portfolio and economic commentary€¦ · portfolio and economic commentary. 2. nd. quarter 2016....

Portfolio and Economic Commentary2nd Quarter 2016

With U.S. stock markets initially range-bound, the bigstory in financial markets for most of the quarter wasbonds, specifically negative yields on governmentbonds. That was until June, when the relative calm inglobal stock markets came to an abrupt end. As themonth unfolded, trading became increasingly influencedby shifts in sentiment and polls predicting the outcomeof the United Kingdom’s so-called Brexit referendum oncontinued European Union membership. Finally,upending most forecasts and taking world financialmarkets by surprise, the United Kingdom voted to leavethe European Union on June 23rd.

In the wake of the vote, the British prime ministerresigned. Overnight, British pound sterling fell 11% to1.33 against the U.S. dollar, its lowest level since 1985.The euro fell 2.4% to 1.10 versus the dollar. U.S.,developed international, and emerging-markets equitiesall plummeted. The S&P 500 fell by 3.6%, while theFTSE 100 dropped by 8.7%. Financial stocks were thehardest hit, while defensive dividend-paying utility andtelecommunications sectors saw strong buying. Awayfrom equities, investors fled to “safe haven”investments: gold, Treasury bonds, and certaincurrencies, such as the Swiss franc, Japanese yen, andU.S. dollar. Days later, ratings agency Standard &Poor’s stripped the United Kingdom of its triple-A creditrating and downgraded the European Union’s rating.Fitch and Moody’s, the other major ratings agencies,also cut their U.K. ratings.

However, in the week following Britain’s historic vote,global equities markets rallied as the quarter ended,despite still significant uncertainty regarding theeconomic, political, and financial market implications ofBrexit. When the dust settled, the Vanguard FTSEDeveloped Markets ETF was down just a slight 0.1% forthe quarter and down 1.9% year to date, while theVanguard FTSE Europe ETF had fallen 1.9% and 4%for the quarter and year to date, respectively.

By month’s end, the amount of government debt(mainly Eurozone and Japan) sporting negative yieldshad soared by nearly $1 trillion, to reach an astonishing$11 trillion. While not negative, the yields on U.K. 10-year gilts breached the 1% level, falling to 0.87% byJune 30. U.S. 10-year Treasury bonds ended thequarter with a yield of 1.48%, close to their low-watermark reached in July 2012. Falling yields have beendriven by economic growth concerns; central banks’ongoing low/negative interest rate policies, includinggovernment intervention (buying) in bond markets; andheightened demand for perceived risk-free assets as areaction to the uncertainty surrounding Brexit’s impact.They have been joined by expectations of imminentrate cuts from the Bank of England, potentialadditional bond buying by the European Central Bank,and a growing consensus that the Federal Reserve willfurther delay raising U.S. rates.

While we do not expect a sharp rise in interest ratesany time soon, at such low starting yields, expectedreturns to core bonds are extremely low. Investors areearning very little (or actually paying via negativeyields) for the safety of holding government bonds.

MARKET AND ECONOMIC OUTLOOK

2www.altriuscapital.com

2nd Quarter 2016

Portfolio and Economic Commentary

Equities

We still believe that U.S. equities, particularly growthcompanies, are overvalued relative to value andinternational stocks and that the expected return for thebroader U.S. market over the next five years will be fairrelative to their risks. While quarterly and year-to-datereturns for global developed equities continued to bedragged down by financial sector holdings, our U.S.Large Cap Dividend Income strategy posted strongrelative and absolute returns, yielding 7.1% and soundlyoutpacing the S&P 500 return of 3.83% and the Russell1000 Value Index gain of 6.29% year-to-date.

Though downside risks remain significant, we view theinitial market reaction to Brexit as a short-term shockthat does not change our longer-term five-year returnexpectations for European equities. Accordingly, as weanalyze the range of possible outcomes stemming fromthe British vote to exit the European Union, we willweigh potential changes to our views or positioningfrom that perspective, while incorporating the likelihoodof increased shorter-term market volatility.

Though international indices have seen significantnegative pressures this year, our International ADRDividend Income strategy has remained relatively flatlosing just 0.40% on the year and has soundly outpacedthe negative returns of the MSCI EAFE index and MSCIEAFE Value index which have declined 4.42% and6.64% respectively year-to-date.

Fixed Income

We saw exceptionally resilient performance for ourUnconstrained Fixed Income strategy which snappedback strongly yielding an 11.8% year-to-date return andsoundly outpaced the Barclays Aggregate Bond andHigh Yield index returns of 5.31% and 8.89%respectively. Though there has been a flight to higherquality bonds due to economic uncertainty, we continueto favor high yield bonds over investment grade corebonds believing high yield issues will be less sensitivewhen rates eventually begin to rise.

Low Yields, Low Returns

Against the backdrop of extremely low bond yields thatlooks set to continue, and our expectation that we are alsotransitioning to an extended period of lower returns forU.S. stocks, in this quarter’s commentary we examine theinterplay between yields and valuations and how theyinfluence our investing strategy. We then discuss the keydrivers of subpar returns across many conventional assetclasses before addressing the impact of changing returnexpectations on a traditional 60%/40% portfolio, splitbetween stocks and bonds. Lastly, we highlight how weare positioning our portfolios going forward.

The S&P Global Developed Sovereign Bond Index hit anew record-low yield of 0.4% as of June 30, 2016.Despite that, it has generated an 11% return so far thisyear in U.S. dollar terms. Also, as noted previously, theamount of global sovereign debt with negative yields hadreached $11 trillion by the end of June, accounting forroughly 55% of total outstanding government debt indeveloped countries. Low, let alone negative, currentbond yields imply very low five-year expected returns forcore, investment-grade bonds. However, as we have seenfrequently over the past several years, and again earlierthis year, they don’t preclude strong returns over shorter-term periods if bond prices are driven higher by investorfears, ongoing central bank bond purchases, and/orspeculative short-term macro bets. Eventually though, the“bond math” catches up to you. In other words, you can’tescape the gravitational pull of the starting bond yield indetermining your total return as a bond investor.

