A View From The Hill, Spring 2015

A VIEW FROM THE HILL
™
A quarterly publication from Cedar Hill Associates, LLC
SPRING 2015 // VOLUME 4 // ISSUE 2
The ABCs of Alternatives
Chris Engelman, Managing Director
Cedar Hill works closely with
each of our clients to develop
portfolios customized to their
needs and risk preferences.
For qualified investorsi, those
portfolios may include alternative
investments, such as hedge
funds, private equity and real
CHRIS ENGELMAN
estate. Below, Managing
Director Chris Engelman explains how Cedar Hill
uses alternatives to meet our investors’ goals.
Why do you implement alternatives
in a portfolio?
Cedar Hill can include alternative investments in client
portfolios for a number of reasons. Depending on the
investment, the goal might be to reduce portfolio volatility,
enhance returns or introduce an investment that will react
differently to economic news than traditional equities and
fixed income securities. For one investor, we may implement
a hedge fund allocation to reduce portfolio volatility and risk
of loss while also gaining exposure to return sources beyond
stocks and bonds. For another investor, we may focus on
maximizing results by investing in private companies that
are positioned for exponential earnings growth. While private
equity investments offer significant capital appreciation
potential by identifying a sustainable consumer products
trend or a technological innovation, or by restructuring a
company and improving profitability, losses could be severe
if business plans are not executed properly.
What is the best way to get started?
Once we collaboratively identify a client’s investment
objectives, we determine which type of alternative
investment meets these needs and then proactively seek
these opportunities. For investors new to alternative
investments, we often start with a hedge fund of funds,
which has more than a dozen underlying hedge fund
managers and is well-diversified by strategy. This type of
investment offers several advantages, including annual
liquidity for those worried about locking up capital, as well as
downside protection from a mix of long and short securities.
In terms of risk, the next step up would be income-producing
real estate funds and private debt investments that pay
a consistent quarterly coupon, which some clients use to
supplement their traditional fixed income investments. The
underlying investments may be quite similar to what a public
REIT or fixed income mutual fund may own, but since the
investment is illiquid, investors should receive additional
return for taking additional risk. Private equity, especially
early-stage companies, is often the farthest out on the
risk spectrum.
An affiliate of MB Financial Bank
1
If hedge funds, private equity and real estate
are so different, why are they lumped together
as alternatives?
Illiquidity is the common link among these three investment
strategies, although the degree of illiquidity varies. Hedge
funds offer partial liquidity, since investors are typically able
to redeem at least annually. On the other hand, an investor
in a private equity fund may not receive his last dollar back
for 12 years after originally investing, though he would likely
receive distributions along the way as underlying companies
are sold. Most real estate investments offer better liquidity
terms than private equity, though funds may still be locked
up for three to seven years, depending upon the strategy.
What should investors expect for tying
up their capital?
For private equity and real estate, we believe investors
should target a 3% to 5% annual return premium above
public equities. Because liquidity is more available for hedge
funds, the return premium is lower, especially taking into
consideration that hedge funds may have one-third to
one-half of the volatility of publicly traded equities.
Aside from liquidity, what other factors
should investors consider before
implementing alternatives?
While there are too many risk factors to list hereii, important
considerations include more complex tax reporting; the large
dispersion between high- and low-returning funds with similar
investment strategies; more complex strategies, which may
require a higher level of investment knowledge to conduct
proper due diligence; and the severity of losses, which may be
quite high depending upon the type of strategy.
How do you mitigate risk?
There are three main ways we mitigate risk in our alternative
investments. First, we invest with well-seasoned managers
who have implemented their strategies through multiple
market cycles successfully and aligned their interests with
their investors, including investing a significant portion of their
net worth in their fund. Second, we understand the types
of risks that each manager takes and each investment’s
potential downside. This allows us to weight each investment
appropriately so that if we are wrong in our analysis, the
investment does not affect the portfolio’s overall performance
disproportionately. Finally, we and the underlying managers
diversify our exposures. Managers have risk limits, including
typically limiting the amount each investment represents to
no more than 10% to 20% of the total fund, and we often limit
each fund investment to no more than 2.5% of the portfolio.
While past performance does not guarantee future returns,
tempering risk has helped our clients proceed toward their
financial goals through the use of alternative investments.
i The alternative investment’s manager determines the level of
qualification required to invest. Clients investing in alternatives usually
must be a Qualified Client (i.e., a person with spouse having $1 million
under management with the investment advisor or a net worth of
$2 million excluding the value of their home) or must be a
Qualified Purchaser owning investments of at least $5 million.
ii Each alternative investment provides detailed offering documents
to prospective investors which elaborate on investment strategy,
administration, key person qualifications, investment risks,
tax information and other disclosures.
