Adams Diversified Equity Fund, Inc.
Q2 2017 Earnings Call Transcript

Published: 17 Aug 2017

[Operator:]

Good afternoon everyone and welcome to the Adams Diversified Equity Fund First Half 2017 Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please also note, today’s event is being recorded. At this time, I would like to turn the conference call over to Ms. Lyn Walther, Director of Shareholder Communications. Please go ahead.

[Lyn Walther:]

Good morning and thank you for joining us today as we discuss the results for Adams Diversified Equity Funds for the first half of 2017. With me today are, Mark Stoeckle, Chief Executive Officer; Lawrence Hooper, General Counsel; and Brian Hook, Chief Financial Officer. This conference call contains statements, which are considered forward-looking statements within the meaning of the U.S. Securities Exchange Act. These statements reflect the Fund’s current views with respect to future events and financial performance and are not guarantees of future performance. These statements are subject to risks, uncertainties and other important factors that could cause our actual performance, returns or investment decision to be materially from what we project. We assume no obligation to revise, correct or update these statements. I will now turn the call over Mark Stoeckle for his remarks.

[Mark Stoeckle:]

Thanks, Lyn. Good afternoon, everyone. Thanks so much for joining us today. On the call, I’m going to review our results for the first half of 2017 and then spend a little time discussing some of the holdings that contributed to our performance. I will then open up the call for your questions. Let me begin by saying, we’re quite pleased with the results for six months of the year. The Fund increased 11.9%, outperforming the benchmark S&P 500, which increased 9.3%. The strongest sectors for the Fund were our holdings in technology, consumer discretionary, consumer staples, telecom and industrials. The year got off to a good start as the positive momentum that began with the Presidential election in November continued into 2017. We saw rotation into technology, which had underperformed in late 2016 when Silicon Valley was out of favor with the President. Expectations for business-friendly policies from the new administration combined with the signs of an improving economy drove the stock market higher. This led to the Federal Reserve to raise interest rates a quarter point at both its March and June meetings. Although the stock market has reached new highs, the energy sector has not participated. It’s been a difficult year for energy companies as the price of crude oil, which started the year at $57 a barrel, fell to a low of $42 in June. Concerns over already high inventory levels in the U.S. combined with rising production levels, drove prices down. OPEC’s decision in November of 2016 to reduce production had little impact on prices as domestic shale production largely offset these cuts. After reaching a low in June, oil prices seem to have a bottom and been hovering in the high-40s. This was driven by declining inventory levels in the U.S. and Saudi Arabia’s renewed commitment to limit its exports. We have positioned the portfolio to have more exposure to the Permian Basin in West Texas and companies that can profitably operate wells at relative low oil prices. Many of these companies came under pressure following 2Q earnings results due to concerns over the oil gas ratios on wells in the Permian Basin. The higher amount of gas coming from the wells caused investors to question the long-term growth of oil production from this region. We’ve done a lot of work on this, and our view frankly is that while there is more gas coming from these wells than initially planned, the oil production potential is unchanged. Despite the turmoil in Washington and a number of geopolitical risks such as North Korea and Russia, the S&P 500 has risen in eight of the past nine months, in which has been a period of extreme low volatility. The inability of congress to pass the healthcare bill has raised doubts over whether the government can pass tax reform. Nonetheless, the stock market has continued to move higher, indicating that the stock market rally which may have initially been driven by expectations for new fiscal policies is really being driven by healthy corporate earnings and solid global growth. In fact, earnings for the S&P 500 companies are expected to increase 10.2% for the second quarter compared to a 13.9% increase in Q1. If this holds true, this will be the first time that the index has seen two consecutive quarters of year-over-year earnings growth since 2011. With consumer confidence at the highest level since 2000 and unemployment at 4.3%, a 16-year low, the economy appears well-positioned for continued growth. At this time, I want to move to the, what I consider the more enjoyable part of the call, which is actually talking about stocks, some of the stocks in the portfolio. As I mentioned earlier, the first six months, we had very good performance in the Fund. And actually 7 of the 10 sectors contributed to the performance with 3 of the sectors that didn’t, really modestly detracting from performance. As I also said, the biggest contributor was technology. Strong stock selection has enabled us to do very well in technology. As many of you I am sure have already done, you see our top 10 holdings include Apple, Google, Microsoft and Facebook, interesting, and all contributed to performance in the first half of the year. But the biggest contributors to performance were names that aren’t in the news every day, semiconductors, Lam Research; Broadcom and software company, Adobe, all three companies, significantly outperformed technology. And as I said earlier, our emphasis on identifying long-term secular growth stories is what got us to these types of names. As we look at the stocks that helped in performance -- I think one of the things I want to also emphasize is notwithstanding the fact that Apple, Google, Microsoft and Facebook get a lot of press and they did perform well, I think there is an important message, and that’s one of patience. We owned all four stocks last year. Many of them did not do very well. As a matter of fact, Facebook was about -- returned less than 10% last year and was up 31% in the first six months of this year. And to me, the long-term focus and the patience is something that has really paid dividends for us. We see really good, solid, long-term stories in all four stocks. Certainly, the monetization levers that Facebook has are very important; Microsoft with its cloud offering, really using what they’ve -- the cash flow from their Windows business to fund the cloud business is something that has been a really remarkable turnaround for that company; Google continuing 20% top-line growth, again, a very solid showing from Google; and Apple continuing to do well, up 25% this year. What’s important for us to make sure that you know is that notwithstanding the fact that they’ve all done well, we don’t view them as being overly expensive. We think that the outlook, the secular growth outlook for each of them is outstanding, and they should continue to be solid contributors for the Fund. What I want to do next after having talked a little bit about technology, is talk about a handful of other stocks and give you a sense of how we think and what’s important to us. Let me start with a company American Express, a very well known company. Interestingly Jeff Schollaert, our analyst, we began talking about American Express in the fall of 2015, and we had identified it as a very high quality company but not a good stock at the time. They had just lost -- recently were going to lose the big Costco business that they had, they were the preferred card at Costco. They had come under fee pressure, their marketing effort was in disarray, and they