FOURTH QUARTER 2015 - files.ctctcdn.comfiles.ctctcdn.com/99a1bab4501/b184eecb-fa45-4d49-af8d-8272594a… · down about 25% in 2015. Stay tuned for more volatility in 2016 as bankruptcies

FOURTH QUARTER 2015

Authors

Mark Scarlett, CFAPrincipal, PortfolioManager

Matt Roehr, CFAPrincipal, PortfolioManager

Alex Dolle, CFAPortfolio Manager

Cheyne SorensenAssociate Portfolio Manager

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© 2016 Northwest Investment Counselors, LLC LIVE WELL. RETIRE BETTER.—2—

The Year, The Quarter, and What’s AheadThe most significant fixed income event of the year took place late in the fourth quarter. The event was significant because it was the first of its kind in over 10 years and followed an unprecedented stretch of monetary policy in this country. The event was the decision by the Federal Reserve to raise its key interest rate from a range of 0-0.25%, where it had been since the end of 2008. Interestingly, the event was rather insignificant as measured by the market’s reaction. The chart below shows the two weeks leading up to the rate hike and the two weeks following the hike. Although there was some minor stock volatility on the days immediately surrounding the hike, the overall movement of stocks from before the hike to the end of the year was slightly positive. Similarly, broader interest rates, as measured by the 10-yr US Treasury actually decreased very slightly after the hike, before rising ever so slightly by year’s end. These benign move-ments in two highly watched market barometers are reflective of the Fed’s successful broadcasting of its intentions and the small absolute change in the federal funds rate, despite being momentous in its actual occurrence.

The graph below shows the S&P 500 (white line with blue shading) and 10-yr UST (pink line) in the weeks leading up to and following the change in the federal funds rate (green line):

A quick look back at other events from 2015 that influenced the fixed income markets include, but were not limited to:

- Europe started a quantitative easing program in Q1, beginning what is now an even wider divergence in monetary policy between the US and Europe, and potentially signaling a wider divergence in economic strength.

- The German 10-yr bond bottomed at a yield of 0.075%

- The Greek debt “crisis,” while still a potentially troubling issue for the country of Greece, was no longer impacting markets after Greece accepted another bailout package and implemented austerity measures.

- Governor of Puerto Rico said it cannot pay its $72 billion in debt.

- China’s central bank cut rates for the sixth time in less than a year to spur economic growth.

These now distant memories pale in comparison to the attention paid the Federal Reserve in the latter half of the year. However, with respect to the shape and level of the yield curve today, monthly inflation and employment reports, taken as a whole, along with long-term growth expectations, have likely had a larger hand in shaping today’s interest rate picture.

A Quarterly Publication by Northwest Investment Counselors

FOURTH QUARTER 2015

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© 2016 Northwest Investment Counselors, LLC LIVE WELL. RETIRE BETTER.—3—A Quarterly Publication by Northwest Investment Counselors

Notable to our clients, due to our corporate bond strategy, was the theme of widening corporate yield spreads throughout 2015, led primarily by the energy sector, whose credit worthiness and fortunes are tied to oil prices. The pain was felt the most in junk bonds (including those energy companies who were formerly investment grade) but the contagion leaked into investment grade spreads, further outlining the need for careful financial consideration of corporate bonds.

Despite narrowing slightly in the last few months of 2015 corporate credit spreads widened throughout 2015 as depicted in the chart below:

Widening corporate spreads did not deter continuing merger and acquisition (M&A) announcements, which hit the highest levels since 2007 with over $5 trillion globally in announced deals. M&A of this magnitude can sometimes indicate a market top,

or at least represent a warning sign. Late into a bull market, especially one accompanied by historically low borrowing rates, companies flush with cash from prior deleveraging cycles, seek to create value by non-organic means. Some of these mergers may well go the way of past deals, needing to be unwound years down the road, as “synergies” fail to materialize. Other deals may prove to be advanta-geous for the shareholders, bondholders, or both, but only time will tell. Despite the future outcome, the possibility for bondholders of event born risk is elevated at this stage of the M&A cycle, as companies often need to issue new debt to finance late stage megadeals. Where possible we seek out bonds

with stronger covenant protection to help mitigate the impact of event risk.