Similarly, starting stock market valuations (i.e. price-to-earnings multiples) have a historically strong inverserelationship to future market returns. That is, the higherthe current valuation, the lower the future realized return.Another way to see this is that a company’s earningsyield, or reciprocal of its P/E ratio (i.e. a 20x P/E ratioimplies a 5% earnings yield), is directly correlated withfuture market returns. Thus, low earnings yields indicatelow future returns.

MARKET AND ECONOMIC OUTLOOK CONT.



Unlike bonds, which have a defined stream of cashflows (interest payments) and a set maturity date, stockmarket returns are subject to a much wider range ofpotential outcomes due to uncertainty and variation inearnings growth and valuation multiples. Wall Streetanalysts, and investors in general, have a very poor trackrecord of predicting near-term earnings—as can be seenby the constant revisions to their forecasts. Valuationmultiples are impacted by earnings fundamentals but arealso driven by investor sentiment (put simply, greed andfear) and herd behavior, at least in the shorter term,making them unpredictable. Consequently, we neverinvest based on short-term stock market forecasts as weview them as no better than a coin toss.

However, even when looking out over longer-term (five-to 10-year) periods and market cycles—a period overwhich we believe fundamentals ultimately are reflectedin market prices—we are very sensitive to the risk of“false precision” in estimating stock market returns.That is why we incorporate a range of plausiblescenarios, assumptions, and potential outcomes in ouranalysis. Nevertheless, in looking at extendedinvestment time horizons, it becomes clear: valuationmatters. Higher valuations mean lower earnings yields,which eventually leads to lower expected and realreturns.

The 60/40 Portfolio - Unattractive Expected Returns

While we have frequently discussed our returnexpectations for U.S. stocks and core bonds, here wewill discuss the return prospects for a traditional60%/40% stock/bond portfolio. No matter how you sliceit—in nominal or real terms, in absolute terms or relativeto historical performance—looking out over the nextfive years, the return prospects are poor.

Looking at some history, the chart at right shows rollingfive-year annualized nominal returns for the traditional60/40 portfolio (60% S&P 500 index and 40% corebond index), starting in 1950. We have assumed annual

rebalancing back to the 60/40 weights. Over thatperiod, the average annual return was 9.5%. The reddot in the chart signifies our base case return estimatefor the 60/40 of roughly 2.5%–3%. This is derivedfrom our current estimate of roughly a 4% return forthe S&P 500 and a 1% return for core bonds over thenext five years. As can be seen from the chart, a 3%annualized five-year return would be among the worsthistorical returns for the 60/40 portfolio. Of the 738rolling five-year periods since 1950, only 67 have hada return less than 3%. The results are much the same ifwe look at things in “real return” terms (net ofinflation) as the average annual real return (i.e. eachrolling five-year nominal return reduced by theinflation rate over that same five-year period) was7.6%. In contrast, our base case expected real return isroughly 0.5%-1% (assuming 2% expected inflation).

Assuming our return expectations play out, investors ina traditional 60/40 portfolio will barely stay ahead ofinflation. And they will earn around 6.5% less per yearthan the historical average 60/40 return, or 37% lesscumulatively over the entire five years.



2nd Quarter 2016


The historical chart also shows the 60/40 portfolio hasgenerated above-average returns over the past severalyears. A key driver of this strong performance has beenthe impact of quantitative easing (purchases ofgovernment debt in an effort to add liquidity to bondmarkets) and other aggressive central bank policies,which have helped push down interest rates. This hasmeant higher bond prices and capital appreciation for thecore bond index in addition to its paltry income yield.Central bank policies also contributed to the meaningfulincrease in stock market valuations. This was one offormer Fed Chair Ben Bernanke’s explicit objectiveswhen the Fed undertook multiple bond purchaseprograms in the years following the financial crisis.Although there was a sharp V-shaped rebound in S&P500 earnings off the extreme lows of the 2008–2009financial crisis, which supported a rebound in stockprices, the hoped-for stimulative “wealth effect” for theactual economy has enabled only sub-par growth.

In more recent years, a significant majority of the S&P500’s return has come from P/E multiple expansionrather than actual earnings growth. For example, for thefive years ending March 31, 2016, the S&P 500 gained73%, but 46 percentage points of that total return camefrom P/E expansion. Meanwhile, total earnings per sharegrowth was just 6% over the entire period (i.e. 1.2%annualized) while dividends accounted for roughly 11%.

The 12-month trailing P/E of the S&P 500 is currentlyaround 23x, compared to its median since 1950 ofroughly 17x. As long as interest rates remain atextremely low levels, P/E multiples may remain higherthan normal. If current interest rate levels are notsustainable, then it is likely the valuation multiple willdrop toward more normal historical levels. If rates dostay at such depressed levels for the next five years (thepossible “lower for longer/new normal”), it likely meanseconomic and earnings growth have remained quitedepressed as well, which may not be bullish for stockmarket valuations. Our base case scenario for U.S.

stocks assumes a 17x multiple for the S&P 500, and welook at different scenarios and sensitivities across arange of multiples around that historical P/E ratio.

Stocks vs. Bonds

We constantly see market strategists point to very lowbond yields as a reason to favor or overweight stocksversus bonds. While we have subpar returnexpectations for stocks, we also believe stocks arelikely to generate higher returns than core bonds overour five-year horizon (absent a deflation/depressionscenario) to the tune of roughly a 3% annualized returnpremium in our base case. However, as we alwayspoint out, you shouldn’t look at expected returns in avacuum while ignoring the risk side of the equation.Stocks have significantly higher volatility, higherdownside risk, and higher risk of capital loss than corebonds. This seems like an obvious point, but rarely dowe hear these strategists make it. This being the case,you should always be compensated for this risk with ahigher expected return from stocks compared to coreinvestment-grade bonds. This is referred to as theequity risk premium.



2nd Quarter 2016


Of course, the fact that the expected return for stocks ishigher doesn’t mean the actual return over a given timeperiod will turn out to be higher. Therefore, why wouldanyone buy stocks if the expected return from owninglow-risk bonds was almost as good?

The actual average annualized five-year excess returnfor stocks over core bonds was 4.6%, going back to1950. However, the average equity return premium hasfallen to 3.4% over the past 30 years—close to ourcurrent expected premium of 3%. There have beenseveral periods where the actual equity risk premiumwas negative which was clearly not the market’sexpectation at the beginning of those periods.