Market Outlook
Declining oil prices and appreciating U.S. dollar
slow down U.S. earnings growth
Equity markets started the year off in relatively encouraging
fashion, as each of the major global equity indices reported
positive returns during the first quarter. Domestic equities
posted their ninth consecutive quarter of gains, with the S&P
500 Index squeaking out a modest 1% return for the quarter.
Although international markets have lagged U.S. equity returns
in aggregate since the recovery from the Great Recession
began, signs that the United States may be passing the
reflation baton to non-U.S. markets began to emerge during
the quarter. This was particularly evident in the international
developed market index (MSCI EAFE), which reported a 4.9%
first-quarter return. Recovery in the emerging market index
(MSCI EM) was less pronounced, with the index gaining just
2.2%, but this figure still exceeded U.S. equity returns and
marked a positive step toward stemming two consecutive years
of losses in emerging markets.
Cedar Hill Associates, LLC
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Equity Market Total Returns
9%
EAFE
7%
Total Return
5%
EM
3%
S&P 500
1%
-1%
-3%
The decline in oil prices and the strengthening of the U.S. dollar
have been the most influential developments for the global
markets over the last several quarters. From June 30, 2014,
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through March 31, 2015, the price of West Texas Intermediate
(WTI) oil dropped 55%, while the U.S. dollar appreciated 22%.
WTI Oil Price
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Diverging Trends in Oil Prices and Currencies
Cedar Hill Associates, LLC
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While the drop in oil prices and the rise of the U.S. dollar are
generally regarded as positive developments in the long term
for the consumer-oriented U.S. economy, the short-term effects
have been decidedly negative. Lower oil prices are pressuring
energy sector payrolls, capital spending plans and profits.
Meanwhile, the anticipated benefit of increased consumer
spending from lower energy costs has significantly lagged the
decline in oil prices. As a result, the S&P 500’s consensus
earnings growth estimate has plummeted from 8.3% at the
beginning of the year to just 2.5% currently, with most of that
revision attributed to the energy sector’s deteriorating profit
outlook. Although energy companies comprise a relatively
modest 8% of the S&P 500, a projected 55.5% decline in
energy sector earnings will drag down aggregate U.S. corporate
profit growth significantly in 2015.
2015 Earnings Growth Projections for the S&P 500 Index
(December 2014 versus March 2015)
30%
3/27/2015
12/31/2014
20%
10%
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While declining oil prices are mainly affecting earnings in the
energy sector, the earnings headwinds from a strengthening
dollar will be broader. Multinational companies across all
sectors are likely to report more challenges in international
revenue expansion in 2015, as a stronger dollar reduces
export demand and produces foreign currency translation
losses. With continued appreciation of the dollar against
other global currencies, analysts have been ratcheting back
profit expectations for companies with foreign currency
exposure. International sales comprise roughly one-third of
S&P 500 revenue, so the drag on total corporate profitability
when the dollar strengthens may be significant. In fact, for
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every 10 percentage points the U.S. dollar appreciates,
earnings-per-share growth for the index declines by 2% to
3%. If oil prices recover during the year as expected or the
dollar’s momentum slows, however, corporate earnings could
grow more than expected in 2015.
On the broader macro front, the U.S. economy remains the
most robust developed market economy. Even so, its growth
has become more moderate since the middle of 2014. In
fact, recent economic data have fallen short of expectations
by the most since 2009, as the Bloomberg U.S. Economic
Surprise Index shows.
Cedar Hill Associates, LLC
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Bloomberg U.S. Economic Surprise Index
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Many forecasters now believe GDP growth downshifted in the
first three months of 2015 to 2%, continuing the deceleration
reported during the fourth quarter of 2014 (2.2%) relative
to second and third quarter (4.8%). We expect this slowdown
to be temporary, however. U.S. economic growth is likely
to reaccelerate later in the year as weather conditions
normalize after the harsh winter, currency headwinds
stabilize, and shipping disruptions created by the West Coast
port shutdowns dissipate. Additionally, with U.S. payrolls
adding more than 200,000 jobs for 12 consecutive months,
the strong labor market should boost consumer spending
and drive GDP growth of 3% or more through the balance
of the year.
We believe equities can continue their positive momentum
in 2015, though caution is warranted. U.S. equity valuations
appear increasingly rich on an absolute basis, with the S&P
500 ending the quarter 17.5 times forward earnings versus
the historical average of 16.4 times. As we’ve noted in the
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past, however, P/E multiples have a poor record of predicting
shorter-term stock market performance. Moreover, a modest
valuation premium for equities seems justifiable against
the market backdrop of low interest rates, low inflation and
limited attractive investment alternatives. That said, earnings
growth will be the key to further stock market gains, as we
believe the P/E multiple expansion story has largely run
its course.
