Adams Diversified Equity Fund, Inc.
Q2 2018 Earnings Call Transcript

Published: 26 Jul 2018

[Operator:]

Good afternoon, and welcome to the Adams Diversified Equity Fund Semiannual Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Lyn Walther, Director, of Shareholder Communications. Ms. Walther, Please go ahead.

[Lyn Walther:]

Good afternoon. And thank you for joining us today as we discuss the results for Adams Diversified Equity Funds for the first six months of 2018. With me today are Mark Stoeckle, the Fund's Chief Executive Officer; Brian Hook, our Chief Financial Officer; and Janis Kerns, our General Counsel. This conference call contains statements, which are considered forward-looking statements within the meaning of the U.S. Securities Exchange Act. These statements reflect Fund Management's current views with respect to future events and the Fund's financial performance over the past six months, and are not guarantees of our future performance. Although forward-looking statements made today are based on what management believes are reasonable assumption, these statements are subject to risks, uncertainties and other important factors that could cause our actual performance, returns or investment decisions to be materially different from what we project. We assume no obligation to revise, correct or update these statements. I will now turn the call over to Mark Stoeckle for his remarks.

[Mark Stoeckle:]

Thanks, Lyn, and good afternoon everyone, and thanks for joining us on the call. As Lyn mentioned, on the call today I will review the results for the first-half of '18 and then talk about some of the companies in the Fund that contributed to our performance. After that I will open it up for your questions. In the first six months of '18, the Fund increased 2.7% on net asset value, which was in line with the S&P 500. Our investments in technology, consumer discretionary and healthcare companies were the biggest contributors to our returns. As you know, 2017 was a very good year for stocks. 2018 started off strong as well driven in part by the $1.5 trillion tax cut package, which led many companies to increase dividend to clear share buybacks and announce one-time bonuses leading to a great deal of optimism in both the business community as well as the consumer. And despite a six-month period filled with potentially significant geopolitical developments, the equity market continued to move higher. Series of a trade war within a number of countries have dominated the headlines for months. We believe these fears are likely to continue as many parts of the world have begun to dig in as a response to the U.S. trade tariffs. Where this will end is very different to know, but we are keeping a careful eye on it as it may affect the stocks in our portfolio. On the heels of the tax cut, companies used some of their tax savings to launch a record number of strategic transactions. In fact the dollar value of merger and acquisition activity in 2018 is on pace to be the largest in history. M&A is reshaping several industries, including telecom, energy and healthcare. M&A has the potential to jumpstart companies who are having a difficult time growing organically and can also rationalize the market. Done well, M&A can be quite good opportunity for companies. Even if the first-half of '18 produced a good return, volatility also returned to the market after record low-levels in 2017. In fact, during the first quarter, the market had a daily move of more than plus or minus 2% ten times compared to zero in all of 2017. Our Fund was down about 1% at the end of the first quarter. However, stocks rebounded in the second quarter due to continued signs of strong economic growth and better-than-expected earnings. The escalated tensions between the U.S. and China over tariffs did very little to slow down the market. With this as a backdrop, let's get to the more fun part of the conversation, which is about our portfolio. Our technology holdings experienced a volatile period in the first quarter due to fears of increased regulation and concerns over data privacy. The sector rebounded strongly in the second quarter and finished up 12.5% for the first-half of the year. A quick look at our holdings shows that we do have exposure to the thanks docs which within technology are Facebook, Amazon, and Google or Alphabet. Many of these stocks seem to dominate the discussion around technology, which is really why I bring it up. I think one of the more important parts about the six-month period is our holding in Adobe systems and salesforce.com were the real standouts for the Fund's six-month performance in the sector. Both stocks benefited and we believe will continue to benefit from growth in cloud computing, and we see continued promise in both. Our analyst, Xu Chang has done a really good job identifying the winners for us in the technology space. Our consumer discretionary holdings also performed well led by our analyst Dave Schiminger. Amazon continues to expand its dominant position in retail, and generate strong returns for the Fund. In addition to their grip on retail, Amazon continues to disrupt other areas of the economy. We believe they continue to have a very long runway of outperformance. We added advanced auto parts to our portfolio in February, and the stock is up 21% since we purchased it. The company is a diversified auto parts retailer and is benefiting from very