Informed investors can reasonably disagree aboutwhether the current expected excess return from owningstocks over bonds is sufficiently high to justifyoverweighting stocks versus bonds (or converselywhether it is too low and therefore favors bonds versusstocks). However, to state that if you believe stocks aregoing to return more than bonds over the next year, youshould therefore hold more stocks and less bonds thanyou normally would strikes us as overly simplistic andpotentially dangerous to one’s financial and mental well-being. Presumably, people who normally hold bonds intheir portfolio are more sensitive to shorter-term marketvolatility and losses, and therefore own bonds tomitigate risk. It is not a simple comparison of whichasset class is likely to return more, because the certaintyof that outcome is nowhere near 100%, especially overshorter-term periods. Even over longer-term periods,where stocks are much more likely to outperform bonds,the path to that long-term outcome will assuredly not bea smooth one. This creates the conditions for moreconservative, risk-averse investors, with too much stockexposure relative to their risk tolerance, to harm theirlong-term returns by reducing their stock exposure atexactly the wrong times—during the inevitable marketselloffs and cyclical scares. In the long run, a largerallocation to equities actually makes these types of

investors worse off.

In addition to the relative return premium you shouldget from owning stocks versus core bonds, we alsobelieve there is a minimum absolute equity return oneshould expect to earn in order to be fully compensatedfor equity risk and to be “fully allocated” to equities.(Note: For a client with the risk tolerance appropriatefor a 60% stock/40% bond balanced portfolio, “full”equity exposure is 60%.) Our absolute-return hurdle forthe U.S. stock market is an upper single-digit return. Ifexpected returns are in that ballpark, we consider thestock market to be within its “fair value range” (again,we avoid over-reliance on a single point estimate), andall else equal, we will be fully allocated to stocks in ourbalanced portfolios. (Note: Our three balancedportfolios contain differing exposures to fixed-incomesecurities and equities with the key determinant ofweightings being investor risk tolerance and desire forcapital preservation versus willingness to assumegreater risk for potential higher long-term returns. Theyare structured and managed so as to limit losses to pre-specified percentage thresholds.)

Our current analysis suggests U.S. stocks are tradingabove their fair value range with expected returns inthe low single digits (or worse), except in ouroptimistic scenarios. Therefore, we are underweightU.S. stocks (particularly growth stocks and even thosewe categorize as persistent earners) and continue tofocus on our core dividend/value process as the P/Eratio for our portfolio is more in line with historicalaverages while also adding an above average dividendyield to supplement long term performance whilepotentially lowering volatility. Because expectedreturns for core bonds are also quite unattractive, weare also underweight to investment grade bonds andcontinue to focus opportunistically in beaten downsectors and in the broader high yield asset class whichwe believe offers better absolute and relativeperformance return potential.



2nd Quarter 2016


Portfolio Positioning

Due to continued sub-par growth expectations andeconomic uncertainty, we are underweight stocks ingeneral, and U.S. stocks in particular. We do howeverfavor a mix of developed European and internationalequities to which we remain overweight relative to ourbalanced benchmark. Our analysis and modelingsuggests both these broad markets offer attractive five-year return potential, driven by improving earningsgrowth and expanding valuation multiples. We don’tdiscount the higher potential downside risk and volatilityfrom these markets, but unlike our expectations for U.S.stocks, we believe we are being fully compensated fortaking on these near-term risks, with low double-digitexpected returns in our base case.

Turning to the fixed-income side of the portfolio, we areunderweight core bonds in favor of a flexible,unconstrained and opportunistic approach. We expect toearn a meaningful return premium from our high yieldsecurities relative to the core bond index over the nextseveral years. In exchange for the higher expectedreturns, we know we are taking on more credit risk andthat they won’t hold up as well if there is deflation or ashort-term flight-to-safety event or shock that pushesTreasury bond yields even lower. However, our highyield positions have less sensitivity to negative priceimpacts from rising Treasury rates. Therefore, inaddition to positive expected excess returns, the issuesalso play a valuable risk-management role in ourportfolios.

Putting It All Together

Given current yields, valuations, and earningsfundamentals, our balanced Global Income strategy isnot expected to generate returns as high as the long-term historical average of a traditional 60/40 portfolio,even with a potential return margin coming from ourability to tactically allocate to what we believe aremuch more attractive asset classes, sectors andsecurities. Our base case expected annualized five-yearreturn for our balanced Global Income strategy as it iscurrently allocated, is in the 5%–6% range. That ismeaningfully higher than the approximate 2.5%–3%return we expect for the traditional 60/40 portfolio.

Of course, there is no guarantee the base case will playout. There is a wide range of potential returns,depending on what scenarios actually unfold over thenext several years. However, we view our base case asbeing the most likely, and we believe our asset classassumptions are reasonably conservative.

Another important message is that, as always, investorsshould have realistic return expectations as they lookout over the next five or so years at least. These returnexpectations should be based on current valuations andstarting yields, and they should encompass a range ofreasonable economic, fundamental, and financialmarket scenarios. Similarly, investors should also becautious in assuming returns will mirror their long-termaverages. There is no economic law that says 60/40investors are owed that historical 9.5% annualizedreturn.



2nd Quarter 2016


Conclusion

We believe patience, discipline, and the tacticalflexibility and expertise to invest across a broadopportunity set will be important attributes fornavigating the next five years. We doubt investors willbe able to simply rely on the U.S. market tailwinds ofdeclining interest rates and rising P/E multiples that haveboosted returns for core bonds and stocks over the pastseveral decades.

Volatile markets, which we also expect, will likelychallenge investors’ convictions and emotions. Asalways, it is critical to do an honest self-assessment tounderstand your temperament, risk tolerance, andobjectives, and to invest in a portfolio that is managed ina manner that is consistent with those attributes beforemarket volatility strikes rather than in the heat of it,when emotions are likely to cloud judgment and lead topoor investment decision-making.

Successful investing requires patience and theunderstanding that investing is a part of a process, nota one-off decision, toward achieving your long-termfinancial goals; there will be inevitable and consistentlyunpredictable shorter-term market ups and downsalong the way. Remaining focused on the long-termobjective is key, as is maintaining a consistentinvestment discipline to guide your decisions overtime. Our valuation-driven discipline means we can useshort-term market volatility to our long-term benefit—managing risk while taking advantage of theinvestment opportunities created by other marketparticipants’ lack of discipline, patience, andflexibility.

