Market Commentary as of 3/31/08
Dividend Growth Continues—Albeit Slowly
Equity income funds in general posted negative returns during the first quarter of 2008, but modestly outperformed the broader market. Dividend growth in the S&P 500 Index continued during the first quarter, albeit at a slower rate than 2007, as a number of financial firms reduced or eliminated their dividend payment to preserve capital. While current growth remains above the long-term average of 6%, we expect it to weaken further in the coming quarters due to more cuts among Financials, and a slower growth rate in other economically sensitive industries. The current dividend yield of 2.2% for the S&P 500, while greater than the previous quarter's mark, remains below its 25-year average of 2.5%.
Financials, which are typically associated with high-yield equities, have been at the center of the recent market correction, resulting in another volatile quarter for equity-income investors. The sector comprises roughly 49% of the Dow Jones Select Dividend Index and 28% of the Fund's Russell 3000 Value Index benchmark, and continues to face pressure. The credit crunch that began in August 2007 was not contained to the subprime mortgage industry, the effect of which has had a broad impact on the entire banking industry. Many companies are evaluating their dividend policy due to financial duress, and some have already cut their payments with others expected to do so in the near future.
Winners and Losers
Interestingly enough, the portfolio's holdings within the Financials sector were the key to its strong relative returns. Despite having been overweight this underperforming sector, effective stock selection contributed to more than 10 percentage points of outperformance relative to the benchmark during the period. After falling out of favor during the third quarter of 2007, domestic title insurance company LandAmerica Financial Group continued its rebound from last quarter. The market had been slow to recognize that the firm had no mortgage credit exposure and that its business is dependent on the number of mortgages originated, not the underlying value of the properties. We expect LandAmerica will continue to rationalize its cost structure, and produce strong cash flow as real estate transaction volumes normalize.
The recent credit crunch has also been advantageous for specialty-finance company Prospect Capital. The firm has capital to lend while competing lenders have been turning business away as they focus on rebuilding their balance sheets. In addition, its focus on the strong energy sector has mitigated concerns about declining credit quality in the broader economy. We also expect the firm to book a substantial gain in its effort to monetize their investment in Texas-based natural gas gathering and processing company Gas Solutions Holdings.
Other contributors to relative performance came from the Materials, Information Technology, and Healthcare sectors. Positive stock selection drove relative performance in the latter two sectors, while robust global demand led to an increase in commodity prices that aided a number of Materials companies. Nucor, a leading US steel manufacturer, continues to benefit from increasing productivity, a lower US dollar, and growing global demand for steel. The firm also increased its regular dividend by 6.6% to $0.32 per share, following a 173% increase in its regular dividend during December.
Utilities, Telecommunications, and Energy all weighed on performance, with the weakening economic environment especially affecting the Utilities and Telecommunications sectors. Verizon Communications, joint owner with Vodafone of Verizon Wireless, posted a double-digit loss during the quarter. A recent price war initiated by Sprint Nextel has forced the firm to respond and reduce margins in its high-growth, high-profit wireless data segment, which we expect will hurt profitability. We remain impressed with the firm’s fiber-to-the-home initiative FiOS, however, which clearly has a technological advantage over its cable competition. Oregon utility, Portland General Electric, also dropped sharply. Although the firm continues to increase the percentage of generation from renewable resources, reducing its dependence on the wholesale market, we trimmed the Fund's position in accordance with our sell discipline due to accumulated unrealized losses.
More Than a Slowdown
Last quarter we noted two likely scenarios for US markets—a long recession with continued turmoil for investors and consumers or a mid-cycle slowdown from which we could recover by the second half of 2008. It is increasingly evident that we are experiencing more than a slowdown, with little clarity as to its duration or severity. The disruption in the financial services sector is a significant headwind, though the prompt action on the part of both regulators and market participants has dampened the impact to some extent.
The health of the US banking system is the key factor that will determine the course for the remainder of 2008. Economic growth rests on capital provided by the financial system. The recent turmoil in the credit markets has stressed bank balance sheets, forcing many to reduce lending and seek out new capital. As long as the banking system struggles, so too will the US economy—hence the impetus behind the effort of regulators to force banks to quickly realize losses and correct their past errors. The Federal Reserve Board's aggressive cutting of short-term interest rates should improve the profitability of banks' core lending operations and eventually help to reduce the adverse impact of continued credit losses.
In the meantime, we continue to position the Fund by investing only in attractive companies that we understand. Our attention remains focused not only on a company's ability to maintain its current dividend, but also to continue the growth of that dividend. This we hope should help us to isolate the firms capable of weathering this tough market.
River Road Asset Management
Louisville, KY
Note: Mid-cap stocks are generally riskier than large-cap stocks due to greater volatility and less liquidity.
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.