Looking forward to the upcoming year requires us to look back in time.

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FOURTH QUARTER 2015

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In the chart below we see the relationship between the Fed’s rate policy and its impact on the yield curve as measured by the spread between the 10-yr and 2-yr Treasury. Going back to 1985, in periods during which the Fed has raised rates for

extended periods (seen by the increasing red line), it is accompanied by a noticeable decline in the blue line, which represents a shrinking spread between the yield on the 10-yr and 2-yr Treasury. In some instances the spread has actually turned negative, indicating a 2-yr bond pays higher inter-est than a 10-yr bond. A negative spread, or invert-ed yield curve, can be an ominous signal for the economy, and a good reason for caution and sound investment analysis.

For those concerned about declining bond values in an era of Fed rate hikes, the chart on the next page reminds us that rates on the long end of the curve can also decline, though it’s almost impossible to predict the direction of interest rates. The direction

of interest rates, while important, is not the final determinant in a successful bond portfolio. Main-taining a prudently researched and laddered portfolio allows investors the opportunity to benefit from changes in the level of interest rates, whether it is from increased bond prices or increased bond yields. Above all, patience is key. There are times to trade, but for the most part a long-term buy and hold strategy will ensure the bonds do what they are intended, which is first and foremost to provide portfolio stability.

Recent Bond Concerns: (cont.)


FOURTH QUARTER 2015

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In case you missed it from an earlier commentary, the chart below shows the power of being invested in bonds for medium to long-term holding periods.

This data, provided by the Ibbotson SBBI 2015 Classic Yearbook, demonstrates how holding assets for long periods of time has the effect of lowering the risk of experiencing a loss of capital:

Throughout these 5-year rolling periods there were times where interest rates undoubtedly rose for an extended length of time. In spite of rising rates, bonds have demonstrated a remarkable ability to preserve capital when held judiciously and through full market cycles.

It should be noted that here at Northwest Investment Counselors we invest primarily in corporate and US Government Agency debt securities. Agency bonds tend to move almost in lockstep with US Treasuries due to their implicit government guarantee, the major difference generally being the structure of

agency bonds, many of which are callable, com-pared with plain vanilla, non-callable Treasuries. The above trends, while similar for all high-quality, investment grade bonds, are likely somewhat different for corporate bonds, with the notable difference being the higher return volatility of corporate bonds. Since they are inherently riskier, the returns in good years will be higher, and the

negative return years will see more capital depreciation. Nonetheless, well-researched corporate bonds will offer many of the same portfolio stabilizing characteristics of US intermediate-term government bonds when held for long periods, while in most cases providing a higher level of income.

Please contact us directly to learn more about the contents of your bond portfolio specifically or to hear about our various fixed income solutions that provide income while also matching cash flow with liabilities.

Recent Bond Concerns: (cont.)


U.S. and most international stock indices ended 2015 about where they began. Emerging market stocks, one exception, were quite a bit lower. China, for a time, was all the focus. Towards the end of the summer we had the first stock market correction (a greater than 10% loss) in a few years due to fears of a recession in China and devalua-tion of the yuan, not to mention a battered stock market. Chinese stocks still ended the year up about 10%.

Federal Reserve interest rate policy grabbed inves-tors’ attention, too. The Federal Reserve Board raised the benchmark Federal Funds rate in December and the stock market seemed relieved that the persistent speculation was over. 2016, no doubt, will contain more such speculation. It is still early in the interest-rate cycle, but the Federal Reserve drives the business cycle with changes in rates, so it stands to reason that investors will be keenly focused on the topic.