As always, we appreciate your continued trust andconfidence. Should you have questions regarding ouroutlook, strategy or your personal financialcircumstances, please don’t hesitate to contact us.

-The Altrius Investment Team



2nd Quarter 2016


• We dig deep for value often viewing crisis as anopportunity. We believe that fundamental research andpatience are critical to long term success and that overtime, the price of a company will rise to reflect thevalue of the underlying firm viewing each purchase asif were buying a piece of a business – not simply astock certificate.

• We believe that global revenue generation is a keycomponent to growth and sustainability and invest incompanies with global growth opportunities. We areunafraid to take contrarian positions, but remaindiligent about the risks of a global economy.

Our investment philosophy is predicated on a time-tested, three pronged approach providing solid riskadjusted returns to our investors for well over a decade.

• We believe in the importance of getting paidimmediately for the risks which are taken and focus onbusinesses which compensate our clients withdividends and above average interest. We believethis income stream, coupled with capital appreciation, isa vital aspect of total return.

GLOBAL INCOME STRATEGY COMMENTARY

9

The Global Income strategy has yielded strong gains thisyear garnering a 7.47% return versus a gain of 3.4% forthe blended balanced benchmark year-to-date. Thetrailing 10-year returns for the strategy are 5.60% versus6.09% for the blended benchmark. The twelve monthtrailing yield for the Global Income strategy stands at5.22% versus 1.71% for the Vanguard Balanced indexfund (VBINX).

During the quarter, we slightly reduced our exposure toU.S. equities while increasing our allocation tointernational stocks. We remain underweight to atraditional 60% stock/40% bond portfolio and ourbalanced benchmark due to the risks which remain andvaluation metrics. That said, our portfolio has a moreattractive price to earnings ratio of 14.32 which is farless than the broader market indices – most of whichcurrently maintain multiples in excess of 20 timestrailing earnings. Our focus continues to emphasize theimportance of immediate income to our investorsparticularly in this volatile, low interest rateenvironment, which we believe will persist for longerthan most economists. In the fixed income sector, ouremphasis remains on high yield bonds, which we believemore adequately compensates our investors for creditrisk, while providing better protection in a potentiallyrising interest rate environment.

PERFORMANCE COMMENTARY

Top Five Equity Holdings Weight

Marathon Oil 1.14%

Aflac 1.10%

AT&T 1.10%

Exxon Mobil 1.09%

Chevron 1.08%

Top Five Fixed Income Holdings Weight

Rent-A-Center 0.62%

Icahn Enterprises 0.59%

Anglogold Ashanti 0.59%

International Game Technology 0.58%

American Greetings 0.58%

35.2%

20.1%

42.6%

2.1%

Disciplined AlphaDividend

International ADRDividend Income

Unconstrained FixedIncome

Cash

Sector Allocation

www.altriuscapital.com


Classic value stocks sell at attractive valuations andprovide above-average dividend yields and growth.Persistent earners are companies which have steadyand predictable earnings and that are selling belowtheir historic valuation. The distressed/contrariancategory refers to stocks that are out of favor due towhat we perceive to be temporary factors and are likelyto appreciate substantially as the temporarilydistressing factor recedes. Typically the distressedcategory is the smallest in the portfolio.

As value investors, we constantly focus on our duty toprotect the principal of our investments even as we lookfor ways to grow them over time as well. As economists,we remain alert to trends taking place in the largerglobal economy. As analysts, we seek to invest insecurities priced with a margin of safety in order toaccount for their near term volatility and our uncertaintyabout what the future holds. With this in mind, we lookfor opportunities in three specific categories: classicvalue, persistent earners, and distressed or contrarian.

DISCIPLINED ALPHA DIVIDEND STRATEGY COMMENTARY

10

The Disciplined Alpha Dividend strategy has had anoutstanding year gaining 7.09% outpacing the Russell 1000Value index which returned 6.3% year-to-date. The strategyhas produced sound ten year risk adjusted returns roundlybesting its indices and peer group for the period. The trailingannualized ten year returns were 8.12% for the strategy,6.13% for the Russell 1000 Value index and 7.53% for theDow Jones US Select Dividend index.

Our stock selection has had a positive effect on absolute andrelative performance while our sector allocation weightinghas detracted from relative performance against the Russell1000 Value index during the first half of this year. Thecommunication services, financial services and basicmaterials sectors have been our largest attributors to relativeoutperformance, while the utilities and technology sectorswere the largest detractors through June 30th. Thoughmaintaining a focus on dividends and above average incomegeneration, we believe the utility and real estate sectorsremain overvalued and will perform poorly in a potentiallyrising interest rate environment; thus, we do not have anypositions in the sectors. The top performers for the year havebeen Freeport-McMoRan (52.7%), AT&T (28.94%),Verizon Communications (23.6%), Aflac (22.1%) andMarathon Oil (20.5%). The bottom performers were KKR &Co. (-18.9), Metlife (-15.9%), General Motors (-14.7%),Pitney Bowes (-12.0%) and Wells Fargo & Co. (-11.6).


Top Ten Holdings Weight

Marathon Oil 3.23%

Aflac 3.12%

AT&T 3.11%

Exxon Mobil 3.10%

Chevron 3.06%

Verizon 3.04%

Pfizer 3.04%

International Business Machines 3.00%

Kellogg 2.99%

Cisco 2.97%

Sector Allocation (Morningstar)

22%

18%

14%14%

11%

9%

6%6%

Financial Services

Energy

Technology

Consumer Cyclical

Industrials

Consumer Defensive

Communications Services

Healthcare



As one may recognize from the below chart, our firmhas consistently provided a steady stream of income toour clients in the form of dividends. It is our assertionthat this income stream has not only reduced the risk ofour portfolio, but also provided a large part of the totalreturn thereby leading to our performance success overthis past tumultuous decade plus.

We believe that dividends allow our investors to “getpaid to wait” while patiently working through volatilebusiness and market cycles. This strategy providesemotional support during difficult cycles enablinginvestors to weather turbulent periods utilizingdividend income for personal needs or to reinvest cashat lower valuations. Our strategy is not only groundedin psychological and behavioral finance concepts, butis also supported by empirical evidence outperformingin both negative and full market cycles.

