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Fund Update: FVCM U.S. Equity Fund

Das folgende Fund Update bietet einen Rückblick auf die Performance des Fonds über die letzten drei Kalenderjahre sowie über die aktuelle Entwicklung. Der Fondsmanager H. Terry Riley III zeigt die wichtigsten Punkte des Investmentprozesses auf und gibt einen Ausblick. Funds | 05.07.2011 04:30 Uhr

Performance Review 2008

H. Terry Riley III: "In 2008 the fund outperformed benchmark return. Recognizing the deteriorating conditions in the real estate market and the risk of losses on the balance sheets of financial firms, the portfolio manager had started to sharply reduce exposure to the financial sector in 2007. The low relative exposure to the financial sector, an over-weighted position in more defensive sectors such as healthcare, and a higher than normal cash position were the primary drivers of the outperformance."

Performance Review 2009

H. Terry Riley III: "In 2009 the fund returned 26.5%, versus a 22.5% return for the S&P 500. The fund remained underweighted in financials in 2009, which continued to underperform the broad market that year. Also, the portfolio manager began to increase exposure to cyclical businesses such as technology and basic materials on the premise that the worst of the recession was completed. Nonetheless, the manager continued to hedge exposure to cyclical names with an over-weighted position in defensive stocks in the healthcare and telecommunications sectors. Such positions helped control risk and volatility, but were also a drag on performance."

Performance Review 2010

H. Terry Riley III: "In 2010 the fund returned 19.2%, versus 23.1% for the S&P 500, with underperformance in the first half of the year and outperformance in the second half. A large exposure to industrial, energy and material stocks aided fund returns. However, early on, a continued overweighting in the defensive healthcare sector, which returned only 2.9% and underperformed the market by 12.0%, was a major drag. The improved second half performance reflected a reduction in exposure to healthcare and other defensive stocks. Furthermore, in view of the leveraged balance sheets of the U.S. consumer, the portfolio manager had small positions in the consumer discretion sector, which includes the auto industry and retail stores. These stocks turned out to be the best performing group in 2010 with a return of 27.4%, an outperformance of 12.6%. The returns for the consumer discretionary stocks reflected a rebound from very depressed levels, despite continued headwinds from a weakened U.S. consumer."

Performance 2011 - Year-to-Date

H. Terry Riley III: "2011 has been another extraordinarily turbulent year with widening variances in returns for individual stocks. Performance year-to-date has been driven by increasing worries about the global economy. The Japanese crisis, the sovereign debt problem in Europe, China’s attempt to dampen inflation, and the end of QE2 in the U.S. are among the factors why many investors have reduced risk exposure and have led to a minor mid-term correction in stock prices. The fund is positioned to take advantage of ongoing growth in the global economy with large positions in industrials, technology and materials stocks. Consequently, the fund has lagged the market during the correction. However, the portfolio manager believes many of these issues will be short-term in nature and that the global economy will remain in an expansion phase for a considerable period. Accordingly, the portfolio manager has positioned the portfolio to take advantage of U.S. corporations that have competitive advantage and will benefit from ongoing global growth."

Performance since 2008

Investment Process and Strategy – How does the Fund Manager invest?

FVCM employs a value-oriented investment style known as Growth at a Reasonable Price (GARP). The portfolio consists between 30 and 35 of medium and large capitalization stocks. The three prime factors relating to this style are as follows:

GROWTH: FVCM constantly searches for stocks for investment which are expected to produce upward earnings momentum and earnings estimate revisions, but we do not limit our target universe to the fastest growing companies in an industry or sector. The key to our strategy is the requirement of expected earnings growth, but only in relationship with the second key variable, value.

VALUE: Overpaying, even for a great company, is not a strategy for investment success. Consequently, we are rigorous in applying a broad range of valuation measures appropriate to each stock under consideration for investment. At its core, we are seeking to buy a future stream of cash flows at the lowest possible price.  Success is determined by a search for value.

DIVERSIFICATION: We seek to minimize the volatility of returns through proper investment in a wide range of companies, industries and economic sectors with little cross-correlation in terms of both the operations of the businesses and the stock behavior. While the concentrated portfolio of 30-to-35 companies is diverse, the common theme holding them together is the combination of growth and value.

General Points:

• Primarily a bottom-up process based on fundamental analysis of public documents in combination with top-down adjustments for risk control.
• Value-based strategy with growth overlay (GARP).  Stocks never purchased based solely on valuation.
• Below market risk (as defined by both beta and standard deviation of returns).
• Portfolio consists primarily of businesses that are headquartered and operate in the U.S.
• Concentrated portfolio of 30-to-35 stocks.
• Capitalization $1 billion up to mega-cap.
• Stock positions range from 1%-to-6% weight depending on manager’s subjective determination of risk (function largely of business risk, capitalization, trade volume, etc).
• Sector weights can vary significantly vis-à-vis the S&P 500 (generally between 0.5-to-1.5 times S&P weights).
• Portfolio target toward full investment, i.e., cash generally kept to less than 5% of total value.
• Stocks not sold based solely on (over)valuation.  As stocks become overvalued according to manager’s criteria, position reduced on scaled basis for risk control purposes and sold entirely if trigger event appears likely.

Investment Outlook

The U.S. economy and corporate profitability continues to emerge from the deepest recession of the past 50 years. Many headwinds remain, but the economy appears to have achieved the point of a “self-sustaining” expansion. The U.S. consumer continues to deleverage and the housing market will likely remain flat for years to come. However, the labor market shows signs of gradual improvement and spending growth is expected as a result of new jobs and income, not borrowing. Also, U.S. businesses are generating high and rising cash flows and corporate balance sheets are strong. With confidence gradually beginning to pick up, we are seeing rising demand for capital goods. Furthermore, exports are reaching record levels, thanks in part to the weak dollar, and manufacturing production is rising. The world remains unpredictable and events in Africa and Asia have proven that volatility is the rule, not the exception. But, investors capable of withstanding volatility and risk are likely to be well rewarded in the years ahead.