There was volatility in the energy sector, to say the least. The energy portion of the S&P 500 was down about 25% in 2015. Stay tuned for more volatility in 2016 as bankruptcies are on the rise. This spilled over to a late-year sharp selloff in high-yield debt--a good slug of it issued by companies in the energy sector. Third Avenue Focused Credit fund, which owned the dodgiest of the dodgiest high yield, had to freeze investor redemptions. While we should hesitate to extrapolate this to the investment grade bonds where we do most of our buying for you, this is one reason we prefer owning individual bonds. No one can cause a run on your own individual bond portfolio which can happen when bonds are owned through a mutual fund. It doesn’t mean prices can’t go down, but no one can prevent you from getting your principal back as long as the borrower makes good on your bonds at maturity.

There will always be something about which investors will fret. Fear and greed are natural states for stock market participants. Now, we think investors

are still on the greedy side and good investment bargains are hard to find. This has been a consistent theme of ours throughout 2015 and longer. We spend a good deal of our time analyzing 10-Ks and crunching numbers in our valuation models to find high quality companies which are undervalued by the market. It is slim pickings now, but all of that research and model building can pay off in the next stock market downturn. We will be ready to snap up some high quality companies which most likely will go on sale.

Our preference is to stay pretty much fully invested for you in prudently diversified portfolios and to be tax efficient. But, some stocks we own have become too expensive and, even considering taxes, we have been booking some gains on some long-time holdings over the last couple of years. You can read more about those below. Professor Burton Malkiel, a sage investor and author, wrote in the December 31st edition of the Wall Street Journal, “U.S. securities markets are highly priced at the start of 2016, and future returns will most likely be lower than in the past. But the timeless lessons—keep invested, don’t try to time the market, and diversify broadly—remain the best guide for investors.” We couldn’t agree more.

You will continue to see that the portfolios we recommend for you are diversified amongst U.S. and international stocks, both large and small. Most of you have large portions of your portfolios allocated to a diversified portfolio of investment grade bonds. Finally, we will continue to hold a small percentage in alternative non-correlated assets like timber, commodities, and energy infra-structure which provide a measure of inflation protection and diversification. Many alternative investments or hard assets have not been rewarding lately with energy prices down and fixed income

—6—

Relative to the S&P 500

Stocks at the End of 2015

FOURTH QUARTER 2015

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© 2016 Northwest Investment Counselors, LLC LIVE WELL. RETIRE BETTER.A Quarterly Publication by Northwest Investment Counselors

Keep invested, don’t try to time the market, and diversify broadly.

FOURTH QUARTER 2015

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returns have been muted at best, but these investments still meet the Malkiel rule.

We have seen many (and academic studies confirm this) who will sell out of an asset just because performance might have been poor for a year only to add to one which has performed well. We caution you that this can be dangerous to your financial well-being. For example, at the bottom of the stock market during the Great Recession (February 2009), the S&P 500 was down 30% over the preceding 10-years—quite a dismal performance for the largest and most widely held American companies. And, it was even worse if you consider the impact of inflation. In fact, you had lost over half of your investment portfolio in real terms over

the 10 years ending in early 2009. Had you sold for greener pastures (and many did) you would have missed out on a good portion (depending on when or if you ever jumped back in) of the subsequent 226% return in stocks through this year. And greener pastures typically turn out to be a mirage. So, we reiterate: be patient, stay diversified, and resist the temptation to time markets. You’ll thank us in the long run.

How did we measure up for the year in our stock strategies? We are pleased with our relative results even if the absolute returns were rather subdued in 2015. All three equity portfolios (Blue Chip Growth, Equity Income, and Smaller Companies) exceeded their primary benchmarks and finished

in positive territory. The S&P 500 was up a little over 1% in 2015. We exceeded that in our Blue Chip Growth composite. Just as a side note, the average stock in the S&P 500 was down over 4% excluding dividends. It was a very narrow market in terms of perfor-mance. The Dow Jones Select Dividend was down about 2% in 2015. Utilities were the main culprit as the prospect of higher interest rates weighed on inves-tor sentiment. We were up in our Equity Income composite. Finally, the Russell 2000 was down over 4%. Financials, in particular REITs, appear to have dragged down the Russell 2000. We had positive performance, in fact very positive, in our Smaller Compa-nies composite. As always, your portfolio will probably differ and we can discuss your performance in detail when we meet with you in 2016. In the meantime, we thank you for your continued trust in us.