While declining oil prices, a strengthening dollar and varying
economic data could inject more short-term volatility into
the markets during 2015, we remain optimistic about the
sustainability of this bull market over the coming quarters.
Market returns are almost certain to decline from the
annualized gains of 20.7% achieved over the last six years.
Nonetheless, we believe continued economic and corporate
earnings expansion will sustain this rally and edge equity
prices higher.
Investment Overview
Core Portfolio
In the first quarter, we initiated new positions in Terex
Corporation (TEX) and Discovery Communications (DISCA).
Terex Corporation is a diversified global manufacturer of
heavy industrial machinery, such as cranes, aerial work
platforms and rock crushers. Unlike many of its industrial
peers, Terex has not yet fully recovered from the 2008
recession. The company is much more levered to nonresidential construction, so it hasn’t been able to capitalize
on the housing market recovery. Also, Terex has heavy
exposure to Europe, where economic conditions remain
challenging. While a number of its end markets remain soft
and choppy, we believe the company’s depressed valuation
and longer-term growth prospects create a compelling
investment opportunity.
Cedar Hill Associates, LLC
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Discovery Communications is a media and entertainment
company that owns domestic and international cable
channels. The company’s global portfolio of wholly owned
networks includes Discovery Channel, The Learning Channel
(TLC), Animal Planet and Science Channel, among others.
Discovery also has partial ownership in joint-venture
channels OWN: Oprah Winfrey Network, which it owns with
Harpo Productions, and Discovery Family Channel, which
it owns with Hasbro. Discovery owns virtually 100% of the
content shown on its networks, which insulates it from the
threat of cord-cutting that other media companies face. Also,
the company’s ability to create low-cost content with broad
appeal offers tremendous scale advantages over its peers
and will allow Discovery to expand its enviable presence in
faster-growing international markets.
We sold our holdings in Freeport-McMoRan (FCX), Charles
Schwab Corp. (SCHW), Microsoft (MSFT), C.H. Robinson
(CHRW) and Nvidia (NVDA) during the first quarter.
companies that we believe offer greater long-term
earnings visibility.
C.H. Robinson is a non-asset-based third-party logistics
provider that mostly focuses on domestic truck brokerage
(70% of net revenue). The company matches customers that
have shipping needs, such as retailers and manufacturers,
with customers who own shipping assets, such as truckers,
and then collects a brokerage fee. With 22% market share,
C.H. Robinson is the industry leader in this growing segment
of the transportation sector, and we like the company’s
prospects for continued earnings expansion. A downshift in
the company’s long-term growth forecast suggests that C.H.
Robinson’s historic premium valuation multiple could be at
risk going forward, however. In light of this risk, we decided to
exit our position in the stock and reallocate the proceeds in
prospects that offer a better risk/return profile.
Freeport-McMoRan is the world’s largest publicly traded
copper and molybdenum producer. With copper accounting
for roughly 80% of the company’s revenue, the decline
in copper prices has affected the company’s profitability
significantly. Longer-term, we believe that this company, or
one of its competitors, will benefit from a recovery in copper
prices. We do not see a catalyst for a near-term recovery in
copper prices, however, so we exited our position in the stock
to deploy those funds into better opportunities.
As we enter the second quarter, we
believe the portfolio is well-positioned
for the challenges facing the markets
in 2015 and 2016.
Schwab operates in the brokerage, banking and asset
management businesses. The company has done an
admirable job of growing its asset base and earnings in
recent years, particularly in light of the challenging interest
rate environment. While Schwab will continue to expand
its client reach and balance sheet in the coming years, we
believe the company’s earnings growth in the near term
could be somewhat constrained without a significant boost in
short-term interest rates. As a result, we sold our holding in
the firm to pursue investments with stronger future
growth prospects.
Nvidia is a leading provider of graphics chips that enhance
the interactive experience on computing platforms. Its
chips are used in a variety of products, including personal
computers, handsets, gaming consoles and automobile
infotainment devices. Although the company’s dominance
in gaming graphics appears sustainable, Nvidia’s future
growth will hinge on a successful foray into the automotive
space, where it will face much more aggressive competition.
Furthermore, the company could lose 30% of its earnings
base in 2017 after a cross-licensing deal with Intel is
scheduled to expire. Given that these potential challenges
were not priced into the shares, which have risen 40% in
the last six months, we sold our holding in the firm to fund
investments with a more secure growth trajectory.