also acknowledged they needed to do more in their platinum card to be competitive. We spent the following year watching, and Jeff did a great job of identifying what we wanted to see, the kind of progress they were making, and in December of 2016, we began a position. And I think it’s a good example of identifying high-quality companies, identifying what we would like to see them do, and having the patience to wait to see that happen, and American Express has been a very good stock for us. In addition to that, a company -- the next company I would like to talk about is Boeing. The focus for us on Boeing has been the building of Boeing’s cash flow. The 737 or the 777 planes remain very profitable. And what we really saw was an inflection point in the 787 transitioning to be cash flow positive, which has been an enormous boost for Boeing, that in addition to very strong backlog and air traffic demand that remains high. As we do across the entire portfolio when we’re managing risk, one of the things that we’ve done this year with Boeing is as it has continued to outperform and it was up over 30% this year so far, we’ve begun to trim it, and we’ve done that acknowledging the fact that Boeing has been good to us, we still like it but it gotten to the point where it’s an outsize position. And what we do in circumstances like that in both industrials and across the risk of the portfolio is recycle some of that money into other stocks that we believe provide good, relative value. And in that case, we recycled some of the Boeing money into Honeywell, again another industrials company. Honeywell has had steady improvement in organic growth, margins and cash flow, trading at a pretty good discount to Boeing, and hadn’t participated as much. So, it’s a really good example to me of taking long-term views of stocks, but when they reward us, not being afraid to trim them and look for other opportunities that can give us more added value. Another start I want to talk about is one that people likely have not heard of which is it’s a real estate investment trust called Prologis. This is a really good example of how you can be successful at having a small team that collaborates together. Jeff Schollaert, our financial services analyst spent a lot of time with the Dave Schiminger, who is our consumer analyst, talking about Prologis which is the largest owner of warehouse and distribution center real estate in the United States. So, effectively, they build the buildings. They build the shelves. They don’t own any of the production or insight, they build the shelves. And they are levered to consumption and distribution. And as you might imagine, when you start talking about consumption and distribution, certainly the name Amazon comes up, and that’s why Jeff collaborated with David, as much as he did, on trying to figure out whether this was a really good opportunity for us. One of the things that was very attractive to us is the warehouse distribution business has very low vacancy rates, under 5%. And when you have a business like this, supply and demand is terribly important. So, we’d identified this name probably six months or seven months ago. We took the opportunity when it along with a lot of other REITs got hit earlier this year, and the valuation came down significantly, and we took that time to enter it. Just as a matter of giving you some perspective. Amazon is adding 40 million to 50 million square feet a year of warehouse and distribution space. And in addition to what they are doing, you have everybody who wants to be like Amazon and wants to get closer to the end consumer, doing much the same thing. So, there is a significant amount of demand. And the way we’ve looked at the market, not nearly as much supply. So, we think the supply-demand equation remains favorable for companies like Prologis. And again, it’s a good sense of what collaboration can do when you have a good team working together. Lastly, I want to talk a little bit about Costco, the warehouse company. We had identified Costco a long time ago as being a great business model, but it’d always been pretty expensive to us. And so, we had never owned it. The name Amazon comes up again. When Amazon announced that they were going to acquire Whole Foods, many of the traditional grocery retailers, Costco, some of the food companies really got hit pretty hard, and we thought for some of them, like Costco, unnecessarily. As I mentioned, it is a great business model. Costco, it’s an annuity like membership with fee income, 75% of operating income comes from membership fees, and incredibly high customer loyalty. They have a 90% retention rate with their customers. So, we saw a good business model with a very attractive valuation, what we believe to be easy comparable store sales coming up and a good runway of new store expansion. So, best-in-class operator; we’re able to take advantage of the market being what we think is incredibly short-sighted. Now, don’t get me wrong, Amazon and Whole Foods is going to disrupt at some point, but we don’t think that Costco is one of those places that will be disrupted. So, that’s a handful of stocks that we own. And I hope that gave you a sense of sort of how we think what’s important to us and the emphasis that we have on knowing the companies and being patient on when is really good time to own them. In addition to that, we remain optimistic about the stock market long-term. However, we do recognize that we have not had a meaningful pullback in the market for quite some time. Although, no one enjoys the pullback, they are normal part of a healthy market and can cause a variety of events -- and because by a variety of events. A potential overhang in the market is that it continued to move higher despite signs it will take longer than expected to path the current administration’s proposed polices on tax reform, healthcare and infrastructure spending. Most policy experts expect some form of tax legislation to be signed next year. However, there is clearly risk that this gets pushed out even further. In addition, as you know, tensions have risen between the U.S. and North Korea. It’s really difficult to speculate what will happen. But clearly, a conflict has the potential to create a lot of turmoil in the market. So, it bears watching closely. Despite these risks, we strongly recommend investors stay invested as time in the market is extremely difficult. And over the long-term buy and hold investors fare far better than those who are in and out of the market. I am going to review a few things about the Fund that we feel are important. First, we remain committed to a minimum yearly distribution of at least 6%. In fact, since we’ve made that commitment -- we made that commitment in 2011, we have exceeded the minimum in each year, most recently distributing 7.8% in 2016. We understand the importance that many of our shareholders placed on this distribution. And it is our intention to continue to honor that commitment. Because of the size of our distribution, we feel it is very important that our shareholders remember that the Fund should be viewed as a total return vehicle. What that means is you can’t just look at the share price performance of the stock. You need to factor into distributions that are paid to you to get a proper understanding of your total return. Before I open the call up to your questions, 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 is supported by a strong infrastructure and accounting in compliance. We are a team that takes a long-term view and incorporates a disciplined approach to investing which focuses on identifying quality companies that are executing at very high levels and are trading at attractive valuations. I am optimistic about our ability to continue to deliver good investment results for our shareholders. With that, I would like to now open the call for your questions.