FOURTH QUARTER 2015

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Let’s recap some of the activity during the year in each of our equity portfolios.

BLUE CHIP GROWTH

We added Scripps Networks (SNI) to the Blue Chip buy list in the third quarter. SNI is a television cable content provider. It owns 98% of the content aired on the channels it owns: The Food Network, HGTV, and the Travel Channel. SNI reaches an audience of over 90 million US households and repeatedly ranks in the top networks in the US. We think SNI has created an enviable position for itself in the world of cable companies and content providers. SNI has high operating margins, excellent returns on invested capital, and consistently strong free cash flow. SNI would be better off merged with one of the bigger entertainment companies, but it will take an agreement with the Scripps Trusts for that to happen.

Whole Foods Markets, Inc. (WFM) was added to the Blue Chip buy list in the fourth quarter. WFM is the largest natural and organic grocer in the US operating over 400 stores. Competition is tough, but WFM routinely displays attractive margins, returns on capital, and free cash flow. Along with its new store format, 365 by Whole Foods Market, management expects to more than triple the store base in the coming years. WFM also announced a $1 billion share buyback program as 2015 ended.

eBay Inc. (EBAY) spun off Paypal Holdings (PYPL) in the third quarter. Paypal is on the source of funds list due to its high valuation. There are a couple other stocks on the source of funds list due to valuation: NIKE Inc. (NKE) and Starbucks (SBUX). Both fairly long-term holdings, but each is trading well above a reasonable intrinsic value range.

Intel (INTC) completed the acquisition of Altera in the fourth quarter for $16.7 billion. That is a rather large acquisition for INTC, representing about 10% of its market valuation. Its strategy, as we under-

stand it, is to integrate the field programmable chips of Altera into Intel’s microprocessors. This allows for better performance and some change in the hardware after the chips leave the factory.

EQUITY INCOME

We added Coach (COH) to the Equity Income buy list in the first quarter. Coach over expanded in North America and lost some of its focus. As a consequence, the stock is down and we think it is a good value. We have owned Coach for many years in the Smaller Companies portfolio after it was spun off by Sara Lee in 2000. We expect management to rationalize and get back on track. In the meantime, we earn an attractive dividend yield and the share base is shrinking as it buys back shares. We think COH has a narrow moat around its business driven by the long history of its leather goods brand which was started in 1941.

Kraft Foods (KRFT) agreed to merge with the H.J. Heinz Company to form the fifth largest food and beverage company in the world, Kraft Heinz Co (KHC). The merger closed early in the third quarter. We like the merger, but at this point the combined company’s valuation is too high. Consequently, KHC is on the source of funds list.

One other holding on the source of funds list due to valuation is Mondelez International (MDLZ). MDLZ was spun off from Kraft Foods late in 2012. We like the company but not the valuation nor the dividend yield for Equity Income portfolios.

Some are on the source of funds list due to lack of economic profit, like Chevron Corporation (CVX) and Exxon Mobil (XOM). If oil had stayed in the $60-80 range, both would have continued to be good income stocks. Below $40 a barrel, neither are producing economic profits. Neither has cut its dividend, yet, but our rules put them on the source of funds list for the time being.

2015 Stocks (cont.)


FOURTH QUARTER 2015

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SMALLER COMPANIES

We didn’t do much buying during the year until the third and fourth quarters when we added Wynn Resorts (WYNN) and MSC Industrial Direct (MSM) to the Smaller Companies buy list. WYNN is a large domestic hotel and gaming enterprise with major operations in Las Vegas and expanding international operations in Macau, China. A new Macau resort is opening in 2016 which should more than double WYNN’s operations in that market. WYNN has been spending heavily on construction and this should begin to taper off over the next year. As capital expenditures decrease, we should see operating margin and earning per share expand. WYNN has also shown itself to be a good steward of capital through its dividend payouts. Recently, WYNN has started to expand its focus from the high net worth individual into the middle market clientele to open new revenue sources. The real growth will come from Macau. As Beijing concludes its corruption crackdown, economic growth should return and with it will come a renewed influx of tourists. We think WYNN has a narrow moat driven by holding one of only six licenses to operate a casino in Macau.

