Market Commentary as of 3/31/08
Encouraging Outlook
The increase in stock market volatility during the second half of 2007 persisted into the first quarter of 2008 with all the major stock market indices showing declines in value. Continuing credit market turbulence, a difficult profit environment and fears of a recession contributed to investor uncertainty. Although the heightened share price volatility may persist for a while longer, we believe the market is in the process of forming a bottom and that the outlook beyond the near term is positive. Share prices have already declined significantly and, in our opinion, are discounting most of the economic and corporate profit weakness that is likely to develop. A more accommodative monetary policy should be particularly favorable for stocks as the Federal Reserve Board acts to reduce the downside risk in the economy.
More importantly, we believe the outlook is encouraging for high-quality large-capitalization growth stocks. We think these shares are attractively valued, have solid balance sheets, and their above-average earnings growth will become increasingly attractive in a more challenging corporate profit environment. Thanks to their product mix, the domestic-based earnings of large-cap growth stocks should do relatively well in a slower growing U.S. economy, and they are well positioned to benefit from better growth prospects abroad as well as a lower dollar. We expect these favorable conditions to continue for a considerable period. On average, the holdings in the portfolio generate 49% of their sales from international markets. Sectors that we find attractive include Energy, Technology, Healthcare and Consumer Staples, all of which have significant global reach and are benefiting from healthy global economic conditions.
Strength in Energy
The Fund's continued overweight in Energy aided performance during the first quarter, with Devon Energy and Halliburton being two of the biggest contributors. Early in the quarter, we added to the position in Devon as the company continued to execute well and on expectations of 8% to 10% production growth and its exploration-driven upside potential. We subsequently reduced the position after significant appreciation owing to big rallies in both crude oil and natural gas resulted in the stock trading at a level close to our fair value estimate. In contrast, we reduced the position in Halliburton early on as a source of funds given the muted outlook for North America in 2008, but increased the position later in the quarter as natural gas fundamentals improved dramatically in just two months.
In addition, the Fund sold its position in Baker Hughes to fund the purchase of other, cheaper stocks within the Energy sector such as Cameron International and Occidental Petroleum. Cameron enjoys one of the best secular growth outlooks in the sector, and the company appears to be executing its strategy well. Occidental at purchase was trading at close to trough earnings multiples, while futures prices for crude oil remained at close to all-time highs. The Fund also re-established a position in energy construction and engineering firm Fluor. We believe the company will continue to benefit from the long-cycle global energy and infrastructure build-out and the upcoming power generation capital expenditure cycle in the US. The timing of this addition helped performance, as Fluor rose subsequent to its purchase.
The Fund's significant underweighting in Financials again aided performance as the battered sector continues to suffer the fallout from the credit crunch. Indeed, the sale of American Express during the quarter has resulted in a zero weighting for the sector in the portfolio. We sold American Express based on the uncertain macro environment, lack of near-term earnings momentum, and the potential for additional earnings weakness should the economy worsen.
Cholesterol (Drug) Problems
Healthcare holdings were a negative contributor to performance as both Merck and Schering-Plough declined sharply amid the ongoing controversy surrounding their joint-partnership in cholesterol drugs Zetia and Vytorin. A recent medical study cast the cholesterol inhibiting drugs in an unfavorable light—with Schering-Plough absorbing the brunt of the blow given that the two drugs comprise a substantial amount of its pre-tax profits. We increased the Fund's stake in Schering Plough on the belief that the market had overstated the likely impact from any decline in prescriptions.
In the Technology sector, Apple and Google both came under pressure as investors took profits in some of last year's biggest winners. Having trimmed both positions several times in 2007, we took advantage of the recent weakness to add back to both holdings. We sold Cisco, Paychex, and Intel, with the Intel sale resulting from a disappointing fourth quarter earnings report. We increased the Fund's positions in Electronic Arts, Hewlett-Packard, and Qualcomm. A favorable analysts' day presentation by Electronic Arts increased our confidence that the company has the right organizational structure and the right people in place. We believe Hewlett-Packard's 69% international exposure coupled with market share gains in PCs, servers, and printers will provide the growth to drive its shares higher. The addition to Qualcomm proved timely as Motorola announced plans to begin using the firm's 3G chips later this year to fix a glaring hole in its product line-up, thereby giving a boost to the stock.
A new position in MEMC Electronic Materials, a company that is transitioning from a semi wafer manufacturer to being a major supplier of solar wafers, purchased early in the quarter didn't play out as expected. We ultimately sold the stock without significant impact on the portfolio following news that the largest solar cell manufacturer in the world announced a long-term contract with a competitor to purchase sizable quantities of metallurgical silicon to use as a replacement for pure virgin polysilicon that MEMC produces. This news is likely to limit further the multiple expansion we had been expecting for the stock.
Profit Growth Challenge
There has been much debate about whether or not the US economy is in or headed into a recession. Regardless of the answer, the environment for US corporate profit growth has become challenging. S&P 500 Index earnings declined during both the September and December quarters of 2007, and expectations for the first half of 2008 are now for declines as well. Still, we continue to believe that the market is nearing a bottom and that for long-term investors the outlook is favorable. Valuations for large-cap stocks appear reasonable, and we think those companies best able to deliver profit growth—such as traditional growth stocks—are poised to stand out as we move forward.
Montag & Caldwell Investment Counsel
Atlanta, GA
Note: Mutual funds that invest in growth companies may be more volatile than other funds because they are generally more sensitive to market moves.
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.
As the fund is actively managed, the securities as presented do not represent the current or future composition of the portfolio.
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.