Dividends also act to align the interests of corporationsand shareholders in helping to eliminate the agencyeffect. Corporate boards have recognized the value ofdividends in stabilizing their stock price andencouraging investment during both high and lower taxregimes. In supporting and increasing dividends overtime, managers are compelled to maintain a reliablestream of cash flows to shareholders rather than wastecapital on those expenses adding little to corporaterevenue including executive perks, pet projects, and ill-timed, unwise acquisitions. It appears a paradox;however, our experience and academic studies havedisplayed that sufficient investment for a good businesscan still occur in conjunction with dividends asmanagers are forced to invest cash flow more prudentlyand only in those capital investments in which they havethe highest conviction in adding to corporate revenueparticularly since stocks buybacks are often ill-timed.


11

ALTRIUS: THIRTEEN YEARS OF CONSISTENT DIVIDENDS

Source: Standard and Poor's


The strategy has consistently delivered a higher dividend yield than the S&P 500 since inception.


0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50% Altrius DA S&P 500


12

We sold Darden Restaurants (DRI) toward the end of the quarter on June 24th taking 44.6% gains since our initial purchase on December 17, 2012 (not including the sizable dividend from our initial purchase price of $46.69). The sale reduces our U.S. equity exposure while increasing our allocation to international equities. At the time of our purchase of Darden, the Street had a highly unfavorable consensus of the company driving shares lower with a certain belief that the restauranteur would never turn around. Though we had to remain patient, and added to the holding as it continued to sell off, Darden well outperformed both the S&P 500 and Russell 1000 Value indices during our holding period – even without including the company’s outsized dividend.

We used the proceeds from the sale of Darden to purchase Lloyds Banking Group as we don’t believe British banking is dead though blood was certainly rolling in the streets of London after the Brexit vote. Many issues will need to be worked through before we know the full impact on British and European banking – and the longer term impact on the economy. However, with Lloyds 25%+ sell-off on the date of our purchase, we believe we have a good entry point to establish a long term position as the European economy continues to slowly recover.

CHANGES TO OUR PORTFOLIOS



Classic value stocks sell at attractive valuations andprovide above-average dividend yields and growth.Persistent earners are companies which have steadyand predictable earnings and that are selling belowtheir historic valuation. The distressed/contrariancategory refers to stocks that are out of favor due towhat we perceive to be temporary factors and are likelyto appreciate substantially as the temporarilydistressing factor recedes. Typically the distressedcategory is the smallest in the portfolio.

As value investors, we constantly focus on our duty toprotect the principal of our investments even as we lookfor ways to grow them over time as well. As economists,we remain alert to trends taking place in the largerglobal economy. As analysts, we seek to invest insecurities priced with a margin of safety in order toaccount for their near term volatility and our uncertaintyabout what the future holds. With this in mind, we lookfor opportunities in three specific categories: classicvalue, persistent earners, and distressed or contrarian.

INTERNATIONAL ADR DIVIDEND INCOME STRATEGY COMMENTARY

13

The International ADR Dividend Income strategy hadpositive relative performance against its primarycomparative index, but slightly negative absolute returns forthe year declining 0.41%. The S&P Int’l DividendOpportunities index gained 6.77% while the MSCI EAFEValue index was lower by 6.65%. Since its inception onJune 1, 2010, the strategy has produced annualized returnsof 3.71% versus 2.23% for the S&P Int’l DividendOpportunities and 4.02% for the MSCI EAFE Value indicesrespectively.

Our sector allocations and stock selections have had positiveimpacts on our relative performance during the year againstthe EAFE Value index. The financial services, consumerdefensive and basic materials sectors attributed the greatestportion to relative performance while the communicationssector and our lack of any real estate holdings were the onlymodest detractors. Going forward, we believe we will findmore value amongst international issues than U.S.companies while expecting the energy and basic materialssectors to be continued benefactors of accommodativemonetary policy and eventual global economic stabilization.The top performers for the year have been Statoil (27.7%),POSCO (25.9%), Royal Dutch Shell (25.4%), BritishAmerican Tobacco (20.3%) and Taiwan Semiconductor(19.6%) while the bottom performers were Credit Suisse(-48.1%), Ensco (-36.9%), Mitsubishi Financial (-27.4%),Aegon (-27.2%) and HSBC (-16.7%).



HSBC 4.43%

Lloyds Banking Group 4.32%

Taiwan Semiconductor 2.89%

British American Tobacco 2.82%

National Grid 2.74%

Unilever 2.74%

Anheuser Busch 2.70%

Diageo 2.65%

Statoil 2.61%

Nestle 2.59%

Sector Allocation (Morningstar)

21%

19%

14%

14%

10%

7%

5%

4%3% 3%

Financial Services

Energy

Basic Materials

Consumer Defensive

Healthcare

Industrials

Consumer Cyclical

Communication Services

Technology

Utilities



INTERNATIONAL ADR DIVIDEND INCOME STRATEGY COMMENTARY

14

We sold Darden Restaurants (DRI) toward the end of the quarter on June 24th taking 44.6% gains since our initial purchase on December 17, 2012 (not including the sizable dividend from our initial purchase price of $46.69). The sale reduces our U.S. equity exposure while increasing our allocation to international equities. At the time of our purchase of Darden, the Street had a highly unfavorable consensus of the company driving shares lower with a certain belief that the restauranteur would never turn around. Though we had to remain patient, and added to the holding as it continued to sell off, Darden well outperformed both the S&P 500 and Russell 1000 Value indices during our holding period – even without including the company’s outsized dividend.

We used the proceeds from the sale of Darden to purchase Lloyds Banking Group as we don’t believe British banking is dead though blood was certainly rolling in the streets of London after the Brexit vote. Many issues will need to be worked through before we know the full impact on British and European banking – and the longer term impact on the economy. However, with Lloyds 25%+ sell-off on the date of our purchase, we believe we have a good entry point to establish a long term position as the European economy continues to slowly recover.

