During the latter part of the first quarter, the annual rebalancing process was completed. The first quarter is the usual time for this procedure. By doing it annually and in the same time frame, the advantages of equal weighting while maintaining some of the benefits of tax efficiencies and controlling trading costs are more likely to be realized. The equal weighting allows all stocks to contribute to performance, prevents over concentration, and incorporates the 'sell high buy low' discipline.
During the annual review process Amedysis and NextEra Energy did not maintain scores high enough to qualify for American Hero status. Both were removed from the American Hero Index and the remaining 115 stocks were rebalanced to equal weight. NextEra Energy was also removed from the American Hero Equity concentrated model. In addition to bringing all stocks back to equal weights this is the time that the concentrated model is most likely to have changes made in sector concentrations or individual stocks.
This year no significant changes were made to sector allocations and the model remains slightly more defensive than the market as defined by the S&P 500. The largest variances are being underweight in the financials, and to a lesser degree in consumer discretionary. Financials are still fairly volatile and there has not been a particular stock in the American Hero Universe to exhibit the type of leadership in investment merit to be included at this point. On the other hand we are slightly overweight in technology and energy which is offset by being underweight in telecommunications. The model is also slightly overweight in consumer staples.
Perhaps the most important part of the annual process is the in-depth look at individual stocks in the concentrated model.The time frame works well since most companies have filed their year-end financial reports making the fundamental metrics used the most accurate. This year three changes were made, CenterPoint Energy, a Houston based electric utility and natural gas distributor, replaced NextEra Energy which is no longer an American Hero Company. American Financial Group, a property and casualty insurance company replaced AFLAC. Not only has American Financial Group's investment merit score consistently met or exceeded AFLAC's, over the last year its business model appears more consistent with the American Hero philosophy than the insurance supplement model of AFLAC. AFLAC is a good company scoring very well as an American Hero Company and remains in the American Hero Index.
The final change to the concentrated model was adding Lowe's in the place of Johnson Controls. Lowe's has been a good performer with steady improvement during the slowly recovering housing market, while Johnson Controls performance has not kept pace with improving auto market. Johnson Controls lost a bid to acquire a major player in its industry and is in the process of selling one of its more profitable businesses raising a yellow flag.In hindsight it would have been better to have included Lowe's last year, but in a close call Johnson Controls was selected as a diversification from the existing retail allocation in Tractor Supply.Johnson Controls remains in the American Hero Index. Changes to individual stock positions are not limited to this time frame. At the end of the third quarter of 2012 Tessco Technologies replaced Blackbaud. There is the possibility of at least one more change in 2013, because one decision was postponed due to the current holding being significantly undervalued while both candidates for replacement are significantly overvalued. The model will continue to hold 24 stocks.
As the second quarter of 2013 begins it appears stocks are fairly priced from a fundamental standpoint. From that perspective for stock prices to continue to move to higher sustainable prices company earnings will need to continue to improve. An improving economy creates a good environment for growing earnings. The macro-economic measurements from the first quarter indicate slow growth overall. If growth remains slow companies with solid fundamentals are likely to be in a position to earn a premium on their stock prices.
From the micro-economic perspective, companies will be reporting their respective earnings over the next several weeks. Many of the companies represented in the American Hero Equity model were cautious with their outlooks for the first half of 2013 and more optimistic about the second half of the year. It will be interesting to see if that point of view is maintained.
Stock prices have basically moved sideways for the last 12-14 years while historical indicators suggest that a new long term bear trend is on the horizon. Has that trend begun?Other historical indicators would suggest the typical spring/summer correction. Technical indicators seem to be all over the board. In the short term emotional factors like the 'Cyprus crisis' continue to raise volatility. Some allocation to equities continues to be prudent especially now since bonds appear to be selling at premiums and current interest rates provide little or no return for cash.
George Parks, CFP
Chief Investment Officer