and the buy and hold results in the very same ETFs. Investors seem to be very bad at timing their purchases and sales of low volatility ETFs.

Either way, we think the valuation dispersion is misguided, and has left many companies with great prospects looking very cheap. We’ve long said that defensives look expensive to us—and now, even more so. We work hard to invest in a balanced portfolio and have a large component of stable and consistent businesses, but we do tend to own less “expensive defensives” than the overall market. This has weighed on performance recently, but we believe it sets the portfolio up well looking ahead.

We also tend not to focus on DCF or DDM valuation approaches in our valuation work. We rely more heavily on tying our adjusted earnings forecasts to the free cash flow generation capability of a business and calculating price targets based on a multiple of adjusted earnings a year or two into the future. We award higher multiples to businesses that we think will grow earnings faster or where we believe the earnings stream is more predictable (i.e. less cyclical). The work that we do on “reason for being” and “competitive dynamics” support our forward earnings projections. On our work, our portfolio of investments looks as attractive as ever vs. the S&P 500 Index, while maintaining a healthy allocation to Consistent Earning businesses that should hold up better in a downturn.

The Quarter
Sector allocation, overall, didn’t impact relative performance materially during the quarter. Though our overweight allocation to financials helped, our underweight to information technology, our cash position and our overweight to energy investments were each a drag on relative performance.

All of our short-term relative underperformance during the quarter was driven by stock selection within sectors. While stock selection aided returns in the energy and consumer discretionary sectors, poor short-term stock performance in the information technology, communication services and health care sectors were a drag on relative returns. Our top and bottom performers list will highlight many of the individual drivers.

Contributors and DetractorsPast performance does not guarantee future results. To obtain the calculation methodology and a list showing the contribution of each holding in the representative account to the overall account’s performance during the reporting period, please email a request to The holdings identified do not represent all of the securities purchased, sold or recommended for advisory clients.

Second-Quarter Top Performers

  • JP Morgan and Citigroup
    JPMorgan and Citigroup showed strength in the second quarter, as financials bounced back from weakness during previous quarters.
  • Thermo Fisher Scientific
    Thermo Fisher Scientific’s fundamentals remain strong as demand from biopharma research continues. The company has been executing on its plan—organic revenue growth, margin improvement and smart capital allocation.
  • Crown Holdings
    Crown noted that the metal beverage can industry is seeing increased demand from new products as some companies rethink plastic bottles, allowing them to increase pricing/ margins in certain geographies. Crown has demonstrated consistent operating income and cash flow generation over the years in its beverage can business, and we believe the stock should re-rate closer to peers as results come through.
  • CarMax
    CarMax saw better than expected same-store sales while continuing to hold their profit per car sold at a steady, above industry average level. The rollout of their new omni-channel strategy, which allows potential buyers to purchase a car in-person or online, is progressing rapidly and should be accessible in most of their markets much sooner than anticipated. This is expected to contribute to both longterm growth and margin improvements.

Second-Quarter Bottom Performers

  • Cognizant Technologies
    Cognizant reset growth expectations for 2019 in the first quarter under a new CEO, sending near-term earnings expectations and the stock price lower.
  • Capri Holdings
    CPRI noted a continuation of weak sales trends at its core Michael Kors brand, and the stock sold off despite management reiterating their FY20-FY22 earnings targets as the targets now appear more difficult to achieve. The stock currently trades at just 7.0x FY20 consensus EPS.
  • Alphabet
    In addition to the ongoing drone of regulatory worries out of Washington, Alphabet disclosed a slower than usual revenue growth rate during their first quarter report. While the lack of segment revenue detail makes it harder to discern the cause of the slowdown, we expect continued strong growth from the company’s mix of dominant businesses.
  • Pure Storage
    Pure Storage narrowly missed revenue expectations against the backdrop of a slowing industry in their first quarter report, sending shares lower. We would note, however, that revenues still grew 28% year-over-year making them a significant share gainer and the stock now trades at just 1.8x EV/Sales making the setup look increasingly attractive moving forward.
  • Alkermes
    Alkermes has been a very weak stock for us of late. The potential for government action on drug prices has depressed stock prices across the space. More than that, Alkermes management is struggling from a lack of investor confidence. While we had very little expectation that their large opportunity depression drug would make it to approval, the FDA rejection of their application in February still weighs on sentiment. During the first quarter, Alkermes reported what appears to be a very short-term inventory related hiccup in Aristada sales. Given sentiment, many investors are not giving the company the benefit of the doubt on this most recent setback.

Thank you, as always, for your trust and confidence.

NOTABLE PURCHASES (Mar. 2019–May 2019)

Crown Holdings, Inc.
Capri Holdings, Ltd.


Owens-Illinois, Inc.
1. Speech by Mr. Andrew G Haldane, Executive Director and Chief Economist of the Bank of England, at the University of East Anglia, Norwich, 17 February 2016
Important Information

Performance data for the U.S. Equity Strategy is from the U.S. Equity Composite, inception date of November 1, 1995. The U.S. Equity Composite includes discretionary institutional and high net worth accounts invested in the U.S. Equity strategy that are not part of a broker-sponsored or wrap program. Effective January 1, 2014, the composite includes separately managed institutional and high net worth accounts. Prior to January 1, 2014, the composite also included broker-sponsored accounts that paid transaction costs. The composite was redefined to include all broker-sponsored accounts in the same composite. Returns are calculated using a time-weighted and asset-weighted calculation including reinvestment of dividends and income. Periods less than one year are not annualized. Individual account performance will vary. The performance data quoted represents past performance; it does not guarantee future results. Net of fee returns are net of transaction costs and investment advisory fees. For periods prior to 2011, net returns for some accounts in the composite also reflect the deduction of administrative expenses. Thornburg Investment Management Inc.’s fee schedule is detailed in Part 2A of its ADV brochure. Performance results of the firm's clients will be reduced by the firm's management fees. For example, an account with a compounded annual total return of 10% would have increased by 159% over ten years. Assuming an annual management fee of 0.75%, this increase would be 142%.

Unless otherwise noted, the source of all data, charts, tables and graphs is Thornburg Investment Management, Inc., as of 6/30/19.

The views expressed are subject to change and do not necessarily reflect the views of Thornburg Investment Management, Inc. This information should not be relied upon as a recommendation or investment advice and is not intended to predict the performance of any investment or market.

Holdings may change daily and may vary among accounts.

The information provided herein should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account's portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account's entire portfolio and in the aggregate may represent only a small percentage of an account's portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

Notable purchases and sales includes material transactions other than recently purchased securities, which may be excluded for best execution purposes.

Portfolio holdings and characteristics shown herein are from a representative account managed within the investment composite. The representative account is selected based on account characteristics that Thornburg believes accurately represent the investment strategy as a whole. Should these characteristics change materially, Thornburg may select a different representative account. Holdings may change daily and may vary among accounts, which may contribute to different investment results. The representative account information is supplemental to the strategy’s composite and GIPS compliant presentation.

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Portfolio construction will have significant differences from that of a benchmark index in terms of security holdings, industry weightings, asset allocations and number of positions held, all of which may contribute to performance, characteristics and volatility differences. Investors may not make direct investments into any index.

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