CHANGES TO OUR PORTFOLIOS



corporate bonds, and mortgage- and asset-backedissues. Sources of added value include:Credit Analysis - We emphasize independent analysisand do not rely on credit agencies.Duration Risk - We avoid long, extreme durationshifts generally operating within a moderate durationrange typically between two and four years.High Income - Our research attempts to identify issuespaying above average income.Risk Premium Management - We seek to attain anattractive yield/spread in relation to a five-year treasurywithin acceptable levels of portfolio risk.

Based on our macroeconomic outlook over a five yearperiod, we employ top-down strategies that focus onyield curve positioning, sector rotation, duration andcredit risk management. We then utilize bottom-upanalysis to drive our security selection process andfacilitate the identification of undervalued securitieswith the potential for above average income. We investin securities that operate across diversified sectors in thefixed income markets of the United States, primarilythose in U.S. dollar denominated high yield andinvestment grade bonds, including government securities

UNCONSTRAINED FIXED INCOME STRATEGY COMMENTARY

15www.altrius-capital.com

MARKET OVERVIEW

The surge in the global bond market, which began totake shape in the latter half of the first quarter of 2016,continued largely unabated throughout the entire threemonths of the second quarter of this year; aside from alittle market turbulence in the final week of June causedby a referendum in the United Kingdom concerning itswithdrawal from the European Union. The Fed leftrates unchanged in its June meeting following therelease of a weaker than expected jobs report in May,yet signaled to the market that it still intended to raiserates twice before year’s end; however, the Fed’s priormessaging and follow-through has been anything butconsistent and/or reliable over the past twelve toeighteen months. In continued efforts to try andstimulate economic activity in their respective markets,the European Central Bank and the Bank of Japan havein recent months cut benchmark interest rates tohistorically low levels (i.e. the main deposit rate for theECB is currently -0.4%) and launched extensive bond-buying programs. As a result of these ‘stimulative’actions there is now over $10 trillion of negative-yielding government debt currently in the market. USTreasuries fell across the yield curve, with the 10-yearTreasury falling 30 bps from a yield of 1.79% on April1st down to 1.49% by June 30th. Oil prices continued to



Rent-A-Center 1.46%

AngloGold Ashanti 1.37%

Icahn Enterprises 1.36%

American Greetings 1.33%

International Game Technology 1.32%

Credit Acceptance Corp 1.29%

GAP Inc 1.28%

The ADT Corporation 1.24%

Oppenheimer Holdings 1.24%

Cooper Tire & Rubber 1.18%

Sector Allocation

24%

18%

13%

12%

9%

5%

5%

5%3% 3%

2% 1%

Consumer Discretionary

Energy

Financials

Industrials

Materials

Consumer Staples

Telecommunication Services

Information Technology

Healthcare

Services

Utilities

Cash


www.altrius-capital.com 16


recover during the quarter, beginning April around $36/bbland steadily climbing to finish the quarter at just above$50/bbl. As a result of the flattening yield curve, and thecontinued recovery and perceived stability in oil prices,longer duration US Treasuries and lower rated corporatebonds (predominantly in the energy sector) were the twobest performing fixed income segments during the secondquarter of 2016. YTD the 30-year Treasury is up +16.82%,putting the broader high yield market’s +9.06% return in adistant second place.

PERFORMANCE SUMMARY

The Unconstrained Fixed Income strategy posted a positivegross return of +8.37% for the second quarter of 2016,outpacing both the Barclays US Aggregate Bond andBarclays US Corporate BB+ indices, with each producingreturns for the quarter of +2.21% and +3.58% respectively.Year-to-date (as of June 30, 2016), the UnconstrainedFixed Income strategy is up +11.79% (gross of fees) versus+5.31% for the Barclays US Aggregate Bond and +7.68%for the Barclays US Corporate BB+ indices. Despitemaintaining exposure to industry sectors largely in-linewith that of the broader high yield market, theUnconstrained Fixed Income strategy generated excessreturns of roughly 300 bps over several high yield bondindices for both the second quarter and cumulative first sixmonths of 2016.

STRATEGY CHARACTERISTICS

There were no major changes to the Strategy’s sectorexposure over the prior quarter. Consumer discretionaryand energy remained the Strategy’s most heavily investedsectors, with each accounting for approximately 24% and18% respectively of dedicated strategy assets.

Investments in companies from the financial, industrial,and materials sectors also makeup a large portion of theStrategy’s assets, with each accounting for roughly 13%,12%, and 9% respectively. Much of the positiveperformance for the quarter was directly due to theStrategy’s exposure to the energy sector, with a number ofpositions rallying significantly during May and June as therecovery in oil prices showed signs of stability, resurrectingboth market demand and liquidity for energy related bonds.

Notable individual contributors to performance for thequarter were AK Steel (+24.8%), Plains Exploration &Production (+23.4%), Elizabeth Arden (+18.2%),AngloGold Ashanti (+13.3%), and Noble Energy (+12.3%)to name a few. Returns quoted above are calculated as endof quarter market-bid level relative to the strategy’saverage cost basis for the referenced position.

The Strategy’s overall credit quality is ‘B+’, which did notchange over the prior quarter’s aggregate rating. Both the

aggregate maturity profile and effective duration for theStrategy continued to modestly contract with each closingout the second quarter of the year at 3.56 years and 2.96


11%

32%38%

9% 10%

0%

10%

20%

30%

40%

50%

BBB BB B CCC N/R

Credit Rating Distribution

2nd Quarter 2016

0.0%

1.0%

2.0%

3.0%

4.0%

1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr20 yr30 yr

US Treasury Yield Curve

1 Yr Ago As of June 30, 2016

www.altrius-capital.com 17


respectively. The longest dated ‘non-callable’ issue held within the Strategy is set to mature in February of 2021.

STRATEGY OUTLOOK

In recent months we have focused heavily on identifyingand initiating positions in ‘higher quality’ high yield bonds,which we typically view as companies possessing BBcredit ratings with interest coverage (EBIT/interestexpense) greater than 4.0x and leverage (totaldebt/EBITDA) below 6.0x. As yields have compressedacross global fixed income markets, both sovereign andcorporate opportunities at the upper tier of the high yieldbond market (companies rated BB- or better) are lessabundant than they have been in the past six months. Bythe close of the second quarter of 2016, spreads in the highyield market have contracted over 250 bps since the marketlows experienced in mid-February of this year. However,valuations are still at reasonable levels, as the greater highyield market still maintains a +600 bps spread over similardated US Treasuries, which is inline with the long-termaverage. At the same time, the default rate in the corporatebond market is slightly below the long-term average rate,and should remain so as long as the price of oil continuesto recover, or remains stable at current levels, inducinginvestors back into the market and giving banks thereassurance they need to extend liquidity to troubledenergy companies. Roughly 75% of new issuances in thehigh yield market are derived from either companiesrefinancing existing debt (~45%) or M&A activity (~30%).

