Adams Diversified Equity Fund, Inc.
Q4 2017 Earnings Call Transcript

Published: 31 Jan 2018

[Operator:]

Good day, and welcome to the Adams Diversified Equity Fund Annual Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Lyn Walther. Please go ahead.

[Lyn Walther:]

Thank you. Good afternoon, and thank you for joining us today as we discuss the results for Adams Diversified Equity Funds for 2017. With me today are, Mark Stoeckle, the Fund's Chief Executive Officer; Lawrence Hooper, our General Counsel; and Brian Hook, our 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 Management's current views with respect to future events and the Fund's financial performance 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 for his remarks.

[Mark Stoeckle:]

Great. Thanks Lyn. And good afternoon, everyone, and thank you participating in our call. My plan today is to review our results for 2017, and discuss a handful of stocks that contributed to our performance. After that, I will open the call to your questions. By any measure 2017 was a very good year for Adams Diversified Equity Fund. The Fund increased 26.2% outperforming the benchmark S&P 500, which increased 21.8%. We also outperformed Lipper large-cap core funds average which returned 20.7%. Our strong performance relative to the Lipper average placed us in the top 10% of our peer group for the year. We are also well-placed over Longer Horizons versus the Lipper benchmark which is 13% out for three years and 16% out for five years. 2017 was a very good year for stocks both in the U.S. and around the world. The S&P 500 hit a record high 62 times, and it was the first time since the index was created in 1957 that it posted a positive total return in every month of the year. The positive momentum that began with the presidential election in November 2016 continued into 2017. Our optimism over the Trump Administration's pro-business agenda calling for fewer regulations and lower taxes both of which were considered positive for economic activity and corporate earnings drove the stock markets to new highs. Due to the strengthening economy, the Fed raised interest rates three times in 2017 which was in line with their plan. The Trump Administration was successful in reducing regulations in general and specifically bank regulations early in the year. By the end of the year, tax reform was passed lowering rates for both corporations and individuals. The confidence in the economy increased as the year wore on and was contagious. Strong global economic growth, go-inflation and a robust labor market led to consumer confidence reaching the highest level on 16 years. U.S. GDP rose over 3% for two consecutive quarters in 2017, which was the first since 2014 and unemployment rate fell to 4.1%, a 17 year low. With all of that as a backdrop, I'd like to talk to you about your portfolio. One way to describe 2017 is it was a year of good stock selection. There are many areas in the portfolio we're having patience paid off. Interestingly, every sector except energy posted a positive return for the year. Our strongest sectors for the year were technology, industrials and consumer discretionary. Reviewing our top 10 holdings, you see many technology companies and that is true that the portfolio benefited from exposure to Apple, Microsoft, Google and Facebook. However, it's really important to understand that that's not the whole story. There were several other tech stocks that allowed us to significantly outperform the tech sector. One of the largest contributors was semiconductor company Lam Research. Lam manufactures equipment for the semiconductor chip makers. They continue to ride the wave of increased memory in areas like smartphones, autos, and data center. Their earnings report last week was a beat and raise on both revenue and earnings. Our tech analyst [Chuan Chang] have done really good work on staying in front of a volatile group within technology. She continues to have a great deal of confidence in expanding margins, and earnings beats at Lam as they continue to reward shareholders with increased stock buybacks and dividends. Another name in tech for outsized gains was Adobe. Adobe is a digital media and marketing company which we believe has been one of the most successful software companies that has transitioned to the cloud. The move to a cloud-based subscription business has been enormous for the company, and positioned an incredibly well to take advantage of the digital transformation that's happening in both media and advertising. They have consistently delivered very clean results that are bulk street consensus. Now we could sit here and talk very long time about many of the tech names in the portfolio but let's move on to industrials, another sector where we did significantly well last year. One of the Fund's three portfolio managers, Cotton Swindell also has endless responsibilities from the industrial sectors. Two of the most important decisions we made all year was to have a good size position in Boeing and have very little weight in General Electric. Coming off the mildly disappointing 2016, Cotton determined that Boeing had good things ahead of it. This is where patience was a virtue. He correctly identified that in addition to having robust demand for its planes, Boeing was entering a period where the 737, the 787 and the 777 planes would begin to throw off a significant amount of cash flow. He was correct and Boeing was the best performer in the industrial sector. And as you have seen this morning, the Boeing report was a monster quarter with revenue, earnings and cash flow topping Wall Street estimates. On top of reaping the Boeing success, we benefited by having a very small position in GE. We've been quite weary of the capital discipline that GE has exhibited, as well as the difficulty in truly understanding a complicated and diverse business. Throughout the year we were hoping that new management would provide more transparency. That didn't come so we remain quite