Market Commentary as of 6/30/08
False Comfort
The spring rally that commenced late in the first quarter revealed itself to be nothing more than a bear market bounce, collapsing in June under the combined pressure of surging commodity prices and the continued deterioration in the Financials sector. This group and the banking industry in particular, represent a sizeable portion of the universe of dividend-paying companies. At the end of the second quarter, Financials accounted for 25.4% of the Russell 3000 Value Index and 44.6% of the Dow Jones Select Dividend Index. The sector's decline resulted in the broad underperformance of value versus growth across the market capitalization spectrum, as indicated by the Fund's Russell 3000 Value Index benchmark return of -5.2% compared with a 1.5% for the Russell 3000 Growth Index. The difference was even greater among the small-cap Russell 2000 indices.
High dividend yields provided false comfort for investors. Traditionally, companies that pay a relatively high dividend yield have offered investors a safe harbor during periods of heightened volatility. This has not been the case during the past twelve months, or in the most recent quarter.
As share prices declined, quoted yields increased sharply. For many financial firms, this high yield was fleeting as announced dividend cuts came at the same time as capital infusions. For others, a dividend cut is possible, presenting a perfect example of a "dividend trap." For example, as of June 30, 2008 the indicated dividend yield of Bank of America was so high at 10.7% that Wall Street projected a reduction in the dividend despite management's stated support.
The dividend growth rate within the S&P 500 Index continued to decline during the second quarter as some large financial institutions reduced payments. Nominal dividend growth was only 5.7% during the quarter versus 8.2% and 12.2% the preceding two quarters. This marked the first time since 2003 that the annual dividend increase was below the long-term average of 5.9%. The current dividend yield of the S&P 500 is 2.2%, below its 25-year average of 2.5%, with limited rewards for firms to increase their payment in the current market environment.
Positives
The Fund outperformed its benchmark by a little more than a percentage point during the quarter primarily due to its holding within Financials and Industrials. Although slightly overweight in the underperforming Financials sector, the portfolio's holdings beat the benchmark by 450 basis points—albeit in delivering a disappointing -14.3% absolute return. Holdings in Industrials bested the benchmark by seven percentage points.
Among individual stocks, Alliance Resource Partners, Chevron, and heavy equipment component manufacturer, Sauer-Danfoss were the Fund's top performers. Alliance Resource, the only publicly traded master limited partnership (MLP) involved in the production and marketing of coal increased substantially during the quarter. Management has a conservative growth policy and has already sold 100% of the firm's production capacity for 2008, and stand not to benefit in the short-run from the dramatic price increase in coal. Instead, they seek to realize the value in 2009 and beyond as they renegotiate contracts and expand production. The sharp upward movement of oil prices in recent months had a positive impact on integrated oil giant Chevron. The firm repurchased $2 billion in shares during the first quarter and followed up with a 12.5% dividend increase in April. Sauer-Danfoss has benefited from global industrialization as emerging economies engage in new construction and road building. We exited the position in June when the firm began trading at a substantial premium to our assessed absolute value.
Struggling Consumer Sector
The Consumer Discretionary sector had the largest negative total effect on relative performance. Only two of the Fund's 14 holdings in the sector posted positive returns, consistent with the macroeconomic challenges confronting the US consumers. The biggest disappointment in the portfolio was Centerplate, a provider of food services for sports facilities and convention centers in the US. In an effort to replace the expected expiration without renewal of the lucrative Yankees stadium contract the firm signed a number of new contracts. To fund these expenditures to grow the business the firm announced in early April that it was eliminating the dividend due to a failure to amend certain covenants on its senior credit facilities. We immediately exited the position following the announcement of the dividend cut, and in retrospect probably took too much comfort in the firm's long-term contracts when evaluating its high debt load.
General Electric and Bank of America were two other major disappointments during the quarter. GE suffered its largest single day price decline since October 1987 after announcing weak earnings. The firm responded, in part, with an effort to sell or spin-off its storied Appliances unit and to reduce its consumer finance exposure while increasing investment in segments with higher growth potential. Bank of America struggled along with the rest of the banking industry. The acquisition of Countrywide Financial closed on July 1, merging the nation's largest mortgage operation with the largest base of low-cost deposits—a powerful combination. But Countrywide's substantial exposure to the troubled California housing market will likely prove a significant distraction for management in the short run as they address growing credit problems in the wider organization. Consistent with our sell discipline, we trimmed both positions to control losses in the Fund.