Given persistently low rates and high levels of M&Aactivity (2015 was a record with over $4.0 trillion incompleted deals) we anticipate full and partial ‘calls’ on anumber of our existing positions to increase in frequency inthe coming months. Faced with a flattening yield curveand increased call activity in the corporate bond market, wehave begun to extend our maturity window out to 2024 inscreening for new investments. Even though rates are athistorically low levels, we believe that general economicgrowth in the next couple of years will continue to be quitemodest, and given low oil prices inflation will likelyremain low. As always we remain disciplined inidentifying and selecting new investments that meet ourfundamental credit criteria, and as we favor no particularindustry at the moment we are currently looking into issuesfrom a broad array of industries including health care,information technology, business services, and industrialmanufacturing.

2%

36%

50%

12%

0%

10%

20%

30%

40%

50%

60%

< 1 Year 1 - 3 Years 3 - 5 Years 5 - 7 Years

Maturity Distribution


UNCONSTRAINED FIXED INCOME STRATEGY OVERVIEW

18

IASIS Healthcare8.375% 5/15/19 – 8.7% YTM

IASIS Healthcare LLC, a wholly owned subsidiary ofIASIS Healthcare Corporation, is an owner operator of17 acute care hospitals and one behavioral health hospitalwith locations in Texas, Arizona, Utah, Louisiana, andColorado. Along with its hospital operations, IASIS alsoowns and operates ‘Health Choice’, a services platformused to manage Medicaid, Medicare, and insuranceexchange health plans, as well as providing variousgeneral management and administrative services to third-party insurers and accountable care organizationnetworks. IASIS exhibits a high degree of financialleverage, which is currently around 8.0x (totaldebt/EBITDA), and it is highly unlikely that thecompany will generate sufficient free cash flows in futureperiods to reduce its existing debt level by any sizableamount. Given the high year-over-year capitalexpenditures required to maintain and operate its existinghospital facilities, IASIS typically produces negative tonear breakeven free cash flows, and revenue increasesare more than offset by escalating operating expenses.IASIS’ liquidity profile is modest with annual interestcoverage being maintained around 1.0x (EBIT/interestexpense) year-over-year, with further support if neededprovided by a $300 million senior secured credit facilitymaturing in February 2021, of which roughly $207million is currently undrawn as of the quarter end March31, 2016. Despite its high debt load and thin creditmetrics, IASIS is well established in all of its geographicregions, and continues to produce steady results from itscontinuing operations, and we are confident that liquiditywill remain adequate in the coming years even ashealthcare costs continue to escalate.

NEW PORTFOLIO PURCHASES

tions (23%), maintenance and servicing of its existingproduct portfolio (52%), and general consulting services(25%). Given its broad array of enterprise softwareproducts and service offerings covering a wide array ofindustries, Infor has broad customer diversification withno single entity accounting for more than 10% of eithercurrent outstanding trade receivables or consolidated netrevenues. Infor’s B-/CCC+ credit rating is representativeof its relatively high degree of financial leverage, whichstands around +9.0x (total debt/EBITDA) as a result ofacquisitions from prior years. The company’s liquidityposition is somewhat modest with respect to its totaloutstanding debt load, yet has proven stable over theyears with interest coverage (EBIT/interest expense)typically being maintained around 1.0x year-over-year,while free cash flow generation (CFO less capitalexpenditures) has been consistently positive with theexception of 2012 due to the completion of Infor’s $1.5billion acquisition of Lawson Software. Additionalsources of liquidity for Infor include an undrawn $150million revolving line of credit, as well as an evergrowing cash position on its balance sheet, which hasconsistently increased year-over-year from around $385million in 2012 to just over $705 million as of the mostrecent fiscal year end.

Infor is one of the world’s largest providers of enterprisesoftware and related services for both medium and largeorganizations in industries including but not exclusivelylimited to light and heavy manufacturing, healthcare,retail and hospitality, real estate management, and publicservices. Revenues for Infor are derived from three keysegments: sales of new software licenses and subscrip-

www.altrius-capital.com

Infor 6.500% 5/15/22 – 7.0% YTM

AECOM5.750% 10/15/22 – 5.2% YTM

AECOM (NYSE: ACM) is a fully integratedinfrastructure design and technical services firm thatcaters to government agencies, public and privatebusinesses, and international organizations in more than150 countries. Through three key operating segments(Design & Consulting, Construction, and Management),AECOM provides planning, consulting, architectural andengineering design, and construction and managementservices for the infrastructure, transportation, industrial,environmental, energy, utilities, and government sectors.AECOM has grown substantially through the years as aresult of pursuing a number of strategic mergers andacquisitions, most recently and notably the 2014acquisitions of URS Corporation (a major engineering,design, and construction firm) and the Hunt ConstructionGroup (a commercial construction firm). As a result ofthe aforementioned acquisitions, AECOM has become



19

one of the largest and most diversified engineering andconstruction companies in the United States, furtherenhancing its ability to provided fully integrated servicesto a broad and ever expanding customer base. Prior tothe acquisitions of URS Corporation and the HuntConstruction Group, AECOM traditionally maintainedrelatively low levels of debt of roughly $1.0 billion,while generating annual revenues between $6.0 and $8.0billion with EBITDA production of around $400 millionyear-over-year. AECOM now has over $4.0 billion oftotal debt on its balance sheet, but revenues as of its mostrecent fiscal year end more than doubled to over $18.0billion. In addition, free cash flows for the newconsolidated company are forecasted to be between $600to $700 million annually after the initial impact ofacquisition related expenses and transaction costs on2015’s financial results subside and operating synergiesbegin to materialize. AECOM has already begunreducing its degree of financial leverage, having paiddown over $600 million of its existing debt obligationsover the past 15 months. Lastly, AECOM’s liquidityposition is good, and expected to remain stable in thecoming years, with support coming from rising operatingprofits, substantial free cash flow generation, and a $1.05billion credit facility maturing in October of 2019, ofwhich $910 million remains undrawn.