[Operator:]

[Operator Instructions]

[Lyn Walther:]

Okay. We have our first question. Your holdings look heavily weighted towards technology, which as you mentioned, have performed well so far this year. Are you concerned that you may have too much exposure to this sector? Mark, do you want to take that?

[Mark Stoeckle:]

Sure. It’s a really good question. Obviously, technology has been in the news a lot and a lot of that has to do with the fact that many of the largest technology stocks have done very well. I would like to say that our performance in the first part of the year -- first half of the year, if we take out the benefit from technology, we’d still be up for the year. So, it’s not like technology was the only thing that worked for the year. We really do have a strong stock picking ability that has helped us. The majority of our holdings have done well. What’s also important is, knowing that we are effectively sector-neutral to the S&P 500, which means we don’t have any more weighting technologies than our benchmark, the S&P 500. Another thing that’s important is we are very-diversified. Notwithstanding the fact that 4 out of the top 10 stocks are tech stocks, we’ve got 15 stocks that we -- tech stocks that we have invested in. And as I mentioned earlier, three of them Lam Research, Broadcom and Adobe, all outperformed the four biggest. So, it’s something that we look at very closely. We are asked that question a lot because of the top holdings. But, I don’t feel -- I am not concerned about the technology weighting we have. And much like I explained in the Boeing example, as some of these technology stocks have done well, we trim them back and recycle the money into other tech stocks that have not done as well.

[Lyn Walther:]

Okay. Our next question is regarding the discount. Can you talk about the discount and the steps that you are taking to reduce it?

[Mark Stoeckle:]

Sure. The discount is annoying for all of us as a company because it’s not something we’d like to see. We talk about it at the Board level at each of our meetings. But, I think there are a couple of things that are important. Number one, the discount actually has narrowed over the past year, which I think is important, and we’re also doing some things that we think over time should help reduce the discount. One is we continue to buy back stock; the second is trying to draw new investors with the effort we’re putting in our website. I can say that Lyn Walther has done a good job of helping us put good contents on the website so that it’s a place where investors can go and learn something about how we do and about investing. We’ve also been working pretty diligently on trying to get our name out in the marketplace more. We have -- again, one of the things that Lyn has been doing with us is getting more interviews with publications whether it’s Bearings [ph] or U.S. News and some of the others that we’ve recently been in. We also think that that raising the recognition of Adams Fund should help it. I also think it is important to know that the discount -- discount has been wide for a very long time. I’ve looked at it over decades and it really has not significantly changed for decades. Although we don’t like it, my sense is that most investors bought at a discount and most investors will likely sell at a discount. So, I don’t think that investors really have been significantly disadvantaged where they bought their stock. But it’s something that is very important to us, the Board takes it very seriously, and we continue to look for ways to reduce that discount.