The outlook for private fixed investment remains good from a cyclical perspective. As recently as the 2010 first quarter, private investment was only 11.7% of GDP, the lowest level in 50 years. Businesses have lots of cash but have been unwilling to expand spending until recently. Total private fixed investment was up 7.2% in the first quarter and further gains likely lie ahead as the economy moves forward off the depths of the recession. Clearly, business investment and the willingness to hire new workers have been negatively affected by the huge volume of new rules and regulations being implemented during the past two years. This is one reason we no longer expect a sharp rise in hiring and investment. But a cyclical rebound in investment is underway for sure.

The U.S. is becoming less dependent on domestic demand. Exports increased 15.9% to a record $175.6 billion in April and the trade deficit shrank to $43.7 billion, down from $46.8 billion in March. The increase in exports during April reflected increases in industrial supplies and materials ($2.0 billion); capital goods ($1.2 billion); and consumer goods ($0.3 billion).   Over the last twelve months U.S. exports of goods and services totaled $1.935 trillion, up an annualized rate of 16.8% over the previous twelve months and 22.9% above the level for 2009.  The weak dollar vis-à-vis the Euro certainly helps, but it’s also worth noting that the situation with China has been reversing: Since the start of 2008, US exports to China have risen by about 40%, while US imports have risen by only about 10%, reflecting partly rising wage and other costs in China as well as a U.S. market that is saturated with Chinese goods. Because of the dollar’s status as the world reserve currency, there will be an ongoing bias for the U.S. to run a trade deficit of perhaps 1%-to-2% of GDP as foreigners seek to import dollars for trade and reserve purposes. However, there appears to be a secular reversal in the trade situation and we expect trade to contribute to U.S. GDP growth and help offset what we expect to be ongoing weakness in domestic demand.

Second quarter real GDP growth is now expected only to be about 2% annualized, but the data should improve as the headwinds ease-up. Energy prices have come down significantly from the April highs and the supply chain problems emanating out of Japan are being resolved.  The consensus is that growth in the second half of the year will be about 3%.  This rate of growth is substantially below the historical averages after a recession.  For sure, a big part of the lackluster performance is due to the ongoing deleveraging of the U.S. consumer, but it also reflects regulatory and budget policies of the Federal government that has put fear into the hearts of business people who make decisions to hire workers and expand operations. Budget negotiations are underway that should lead to an agreement to cut spending and raise the debt ceiling by August.  Such an agreement should help market sentiment.  Also, there are ongoing concerns about the end of QE2, which is effectively a program where the Fed acted as a lender and provider of liquidity at a time the commercial banks were reducing loans outstanding.  From our perspective, the thing to keep in mind is that the Fed is not planning to do anything drastic such as suddenly shrink its balance sheet or raise interest rates. Furthermore, if bank lending shrinks in the future or there are signs that the demand for liquidity is not being met, the Fed will undoubtedly step in again. A QE3 is unlikely, but not impossible.

U.S. corporate sales and earnings have been expanding at a very healthy pace and further gains look to be ahead. Thanks in large measure to strong foreign demand, sales for the S&P 500 rose 7% in 2010 over the previous year and were up 10%, year-over-year in the first quarter of 2011. Furthermore, profit margins have remained high and earnings are expected to increase at least 10% this year, and another 8% next year. In fact, these figures are probably low as margins will likely widen more as existing capacity operates at higher levels. Furthermore, globalization has provided U.S. consumers a chance to buy a wide variety of products manufactured at low prices, but it has also put downward pressure on labor rates, particularly at the low end of the skill level, because of competition from foreign labor. This trend is not likely to end soon. A slow rate of wage growth should help keep corporate profit margins high and rising as the economy continues to expand.

Near term,  some technical indicators (14 day RSI of 33) indicate that the S&P 500 is nearing the point of being oversold, and chances are improving that investors will soon begin to refocus on the global growth story.  If that scenario plays out as we expect, the growth sectors that have been beaten up the most should rebound strongly.  In particular, we would expect energy, industrial, technology and material stocks to regain their leadership.  For sure this has been a painful period, but ongoing strength in the defensive sectors seems unlikely to us.  Growth of the global economy, the weak dollar and a resurgence of U.S. exports should continue to support the more cyclical names.  Accordingly, we believe it is prudent to stay with our growth-oriented strategy despite recent market moves.

We think the S&P 500 has the potential to reach 1600, a gain of about 25%, before a major correction occurs. Stock valuations, like bond yields, are directly affected by inflation.  Given our expectation that inflation pressure will ease and remain low, bond yields should be low and P/E ratios high.  At 1600, the S&P 500 would be trading at 17.7 times our forward estimate of conservative GAAP earnings, and 15.5 times the consensus estimate of operating earnings. These figures are reasonable based on the historical relationships with inflation.

Even though we think 1600 is a reasonable target for the S&P 500, the human condition would lead us to expect a sizable correction at that point. Because the 1500 to 1600 level represents the major tops reached in 2000 and again in 2007, we wouldn’t be surprised to see a correction at that level as people nervously take profits from this Bull Market. Based on our experience, it seems natural that people would look at the long term charts, see the market at the old highs and decide to take money off the table. However, our expectation is that such a correction would be a buying opportunity as we think the market will ultimately break through to new highs beyond those that were first achieved more than a decade ago.

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