positive trends in the do it yourself market. It also has a new management team that's focused on reducing costs and improving profitability. Lastly, within discretionary, we initiated a position in Chipotle Mexican Grill. With the food contamination issues behind it, Chipotle appeared to us to be worth spending timeline. We like the fast casual concept and especially liked the new CEO. He comes to Chipotle from Taco Bell and has a vision that incudes menu innovation and improved marketing. He is also focused on improving store level execution and expanding margins while also increasing store expansion. Within industrials, our Fund generated strong returns due to good stock picking by our analyst, Cotton Swindell. We think this sector will continue to benefit from tax cuts, increased capital investments and strong global growth. Boeing was once again a driver of our outperformance in industrials, increasing 15% in the first-half. Boeing reported this morning, and although the stock is off a bit, the story continues to be one of monster free cash flow, which we see continuing for quite some time. Although Boeing has been a real performance horse for our Fund over the past few years, we continue to see meaningful upside from this holding. Another contributor to our returns in industrials was Cintas, a company we added to the Fund in early 2018. Cintas provides uniforms, supplies and services to businesses. The company executes it at a very high-level, and is benefiting from the lower tax rates, which has enabled its customers to hire and provide uniforms for more people. After a disappointing start to 2018, healthcare stocks rebounded in the second quarter. Our healthcare analyst, Steve Crane has done a good job of navigating a challenging sector. Our holdings in Thermo Fisher Scientific performed particularly well. Thermo Fisher is the market leader in life science tools and diagnostics. The company has a consistent track record of growing organically using its capital effectively and achieving its strategic objectives. As a matter of fact, Thermo reported a really fine quarter this morning, registering both revenue and EPS beat. We believe Thermo to be the best in the life science's industry group within healthcare. During the quarter, we added Merck to our portfolio. We are attracted to Merck's leadership in immuno oncology, which is one of the fastest-growing markets within pharmaceuticals. The star from Merck recently has been their cancer drug, KEYTRUDA. KEYTRUDA addresses a number of different cancers, but the biggest breakthrough has been in non-small cell lung cancer. They continue to be ahead of the curve with this drug. Additionally, their diabetes drug, JANUVIA continues to beat expectations. Although the many geopolitical developments mentioned earlier have not had a big affect on companies, it's certainly possible things could get worse, or they may not. Because it's not possible to know for sure, we have no interest in guessing the outcome, and therefore remain vigilant in trying to identify cracks in the system. One thing we think is likely is that market volatility will be around for quite some time. I want to review a few things about the Fund that we feel are important. First, we remain committed to a minimum distribution of at least 6%. In fact, since we made that commitment in 2011, we have exceeded the minimum in each year, most recently distributing 9.8% in 2017. We understand the importance that many of our shareholders place on this distribution. Because of the size of the distributions we pay, it is important that our shareholders remember that our Fund should be viewed as a total return vehicle, meaning, you cannot just look at the share price performance of the stock; you need to factor in the distributions that we have paid to you to get a proper understanding of our total returns because most of the return on the stock comes from them. Before I open it up to your questions, I would like to thank Lawry Hooper for his 21 years of service to our Fund. Lawry served as our General Counsel, Corporate Secretary, and Chief Compliance Officer, and retired earlier this month. He made numerous contributions to our Fund over the last 21 years. We will miss him, and wish him the best in retirement. I would also like to welcome Janis Kerns to Adams, who has taken over for Lawry. Janis joined us earlier this year with more than 20 years of legal and compliance experience in the investment management industry. We are very excited to have her join our team. I would like to acknowledge the talented team we have here at Adams. We have an experienced group of industry analysts and portfolio managers, which are supported by a strong infrastructure and accounting and compliance. We are team that takes a long-term view and incorporates a disciplined approach to investing, which focuses on identifying quality companies, executing at the highest levels and are trading at attractive valuations. I'm optimistic about our ability to continue to deliver good investment results for our shareholders. With that, I will now open up the call to your questions.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions]

[Lyn Walther:]

Okay. Our first question, you touched on this briefly, but in light of the current trade situation, how are you positioning the portfolio? Are you reducing exposure to certain sectors that might be more impacted by rising input costs?