Pepsi Generation
Six new positions were established during the quarter, the two largest being PepsiCo and Boardwalk Pipeline Partners. Although PepsiCo is the global runner-up in carbonated beverages to Coca-Cola, it is the leading seller of non-carbonated drinks in almost every market it competes. The company has raised its dividend for 36 consecutive years, including a 13.3% increase in May 2008, and the dividend has increased at a 21.6% annual rate during the previous five years.
Loews Corporation formed Boardwalk Pipeline Partners in 2004 via the fusion of two pipeline systems, Texas Gas and Gulf South, into a single MLP. Unlike many competitors, the firm does not trade in the natural gas market, instead it is solely focused on the more predictable and sustainable business of wholesale transportation and storage. Boardwalk has raised its distribution in each quarter since its public listing. Supporting the firm’s investment grade credit ratings are low-cost, fixed-rate debt, and a $1 billion revolving credit facility. The firm highlighted its investment merit during the first quarter by placing $250 million worth of five-year notes at 5.5% in the middle of a national credit crisis.
The Economy's Ball and Chain
From a macroeconomic perspective, we do not know if oil prices will move higher or lower from the current level. We do feel reasonably confident, however, oil prices are going to remain elevated for an extended period. As we previously commented, even accounting for a large measure of speculative excess, the likely intermediate-term floor for oil is $75 to $90 per barrel. At $90 a barrel, oil is a significant drag on the US economy. At the current level of roughly $135, it is a ball and chain.
Most US banks have successfully weathered the implosion of structured securities in their investment portfolios, but now face a larger problem. Banks value their loan book on an accrual basis, and they will realize significant credit losses over time as their customers default. According to the first quarter Federal Deposit Insurance Corporation's (FDIC) Quarterly Banking Profile, non-current loans rose to 1.71%—the highest level since the first quarter of 1994! Although banks began increasing loan-loss reserves in recent quarters, negatively affecting earnings, they did not completely cover the simultaneous increase in non-current loans. Dividend cuts, capital raises, and reports of credit tightening at regional banks throughout the second quarter certainly suggest that the environment is not improving. Unless the economy improves significantly in the coming months, we expect to see continued increases in non-current loans and charge-offs plague the Financials industry for the remainder of 2008.
In our view, the Federal Reserve is also in a bind as the housing market continues to decline, the consumer has become squeezed on multiple fronts, and key components of the US financial system are crippled and/or on the brink of collapse. With inflation on the rise, the dollar at multi-decade lows, and interest rates already low, it is difficult for the Fed to cut interest rates any further. Arguably, the Fed should raise rates in an attempt to support the dollar, lower oil demand, and drain some of the massive global liquidity that contributed to our current predicament. Higher rates might be painful for the economy and the market in the short-run, but it could prevent a much deeper and more prolonged downturn. Unfortunately, this action is unlikely to happen in 2008 given the upcoming presidential election, a weakening economy, and rising unemployment.
From a fundamental standpoint, we want to be more positive. Interest rates are low, overall valuations are attractive, and the universe of high-yielding companies is growing. Unfortunately, the macro overhang is such that until we see a significant reduction in commodity prices, and a material stabilization of housing and US financial intermediaries, earnings are likely to continue to drop and multiples will decline across a broad swath of the economy. Furthermore, we expect dividend growth for the broad market will weaken as banks look to preserve capital and rebuild their balance sheets, and firms in other industries adjust their growth expectations.
One of the Fund's core tenets is that we look for companies that pay a high current dividend and have the ability to raise payments regularly in the future. Despite the modest underperformance of dividend-increasing companies during the second quarter, this remains a key aspect. We will continue to search the dividend universe for those firms that meet our six critical criteria, while balancing the macroeconomic risks to the best of our ability. We remain convinced that a dividend increase provides a tangible indication of management's expectations as to the stability of future cash flow and our investment efforts will be guided accordingly.
River Road Asset Management
As of June 30, 2008, Alliance Resource Partners comprised 1.35% of the portfolio's assets, Chevron - 2.90%, General Electric – 1.64%, Bank of America - 1.17%, PepsiCo - 1.29%, and Boardwalk Pipeline Partners - 1.02%.
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. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned.
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.