Microsoft has done a commendable job of repositioning
itself amid new computing trends and evolving customer
preferences. Nonetheless, we have become increasingly
concerned about the company’s core Windows franchise.
While Microsoft’s transition to a mobile and cloud services
firm is necessary for the company to remain relevant,
we think the company could face more competition and
lower margins going forward than it experienced under its
traditional software licensing model. Thus, we decided to
sell our position in Microsoft and redeploy the capital into
As we enter the second quarter, we believe the portfolio is
well-positioned for the challenges facing the markets in 2015
and 2016. Although we reduced the number of holdings
in the portfolio during the first three months of the year,
we used some of the cash raised in those sales to add to
specific existing holdings that we believe have the best
risk/return profile and to fund the new investments
mentioned above.
Cedar Hill Associates, LLC
6
Fixed Income
Yields dip slightly during the quarter
The yield curve shifted modestly lower in the first quarter,
with yields on five- and 10-year Treasuries generally declining
by a quarter of a percent. The yield on the 10-year U.S.
Treasury declined 25 basis points from the beginning of the
year to end March at 1.92%.
The Federal Reserve continues to prepare the market for
eventual increases in short-term rates, although recent
economic data suggests the Fed may wait a bit longer to
begin this change than expected.
Spreads on corporate bonds continued to widen during
the quarter, as investors desired higher yields for taking
incremental credit risk. Municipal bonds generally did
not participate in the bond rally this quarter, and despite
continued low absolute yields, tax-free bonds offer a more
attractive investment opportunity than Treasuries.
Treasury Yield Curve
3.5
12/31/2013
3
Yield (%)
2.5
12/31/2014
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3/31/2015
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Alternatives
Trading-focused hedge funds benefit from market volatility
and strong U.S. dollar
Market volatility, especially in energy-related markets, and
an appreciating U.S. dollar allowed Hedge Funds focused
on trading strategies to post strong results in the first
quarter, while those with more of a longer-term thematic or
event focus lagged. Global Macro managers who invested
alongside a rising U.S. dollar and volatility-oriented managers
who position their portfolio to profit when markets move up or
down quickly outperformed most major equity markets. While
event-oriented managers profited from a number of merger
announcements, volatile equity markets caused declines
in other positions and offset some of these gains. The shift
to momentum-driven trading from longer-term fundamental
investing is part of a normal market cycle.
Low interest rates continue to fuel investor demand for
income, adding further upward pressure on the price of
yield-oriented Real Estate properties. While cap rates
are near historic lows, yield-oriented real estate appears
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attractive relative to the yields available on U.S. government
and corporate bonds. Assets with high-quality tenants and
long lease terms command the highest premium in the
marketplace. Also, aggressive lenders are offering attractive
financing, which has helped drive prices higher.
With the announcement of a merger between Kraft Foods
and private equity-backed H.J. Heinz Co., Private Equity
buyout deal value surged in the first quarter of 2015 to $97
billion. While this quarterly deal flow is the highest since the
third quarter of 2007, this statistic is somewhat misleading,
as the Kraft acquisition represents nearly 40% of this
volume. A figure that better reflects the current environment
is the total number of deals, which fell by 20% from the
previous quarter, according to private equity industry data
provider Preqin. Buyout deal activity is focused at the top of
the market, which has skewed the total dollar value upward,
with corporate buyers taking up a large chunk of deals as
they seek top-line revenue growth. While private equity funds
have committed capital to put to work, they are proceeding
patiently and seeking the right opportunity at the right price.
Cedar Hill Associates, LLC
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Emergency Contact
s a reminder, our website (www.cedhill.com) has an “Emergency” link under the Contact Us tab. In the event of an interruption
A
to normal business operations at our office, this link will redirect users to a Web page that will provide updates and alternative
phone numbers for communications with clients and interested parties. In such an event, updates will be provided continually
until operations are fully restored to normal.
Disclosure
This newsletter is intended to provide general information only and should not be construed as an offer of specifically tailored
individualized advice or results. Clients or prospective clients should not assume that their performance will equal or exceed
historical market results and/or averages.
Specific securities identified do not represent all of the securities purchased, sold, or recommended for advisory clients,
and the reader should not assume that investments in the securities identified and discussed were or will be profitable. Past
performance is not indicative of any specific investment or future results.
Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be
guaranteed to be accurate and may result in economic loss to the investor. All statements other than statements of historical
fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and
“expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give
no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ
materially from those discussed in such forward-looking statements.
Cedar Hill Associates, LLC
120 South LaSalle Street, Suite 1750, Chicago, Illinois 60603 // P 312/445-2900 // F 312/445-2901
Cedar Hill Associates, LLC