MSC Industrial Direct is a supplier of maintenance, repair, and operations (MRO) equipment and consumables to U.S. industrial companies. MSM has carved out a narrow economic moat in the metal-working industry where it dominates its competitors. Results have been slow of late along with global manufacturing activity, but we think the longer-term outlook is positive.

We sold a couple stocks that haven’t performed as well as we modeled or hoped: St. Joe (JOE) and Tejon Ranch (TRC). Both companies shared a similar story in that they were real estate holding companies with zero debt that we believed would return to operating at a profit. The only exception to that story was the time horizon. We decided there were better opportunities for your capital.

There are a couple holdings on the source of funds list due to valuation: CoStar Group (CSGP) and Mettler-Toledo (MTD). Both have been solid long- term holdings with good economic moats. Both, however, are too expensive now.

Long-time holding Advent Software (ADVS) was bought out in the summer by SS&C.

Smaller Company holding Sirona Dental (SIRO) is merging with DENTSPLY International (XRAY) to form the world’s largest dental supply company. The merger is expected to close in the first quarter of 2016. We are busy assessing the merger and will have more to write at the end of the first quarter.

2015 Stocks (cont.)


FOURTH QUARTER 2015

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Relative to S&P 500

NW BLUE CHIP GROWTH STOCKS

Top Ten Holdings Percent

AutoZone Inc. 5%

Microsoft 4%

Oracle Corp.

Accenture PLC

4%

4%

Procter & Gamble 4%

Automatic Data Proc. 3%

PepsiCo Inc. 3%

Apple Inc. 3%

Cisco Systems 3%

Disney (Walt) 3%


AMN Healthcare 5%

Equifax 5%

Fair Isaac Co.

Insperity

5%

4%

SEI Investments 4%

Broadridge Fin Sol 4%

DST Systems 4%

T. Rowe Price 4%

Waters 4%

Factset Research 3%

NW SMALLER COMPANIES STOCKS


NW EQUITY INCOME STOCKS


Stanley Black & Decker 5%

Clorox 5%

Wells Fargo 5%

Johnson & Johnson 5%

Paychex 5%

Adidas AG 4%

Sysco Foods 4%

3M Company 4%

Emerson Elec. 4%

McDonalds 4%

Fixed Income IndexesShort-Term G/C

Barclays Intermediate G/C

1 Year

0.2%

0.8%

3 Years

0.5%

0.9%

5 Years

0.9%

2.3%

AlternativesTimber

Energy Infrastrcture

Commodities

1 Year

-8.0%

-35.3%

-25.7%

3 Years

3.4%

--

-19.7%

5 Years

3.1%

--

12.8%

Equity IndexesLarge Stocks (S&P 500)

Small Stocks (Russell 2000)

International Stocks (EAFE)

Real Estate (NAREIT)