comfortable being significantly underweight GE. Consumer discretionary sector is a very diverse sector. In addition to having traditional retail and consumer services like hotels and restaurants, it also has media, as well as autos. Our discretionary analyst Dave Schiminger navigated this broad array of groups quite well. Certainly our holding in Amazon was a great help. We continue to believe in the power of disruption and no company has been able to disrupt that of an Amazon and I love the Jeff Bezos quote "your margin is my opportunity". The incredible cash flow engine that is Amazon Web Services drives a great deal of the investments in their other businesses, and we suspect that the acquisition of Whole Foods markets last year is just the beginning of their margin to food retail. And although Amazon continues to be one of Dave's favorites, we keep a close eye on their operating metrics. During the year we benefited from a very conscious decision to stay away from typical retail stock like department stores, clothing retailers and restaurants. Dave was convinced there was an opportunity in home-improvement. Within home-improvement we own both Home Depot and Lowe's. The operating metrics and growth in this space were in our opinion superior to other traditional retail opportunities. Both companies are executing very well with continued margin improvement expected. Dave also has responsibility with Consumer Staples and within the Staples sector our position in Walmart proved to be very rewarding. In late 2016, we identified what we believe to be a seachange at Walmart. Our thesis was that Walmart had made strategic decision to invest in price, people and process in addition to rapidly expanding its e-commerce platform and capabilities. The reward for this type of work is that you can get an outsize return from a very large company. Walmart continues to execute in many areas at a very high level. They have the physical store structure, as well as growing online presence to effectively compete against Amazon. In a short period of time, management has done a remarkable job turning round a very large company. Although our performance healthcare was positive, I think it's important to identify the strongest performing stock in the sector. AbbVie is a biotech company whose main drug Humira has been around for very long time. Humira is used in the treatment of rheumatoid arthritis. The market has consistently called for the death of Humira for quite some time. Our analyst Steve Crane dug into the AbbVie opportunity and was able to identify good things that other investors were missing. Not only had AbbVie been able to continue to keep Humira relevant, the launch of their hepatitis C vaccine was much better than expected. We see AbbVie as the strongest name in the biotech industry group and believe continued execution along with expected new drugs and share buybacks should position the company for continued outperformance well into 2018. And I want to make a special mention of the work that our analyst Greg Buckley did in the utility sector. The work he did to not only understand the operating metrics of stocks that we own, but also the regulatory environment paid off handsomely. The utility sector only makes up about 3% of your fund but it provide outsize returns in 2017. I've informed Greg that he has set a very high bar for value coming from utilities going forward. Looking ahead into 2018, we anticipate a continuation of the current conditions of strong U.S. and global economic activity and growth and slowly rising interest rates in 2018. The underlying fundamentals remain strong for companies which combined with new tax legislation should lead to higher profitability and sustain the economic expansion. The new tax bill benefits those companies that generate most of the revenue domestically and have higher effective tax rate such as banks, retailers, industrials and energy companies. We have seen many companies raise earnings guidance for 2018 which has further driven the market higher. While we remain optimistic about the stock market long-term, we expect volatility to increase from the record low levels in 2017. The S&P has gone without a correction of 3% for the longest period on record. As you know, tensions have been rising between the U.S. and North Korea. It's really difficult to speculate what will happen but clearly the 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 to stay invested as time in the market is extremely important. Over the long-term buy and hold investors fare far better than those who are in and out of the market. And over the next week, we’ll be rolling out a new series of reports about the benefits of staying invested. So please keep an eye out for these. I want 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 made that commitment in 2011 we have exceeded the minimum in each year most recently distributing 9.8% in 2017. We understand that many of our shareholders placed significant amount of importance on this distribution. Because of the sizable distributions we pay out it's important that 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 we have paid to you to get a proper understanding of your total return because the majority of the return on the stock comes from that. Before I open up to 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 are supported by a strong infrastructure and accounting in compliance. We are a team that takes a long-term view and incorporates disciplined approach to investing which focuses on identifying quality companies that are executing at the highest levels and are trading at attractive valuations. I am optimistic of our ability to continue to deliver good investment results for our shareholders. With that, I will now open the call to your questions.

[Operator:]

[Operator Instructions]

[Lyn Walther:]

Okay, our first question. There is a lot of debates around the active versus passive investing and fee structures. How does your expense ratio compare to your peers?