[Mark Stoeckle:]

It's a really interesting question in an interesting position to be in. As I mentioned in my remarks, one of the things that we are not interested in is guessing. And one of the challenges with the trade issues is it's hard to understand what the policy is right now, it's hard to understand what's going to happen next. And so, for us, we are looking at it very carefully, very closely, but we have not made portfolio decisions because there are too many unknowns. As I mentioned, it is something that we are staying vigilant on. We talk about it all the time, whether it's industrial companies with steel or other input cost going up, it is something that we're keeping an eye on. But it's really hard to at this point guess how bad or how benign the trade impact is going to be. So, our tax has been, and will continue to be until we get more firm information to wait and see, and just look very closely.

[Lyn Walther:]

Okay. Our next question, are you comfortable with your exposure to technology? The group has had a great run in 2017 and so far in 2018. Do you see the sector continuing to generate such strong returns or are you repositioning your portfolio?

[Mark Stoeckle:]

There is no question that technology has had a good run in the last couple of years. That being said, I think there is a little bit of a misunderstanding as to what's generating those returns. As I mentioned in my remarks, there is no question that Facebook and Amazon, Netflix, Google, some people throw Apple in there; that the bigger stocks have done well over the period, over the last two years. But that isn't where all of the return is coming from. As a matter of fact, as I mentioned, in technology specifically, our biggest contributors to outperformance in technology was Apple -- oh, I'm sorry; Adobe and salesforce.com. In addition to that, our positions in Visa and MasterCard were also a real big contributor. So, I think that the -- to us, the real reason for being optimistic in the technology sector is relative to other sectors it's really where there is a lot of the growth, and it's both top line and bottom line growth. Specifically in technology as you look at the software and services areas, the top line growth is -- and by the way, EPS growth is really hard to overlook. So, we do not think it's over. We look at it very carefully. This is an actively managed portfolio, so we do manage our position sizes based on what we think the outlook -- what the outlook for companies we own is, and what the relative opportunities are. But we still remain pretty bullish on technology. It doesn't mean that the stock that have been the successful last two years will continue to be a success over the next two years, but certainly something that we spend a lot of time and work very closely with Xu Chang on.

[Lyn Walther:]

Okay. So, one more question right now, the expense ratio has been trending lower over the past few years, which is impressive in this environment. Do you see this continuing or have most of the big trends reductions already occurred?

[Mark Stoeckle:]

Let me begin answering that question by saying that you know, I have been here for five-and-a-half years and the one thing that is very clear is there is a culture of trying to starting at the Board level all the way through the people, the company to try to offer a product with low expenses. And it's something that is on the top of mind of certainly Brian Hook, our CFO who is sitting here with me, but everybody in the company. And so we work very hard at doing that. That being said, even though the expense ratio has been flat to down, we've been able to continue to invest, and I will never apologize for investing, we have been able to do it without the expense ratio going up, and it's something we look at very carefully. But we have also been fortunate to be able to invest in systems, to invest in people. And I think it's one of the reasons why we have been able to have the results over the last several years that we have been able to have is a result of those investments. So, I'm not -- for shadow, I admit it's going to go up or down, I think the most important message for our clients, for our shareholders is that it is something that we remain vigilant about.

[Lyn Walther:]

I don't show any further questions.

[Operator:]

[Operator Instructions]

[Mark Stoeckle:]

I'm going to ask the people that are listening not having questions is fine; if you have any questions, send them along after. You can send them through our Web site -- through the email on our Web site. But also -- I might get killed for saying this, what also might be interesting is your comments about the call, we do spend time on this, it's important to us. I do enjoy talking about stocks, so we hope that is useful, but if you have comments or suggestions, send those along as well.

[Lyn Walther:]

All right. With no further questions, this concludes our conference call today. Thank you for joining us. Our next call will be held in January. We look forward to speaking to you again at that time.

[Operator:]

This conference has now concluded. Thank you for attending today's presentation. You may now disconnect.