1 Year

1.3%

-4.5%

-1.0%

4.1%

3 Years

15.0%

14.7%

4.1%

11.5%

5 Years

12.5%

9.2%

3.3%

12.0%

CASH RESERVES PLUS

Top Ten Holdings Coupon/Maturity Percent

Intuit 4%5.750% Due 03-15-17

Intl Paper Co 5.250% Due 04-01-16 3%

Federal Natl Mtg Assn 3%1.250% Due 09-28-16

Federal Farm Cr Bks

3%

0.750% Due 05-30-17

Laboratory Corp Amer Hldgs

3%

2.200% Due 08-23-17

Cameron International Corp 3%1.400% Due 06-15-17

Amgen Inc 1.250% Due 05-22-17 3%

Federal Natl Mtg Assn 2%1.000% Due 12-17-19

Maxim Integrated Prods Inc 2%2.500% Due 11-15-18

Scripps Networks Interact Inc 2%2.700% Due 12-15-16

INTERMEDIATE FIXED INCOMETop Ten Holdings Coupon/Maturity Percent

Maxim Integrated Prods Inc 3%2.500% Due 11-15-18

Federal Natl Mtg Assn 1.250% Due 09-28-16 2%

Fiserv Inc 2%4.625% Due 10-01-20

Federal Natl Mtg Assn

2%

1.000% Due 12-27-19

Carnival Corp

2%

Amgen Inc 4.100% Due 06-15-21 2%

1.875% Due 12-15-17

Symantec Corp 2%2.750% Due 06-15-17

Agilent Technologies Inc 3.200% Due 10-01-22 2%

El Segundo Calif Uni Sch Dist 2%2.264% Due 09-01-19

Mead Johnson Nutrition Co 2%4.900% Due 11-01-19

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Please read this Disclosure section for a summary of changes made to our Form ADV Parts 2A & 2B, which we recently filed with the Securities and Exchange Commission (SEC). As a reminder, Registered Investment Advisers, like us, make at least annual filings with the SEC regarding changes in our business practices and how we manage money for our clients. It is the summary of these changes that you will find below in Disclosures. Should you want a complete copy of our Form ADV, please do not hesitate to contact anyone here at Northwest.

Item 4. Advisory Business We removed a section on services for Emerging Wealth clients; we ceased providing this service.

Item 8. Methods of Analysis, Investment Strategies and Risk of Loss We removed Preferred Stocks as a separate single asset strategy. For portfolios or models which use preferred stocks, we have switched to using an exchange traded fund.

Part 2b of Form ADV Item 4 We added disclosures about the volunteer activities of Matthew J.N. Roehr which occur partially during the business hours of Northwest Investment Counselors, LLC. We updated the disclosures regarding Mark E. Scarlett’s volunteer activities. We updated the disclosures regarding Michelle C. Garcia’s volunteer activities.

Investment Objectives. Please remember to contact us if there are any changes in your financial situation or investment objectives or if you wish to impose, add or modify any reasonable restrictions to our investment management services.

Brochure Rule. Should you want a complete copy of our Form ADV Part II A & B, please contact us.

Performance. Complete composite performance data and disclosures are available upon request. Your account performance may differ from our composite performance or model benchmarks due to specific holdings, weightings, cash, and any restrictions you placed upon us. Your performance, if included, is before management fees. Performance of indexes referenced does not include the deduction of management fees. Individual securities, if referenced above, do not represent all of the securities purchased, sold or recommended and you should not assume that any listed security was or will be profitable. Composite and individual security performance for the period above or your account(s) are available upon request. Your performance benchmark may differ from the model benchmarks displayed above depending on your specific asset allocation.

Prices. Prices are obtained from independent pricing services and prices for certain securities, especially bonds or infrequently traded securities, may not represent the current price or market value.

Proxy Voting. Specific proxy votes and policies are available upon request. We may choose not to vote the proxies of the companies which are transferred in with your account(s).

Code of Ethics. We maintain a code of ethics. A copy of our code of ethics is available upon request.

No Guarantee. Investments are not guaranteed. Market values will fluctuate and you may lose money.

Client Benefit Agreement. In 2012 and 2013, we entered in to a Client Benefit Agreement with Charles Schwab in exchange for their waiver of the IMPACT 2012/2013 Conference fees for one attendee (valued up to $1,150). The Client Benefit Agreement requires us to maintain at least $10 million in client assets in custody with Charles Schwab. Please request a copy of our Form ADV Part II A for more information about our use of the Schwab Advisor Services platform.

Securities Mentioned. The securities mentioned are not the only securities we have purchased in the last year for our clients. If you would like a list of all securities purchased in the last year, please contact us. Additionally, it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities mentioned.

Disclosures

FOURTH QUARTER 2015


Documents

FOURTH QUARTER 2015 - files.ctctcdn.comfiles.ctctcdn.com/99a1bab4501/b184eecb-fa45-4d49-af8d-8272594a… · down about 25% in 2015. Stay tuned for more volatility in 2016 as bankruptcies