We made reasonably good money in 2014 even though the market was not nearly as cooperative as it was in 2013. While the S&P 500 provided a total return of 13.57%, the broader market as measured by the Russell 2000 Index lagged significantly with a gain of only 4.86% for the year. Similarly, the Dow Jones Industrial Average and the S&P Midcap 400 were more in our range, gaining 10.04% and 9.77% respectively. This narrow breadth did much to make it the toughest year for active money managers in well over a decade. Our results were about average among active managers, good but hardly spectacular. For the year we were up 9.21%.
At this time last year, we wrote: Now that market valuations…regressed back toward mean levels, further gains depend upon growth in GDP and in corporate earnings…” In 2013, the economy grew by 1.9% and the S&P 500 Index returned 32.2%. GDP growth accelerated to a pace of over 4% in 2014 and corporate profits grew by 8.9%. But the market is a discounting mechanism; people try to peer as far as reasonably possible into the future before they commit their capital. So returns were still good, but not as good as the previous year. Now the question is: can the economy continue to grow and justify or support continued upward movement in stocks?
Many smart analysts see corporate earnings growth of nearly 10% in the year ahead, and stock appreciation of about the same amount. This is a very reasonable proposition. The only problem is that the market has a history of confounding the conventional wisdom. The crash in oil prices, while putting more money in the pockets of consumers, could also destabilize certain high yield bonds and oil-dependent emerging economies. Recent instability in the Russian ruble could pre-sage more volatility ahead. But it is reasonable to expect another year in which stocks outpace most or all other asset classes.
Oil certainly confounded the conventional wisdom this year. Although we never over-weighted energy stocks, we still got beat up. Chevron dove from $130 in the summer to as low as $101 by mid-December. Similarly, Exxon dropped from the low $100s to as low as $86 despite a much-heralded investment by Warren Buffett. Oil had already dropped a lot when OPEC met in early December and decided not to try to support the price. The decline accelerated. It did so right after we bought into Continental Resources, which promptly tanked. It seemed like a good idea at the time – a history of very strong earnings growth, a top rating from Value Line, and cheap relative to projected earnings. But Continental is also a high cost producer, operating in places such as North Dakota. Such producers got hit the hardest, and this investment was, well, brief.
The weakness in oil had a number of ripple effects in industries ranging from railroads to steel. Railcar manufacturer Greenbrier, which had given us great gains this year, plunged 10% on the first day of the quarter, getting us off to a lovely start. The initial drop was due to talk of tougher government safety standards which would increase manufacturing costs, and then the plunge in oil accelerated the drop in Greenbrier. I didn’t foresee this, but it is why I cut losses (or in this case lock in gains) when prices drop beyond a certain point. The steel industry also suffered since much steel production today is for drilling.
We try to limit losses in stocks that have changed course, or when markets are weak in general, such as during the 10% drop from mid-September to mid-October. I’m willing to give up some upside in order to protect what we have. But when the market turned back up very suddenly in mid-October, we were a little too defensive. That cost us a bit of upside.
Despite some roller-coaster conditions, we did some things quite well. Our exposure to the biotech sector has continued to serve us well. Celgene gained 18% in the fourth quarter, and 32% for the full year; we now have an unrealized gain of over XX% in it. Regeneron also had a strong quarter, gaining 14% and posting a 49% return for the full year. Our smaller biotech holdings have done pretty well on balance. But biotech can be volatile; the IBB biotech ETF has experienced multiple drops of over 15% within a month. And although Gilead gained 25% for the year, it has had two single-day drops of over 14% in the past three years – one very recent. Things like this make us reluctant to put too many eggs in one basket.
There were bright spots in other sectors as well. Apple and Microsoft continued to shine, returning 40% and 27% respectively for the year. Since their market caps are so large, they are part of the reason the S&P 500 Index appreciated so much more than the broader market this year. But here again, since part of our job is to make sure that you are appropriately diversified, we can’t just own a few stocks like Apple and Microsoft. Both have had big downturns at times in recent years. Remember Lucent? Sometimes companies don’t keep up in the fast-changing world of technology, so I can’t take selloffs lightly. IBM is a tricky case today. The stock has plunged from the low 200s earlier this year to only $160.44 at year-end. Their revenue has actually been shrinking in recent years as innovations elsewhere are passing them by. [Our sale/s of IBM at $XX earlier this year look pretty good in the rear view mirror.
Meanwhile, the conventional wisdom has been that strong GDP growth and declining oil prices must be great for consumer stocks. Well, they have been a mixed bag – and according to Morningstar, returned only 2.5% on average. Home Depot returned 30%. But McDonalds was unchanged while more innovative brands such as Sonic gained 35%. Some of the strongest performers were consumer staple stocks, such as Church & Dwight (baking soda), which returned 20% for the year. Johnson & Johnson was another strong performer this year with a 17% total return.
Utilities were strong in 2014 as interest rates continued to plunge. The ten year Treasury ended 2013 at 2.99% and fell to 2.18% this year. Almost no one predicted that. In retrospect, we should have owned more utilities. But this deflationary trend hurt gold and commodity stocks. Gold lost 2.2% in 2014. We held a fair amount of it during its move to $1800, and we cut that exposure sharply many months ago. It is hard to tell when psychology might turn inflationary again, but we do our best to monitor those conditions.
One small bit of diversification that did not help us this year was our exposure to foreign markets. This often makes good sense. But right now, our economy is strengthening while Europe has fallen back into recession and Chinese growth is slowing. We have de-leveraged our financial system more quickly and effectively than these other nations. Emerging markets are now relatively cheap and should be a good buy at some point unless oil-induced currency instability becomes too great a risk. Weakness elsewhere does matter; S&P 500 companies get 13% of their revenue from Europe.
We were mindful of tax efficiency toward year-end, and realized some losses particularly in the energy sector. But we also put on some promising new positions in stocks such as Church & Dwight, Korn Ferry, and Ingram Micro. Church & Dwight has grown its earnings steadily at 8 to 12 percent a year regardless of economic conditions. Korn Ferry, involved in recruitment and talent management, has grown earnings at nearly 20% compounded annually over the past three years but has a PE ratio of only about 12. Ingram Micro, a technology distributor and service provider, has a single digit PE ratio and earnings growth of about 15% annually. We also added a little in the consumer sector with Royal Caribbean Cruise Lines and Amazon – which is trading cheaper to cash flow than it has in many years.
In sum, the year was profitable but challenging. But American companies continue to march ahead to new levels of profitability. The conventional wisdom now is that the S&P 500 companies will earn about $127.80 in 2015. At current interest rates, a PE multiple of 17 is certainly justifiable. That would translate to an index level of 2172 in a year from now, which would be appreciation of 5.5%. That plus dividends of about 2% would add up to a decent year. A lot can happen between now and then, but that is a reasonable initial look ahead. I’d be happy with another year of returns in the mid to high single digits, and thrilled if we do better. I do hope to report better relative performance next year; this year was truly an oddity for active money management. We’ll certainly keep our nose to the grindstone. One of the great things about this business is one never stops learning. We’ll do our best to put that to good use for you in 2015. We appreciate your confidence and business, and extend all good wishes for the New Year.
* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.