[Mark Stoeckle:]

It’s a really good question Lyn because one of the things that is important to us here at Adams Fund's is that we have an expense ratio that is low. I will tell you it was in place before I got here five years ago and it remains an important consideration for both senior management and the Board. Like when you look at what active management cost in the marketplace are 56 basis points - are approximately 56 basis points expense ratio was about half that of active managers. So not only we're proud of that, it is something that is very important to both Management and the Board.

[Lyn Walther:]

We have another question, what do you think the impact will be of the new tax plan and have you made adjustments to the portfolio based on these announcements?

[Mark Stoeckle:]

Well I think the reaction to the tax plan has been I believe better than most people expected. We've seen it manifest itself in a couple of ways. One is, we’ve seen earnings estimates for companies have gone up and in some cases quite significantly. So there has been a direct impact on companies and their bottom line. And the other thing that we've seen is companies deciding to take forward some of the savings that they will be getting and changing the way they pay people, we've seen that all with one-time bonuses, we've seen with some companies that have decided to raise hourly wages and we seen some companies that have gone as far as just to say that they will be looking at increasing pay for employees overtime. So I think that - for most companies it's been a good strategic move the way they have at least identified how they will spend part of it. I think one of the unknowns is how they will spend the balance of it. Certainly those companies have come in and made one-time payments. These tax benefits will certainly go beyond one year. So one of the things that we’re looking at very closely is power management thinking about this new largest strategically. And I think that our opinion is we need to give companies plenty of time to be thoughtful about how they're going to strategically change the way they do things given the increased earnings and cash flow that they have seen from this. We have not significantly changed many things in the portfolio as a result of this but we are keeping very close tabs of it and we'll be reviewing that as we go through the balance of the year.

[Lyn Walther:]

Our next question, regarding the turnaround in the energy sector the U.S. is a major exporter of various gas, oil et cetera what is your outlook for the energy sector?

[Mark Stoeckle:]

That's a really good question, I think one that we feel very comfortable with is our sister company Adams Natural Resources Fund is a fund we also run. We feel good about the - looking out over the horizon for energy. The biggest reason for that is we're very comfortable where we are today with supply and demand. It's something that we spent a lot of time looking at. One of the things we do not do is try to make a call on the price of crude, but we do spend Greg Buckley and Mike Kijesky and Jim Haynie who run the fund are. We spent a lot of time looking at both U.S. supply and demand, as well as global supply and demand. And we are comfortable where the crude is gotten to the at least WTI has gotten to the low to mid 60s. We think that is a good area especially for E&P companies. We have a - within PEO the Adams Natural Resources Fund and within - therefore it’s by extension and Adams Diversified Equity Fund. We have a commitment to the Permian where there are a lot of pure play E&P companies that benefit from crude being pretty stable here in the low to mid 60. So looking at over the horizon we feel pretty good about where energy is right now in both the fund PEO and in ADX.

[Lyn Walther:]

And I think this is our last question, given that the market has been at record high, how are you positioning the portfolio what changes are you making?

[Mark Stoeckle:]

One of things that's important about the way we manage the fund is that we are always fully invested. So we will not - even if we think the market has gone ahead of itself, we will not raise cash to reduce risk. What we will do is look to see where we’re taking our risk within each of the sectors and adjust accordingly. One of the things that we do and have been doing for certainly the back half of 2017 and the beginning of 2018 is trimming our winners. Risk control is a very important part of the way we manage ADX, and part of that is making sure that we are comfortable with position sizing, and one of the things you will not see is that you can see in some other funds is that we just let the winners run. We think that that proposes outsize risk to the portfolio and therefore we - as the company's position in the fund get bigger and they perform well, we will systematically reduce some of our exposure there. That’s primarily what we've done so far. The other thing that I think is really important anytime you have a market that is done with this market did last year has started to do this year is, we all should remember that markets generally do not go down because of valuation. They go down for a number of other things but certainly isn’t valuation. And markets can outperform for a lot longer than you expect, they can also underperform a lot longer than you expect. So, I think simply using a number that the market is outperformed by 6% to 7% this year so we must be well ahead of ourselves, we certainly could be ahead of ourselves a bit. But I would say that the market can go on a lot longer than most people think, and our job is to make sure that the risks that we're taking within the portfolio are commensurate risk what we’re seeing in the economy and in the market.

[Lyn Walther:]

Okay. That concludes our conference call today. Thank you for joining us. Our next call will be held in July. We look forward to speaking to you again at that time. Thank you.

[Operator:]

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.