[Lyn Walther:]

Okay. Our next question, to what extent does the issuance of new shares for the first quarter dilute shareholders who do not invest their distribution? And as a follow-on, since this is a regular recurring event, is it fair to think of this as similar to an increased expense ratio for non-investing shareholders? Brian, do you want to start?

[Brian Hook:]

I will start with that one. So, we do four quarterly distributions a year; our first three are done solely in cash and our fourth quarter distribution, we provide our shareholders with the option to take either cash or shares for that distribution. As we’ve seen over the years, a very large portion of our shareholders has opted for reinvestment that they are very interested in reinvestment. Specifically last year, we had a reinvestment rate of approximately 40% in Adams Diversified Equity. And so, we know it’s something that our shareholders are -- it’s something that is very desirable for our shareholders. With that said, with the reinvestment, we do issue new shares to provide those shares to those that have elected for such. And with that, there is dilution, given the fact that we do trade at a discount. For the receiving shareholders, obviously receiving more shares at a discounted rate is a good thing. So, as Mark talked about us not liking the discounting, and this is one regard that is very helpful to shareholders to leverage that discount to their benefit, receiving shares, in our case roughly 85% of the book value of the shares is very attractive to the shareholders. With the issuance of those added discount, we have the dilution which runs approximately to the tune of about half of 1%. But, in order to help minimize that dilution -- and that dilution by the way is impacted to all shareholders, it’s not just those shareholders that did not reinvest, that is something that is impacting to the entire shareholder base. One of the ways that we try to minimize that impact of dilution is through the buybacks that do. So, the contrary point here is that because we are buying back at a discount, it’s actually accretive to the Fund as whole. And we can minimize that dilution impact through the course of those buybacks. That effort to minimize is something where we can minimize that dilution from about 0.5%, down to about 0.3 or 0.3%, which should be the net dilution, specifically for last year [ph] to the underlying shareholders.

[Lyn Walther:]

Okay. Thank you. We have another question. The question is, there has been a lot of growth in Chinese companies like Tencent and Alibaba. Is ADX interested in taking a position in companies like these?

[Mark Stoeckle:]

It’s a good question and it’s a question that I’m asked pretty frequently. The short answer is no. They’re fine -- they’re high quality companies, they’re fine companies. We believe we have enough work to do on the U.S. companies that are here that are in our -- in the S&P 500 and Russell 1000. And trying to overlay the risks of China as a place to operate is something that we feel is not really something where we should be spending our time. So, don’t take the fact that we’re -- they’re not stocks that we are interested in, to me that they are not good companies, because they very likely could be. But, it’s not anything that is really on our radar. And on other hand, we have in the past owned stocks that are European based. And to me, that’s a lot easier for us to assess the risk where it is a big consumer Staples stock that happens to be in the Switzerland or some other part of Europe. That’s a risk that’s easier for us to identify and understand than the risk of operating in China.

[Lyn Walther:]

Okay. Our next question regarding the market, given the market has been at record highs, how are you positioning the portfolio?

[Mark Stoeckle:]

Well, the way that we -- we’re not positioning the portfolio any differently because the market is at new highs really. But what we are doing is we’re continuing our process, which is the same way the markets at new highs are not. And what we mean by that is, as stocks become expensive and we reap the benefits of that, we are looking to reduce our exposure there and reinvest that money back into stocks with better valuations. So, I wouldn’t say that we are doing -- necessarily doing anything really differently. We really do not time the market. Our goal is to provide our investors with as much of a market exposure as possible. We usually run 1% to 1.5% cash. So, we really try to keep it low. We believe our job is to do our best to give large cap U.S. exposure to our investors, and timing to market is something that their financial advisor can do or they can do for them. So, remaining fully invested, but really a sharp eye toward stocks that have done well and gotten expensive and recycling that money into better, relative opportunities within each sector.

[Lyn Walther:]

Okay. Not showing any further questions. Operator, do you have any questions, should we just turn it back over to Mark?

[Operator:]

I am not showing any additional questions.

[Mark Stoeckle:]

Okay, great. Well, again, I want to thank everyone for participating in our shareholder call. We appreciate your attention, we appreciate your questions, and we look forward to updating you on our next call. Thank you very much.

[Operator:]

Ladies and gentlemen, the conference has now concluded. We do thank you for attending. You may now disconnect your lines.