The ADT Corporation6.250% 10/15/21 – 5.9% YTM

The ADT Corporation (NYSE: ADT) is an industry-leading provider of electronic security, interactiveautomation and monitoring services for residential homesand small businesses in the U.S., Canada, and PuertoRico. Acquired in 1997 by Tyco International, a globalsecurity products and services provider, ADT officiallyseparated from Tyco via a ‘spin-off’ in September of2012 to become a fully independent, publicly tradedcompany. Since the completion of its separation fromTyco, ADT has grown to become the largest singleprovider of interactive, monitored security systems andservices in North America, currently serving over 6.5million active subscribers. ADT’s subscriber basedbusiness model provides a steady and predictable streamof revenues, with recurring revenue accounting for over90% of year-over-year total revenues. In addition,

ADT’s customer retention rates are some of the highestin the industry with average customer tenure currentlyaround six to seven years, while the industry average forlength of subscriber contract is approximately threeyears. ADT does face high customer acquisition costsand generates roughly 60% of new customer contractsthrough internally managed direct sales initiatives, suchas national television and internet advertisements, whilethe remaining 40% is derived from a mix of a growingnetwork of authorized third-party dealers, the pursuit ofstrategic acquisitions, and the purchases of activecompetitor contracts. Revenues have increased onlymarginally over the prior three years, and due to theaforementioned high customer acquisition costs andincreases in annual interest expense related to a largerdebt load on the balance sheet, ADT’s net profitabilityhas declined from over $420 million in 2013 toapproximately $296 million as of the fiscal year end2015. ADT maintains good liquidity with annual interestcoverage (EBIT/interest expense) currently above 3.0x,with additional support provided by a $750 millionrevolving credit facility maturing in June 2017(of which$470 remains undrawn as of March 31, 2016), as well asa stream of relatively consistent free cash flows, whichshould exceed $100 million annually in the years ahead.Leverage currently stands at roughly 3.0x (totaldebt/EBITDA), which if maintained at that level willcontinue to assure that ADT retains its BB credit ratingand puts it in range of potentially receiving a ratingupgrade to BB+ should the company reduce and sustainits leverage below 2.5x and commit to more conservativefinancial policies.


Penske Automotive Group5.750% 10/1/22 – 5.5% YTM

Penske Automotive Group (NYSE: PAG) is aninternational transportation services company thatoperates retail automotive and commercial vehicledealerships primarily in the United States and UnitedKingdom, with operations in each country accounting forroughly 61% and 34% of total revenues respectively. Asof December 31, 2015 Penske had 181 retail automotivefranchises operating in the United States and 174 outsidethe U.S., and sold approximately 523,000 vehicles duringthe most recent fiscal year. Although new and used


20

vehicle sales account for over 80% of Penske’s revenuemix (52% and 30% respectively), Penske is also involvedin the distribution of commercial vehicles, diesel and gasengines, power systems, and related parts and services, aswell as operating a small finance and insurance businesssegment. For fiscal 2015, Penske generated over $19.0billion of total revenues and close to $330 million of netprofit, which represents a greater than 15.0% and 16.5%5-year compounded annual growth rate on both top linerevenues and net income respectively. Penske hastraditionally maintained a modest degree of financialleverage with total outstanding debt/EBITDA rangingbetween 2.0x to 3.0x year-over-year, which is inline withthe industry average for automotive retailers, and we donot anticipate Penske having any need and/or desire toincrease its debt load over the course of the next coupleyears. Although positive year-over-year free cash flowgeneration is somewhat sporadic and largely dependenton the company’s need/desire to make capitalinvestments and strategic acquisitions, Penske maintainsa good liquidity profile with annual interest coverage(EBIT/interest expense) typically sustained around 5.0x,with further support provided by a $700 millionrevolving credit facility maturing in September of 2018(of which $463 million remains undrawn as of the mostrecent quarter end March 31, 2016).




DISCLOSURES

This report includes candid statements and observations regarding investment strategies, individual securities, andeconomic and market conditions; however, there is no guarantee that these statements, opinions or forecasts willprove to be correct. These comments may also include the expression of opinions that are speculative in nature andshould not be relied on as statements of fact. Altrius is committed to communicating with our investment partners ascandidly as possible because we believe our investors benefit from understanding our investment philosophy andapproach. Our views and opinions include “forward-looking statements” which may or may not be accurate over thelong term. Forward-looking statements can be identified by words like “believe,” “expect,” “anticipate,” or similarexpressions. You should not place undue reliance on forward-looking statements, which are current as of the date ofthis report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of newinformation, future events or otherwise. While we believe we have a reasonable basis for our appraisals and we haveconfidence in our opinions, actual results may differ materially from those we anticipate.

The information provided in this material should not be considered a recommendation to buy, sell or hold anyparticular security. The S&P 500® Index is an unmanaged index of 500 selected common stocks, most of which arelisted on the New York Stock Exchange. The Index is adjusted for dividends, weighted towards stocks with largemarket capitalizations and represents approximately two-thirds of the total market value of all domestic commonstocks. The Russell 1000 Value Index is an unmanaged index commonly used as a benchmark to measure valuemanager performance and characteristics. The Dow Jones U.S. Select Dividend Index is an unmanaged indexcommonly used as a benchmark to measure dividend manager performance and characteristics. The Russell 2000Index, the Russell 2000 Growth Index, and the Russell 2000 Value Index are unmanaged indices commonly used asbenchmarks to measure small cap manager performance and characteristics. The MSCI EAFE® Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding theU.S. & Canada. The Barclays Capital U.S. Aggregate Bond Index and Barclays Corporate BB+ Index areunmanaged indices that are commonly used as benchmarks to measure fixed income performance andcharacteristics. Index performance returns do not reflect any management fees, transaction costs or expenses.Investments cannot be made directly in an index. Investments made with Altrius Capital Management, Inc. arenot deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or anyother agency, and involve investment risks, including possible loss of the principal amount invested. Pastperformance is not a guarantee of future returns.



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