Market Commentary as of 3/31/08
Negative Headlines Dominate
Surging oil and food prices, rising core inflation, crumbling home prices along with record foreclosures, slowing economic and job growth, declining corporate profits, tightening credit standards and failed securities auctions, dividend cuts and massive liquidity infusions required by some of the nation’s largest banking institutions, a run on a top Wall Street brokerage firm followed by a Federal Reserve-led bailout. A declining dollar, an expensive war in the Middle East for which there appears to be no practical end in sight, all accompanied by the very real threat of higher taxes following the fall elections. Other than the Federal Reserve Board slashing interest rates, positive headlines were tough to find during the first quarter of 2008—and investors were paying attention. Bombarded with negative news, they dumped equities around the globe. In the US, every major equity index declined sharply during the quarter.
It's not uncommon for growth stocks to outperform value during the early stages of a bear market as investors flock to stocks they believe can maintain their earnings momentum. Indeed, such was the case in 2007. When the slowdown broadens, however, even the hottest growth stocks inevitably experience diminished expectations—as occurred during the first quarter of 2008. Stocks on the high-flying NASDAQ exchange lagged all other major domestic indices, and value outperformed. Although less noticeable with large-cap stocks, the advantage for value investors was pronounced among small-caps as the Russell 2000 Value Index (the Fund's benchmark) outperformed the Russell 2000 Growth Index by more than 600 basis points. Within the Russell 2000 Value itself, stocks with long-term earnings growth rates in excess of 20% declined -11.3%, while those with growth rates under 10% declined just -3.2%.
Still, extreme volatility was the order of the day. According to data from Russell Investment Group and Merrill Lynch Small Cap analyst Steven DeSanctis, the spread between the daily high and low on the Russell 2000 Index exceeded 1% every day during the quarter. Volatility exceeded 2% on 70% of the trading days! In addition, according to figures from Lipper Analytics and Merrill Lynch, only 45% of active small-cap value managers beat the Russell 2000 Value during the quarter compared with 75% in 2007, we think because Financial stocks surprisingly suffered less than the broader index.
Booming Energy
During the quarter, the Fund beat the benchmark by more than a percentage point. Although that's the eighth consecutive quarter in which it outperformed the index, we remain disappointed with our inability to generate more-attractive absolute returns.
The Fund managed to post positive returns in two sectors—Energy and Industrials—with Energy providing the most significant contribution to performance. An overweight stake in the sector combined with substantial outperformance in the stocks the portfolio held relative to the benchmark aided returns. After struggling to meet production guidance last year, Encore Acquisition moved sharply higher by forecasting 6% to 8% production growth and announcing that proven reserves were up 13% in 2007. Energy-services firm CHC Helicopter accepted an offer to be acquired by First Reserve—a 25-year old energy private equity firm. The stock quickly traded above our assessed value, providing us an attractive opportunity to liquidate the Fund’s position. Although the charts for many Energy stocks have shown a near-vertical slope over the past few months, we continue to find attractive values in the group and to maintain our overweight position.
Within Industrials, half of the portfolio's 19 companies delivered positive performance, including five with double-digit returns. The largest contribution came from leading global security services provider Brink’s, which is also one of the Fund’s largest holdings. Exceptional performance from its underlying businesses and an acquisition within the industry that provided a comparable valuation measure drove the stock's strong performance. Brink's grew its top- and bottom-lines by 18.5% and 36.5%, respectively, and announced the tax-free spin-off of its home security business, which should unlock tremendous value in this under-appreciated asset.
Travel Centers of America
Only three sectors had a negative total effect on relative performance—Financials, Consumer Discretionary, and Utilities. Financials suffered from both an underweight position and poor industry positioning. The Fund was overweight several underperforming financial subsectors and underweight the top performing groups—commercial banks and REITs—which represent more than 19% of the index. We have scoured the landscape looking for attractive commercial banking investments, but find the industry characterized by a lack of balance sheet transparency, forward earnings predictability, and overall value. While REITs can provide an attractive total return for clients seeking income, we typically avoid them as unsuitable for our small-cap strategy, and that they rarely meet our discount to valuation criteria.
Disappointing performers during the quarter included Casey’s General Stores, Meredith Corporation, and Travel Centers of America. Casey’s was a top performing holding during the fourth quarter, but after several quarters of strong revenue and earnings growth the firm produced results that did not meet Wall Street’s heightened expectations. We believe the current stock price now reflects the prospect for declining gas margins and higher food prices, and still think the firm represents an attractive longer-term investment opportunity. Media and marketing company Meredith is suffering from a weakening US economy and lower advertising revenue. While we believe the firm's magazines have significant franchise value and have confidence in the management team, we found it prudent to reduce our position significantly.
We wrote extensively about our disappointment in Travel Centers of America as part of our last commentary. Unfortunately, things turned from bad to worse. Although the firm’s fourth quarter results were predictably bad, they sank below even our lowest expectations. Management still dismissed the possibility of renegotiating leases with landlord Hospitality Properties Trust (HPT), and it became apparent that the firm could very possibly require a long and drawn-out litigation process to unlock the value. At that stage, we determined it best to liquidate the Fund’s position. We clearly made mistakes in our analysis of the firm's operating model, the impact of rising diesel prices, and (most importantly) the quality of its management team. The silver lining is that despite the sharp loss, the Fund still achieved good relative performance throughout 2007 and during the beginning of 2008. Our policy of not averaging down prevented us from compounding what could have easily been a more significant loss.
Major Threat—Higher Oil Prices
Our outlook has continued to evolve since our last commentary. In January, the Federal Reserve Board’s drastic rate cuts in response to the deepening credit crisis served as a powerful catalyst for small cap stocks, and our outlook improved materially. The performance of small cap stocks picked up in February and small-cap earnings growth expectations now stand at just over 10%. This figure is probably still too high, but the downside from this level may be less significant.
The biggest concern we have now is the price of oil. Oil prices have finally surpassed their 1980 inflation-adjusted highs. The issue today is that supply, more than demand, is influencing oil prices as declines from mature fields tighten production. In addition, the freefall of the US dollar has probably been responsible for some portion of the recent oil price spike as well. We are certain that financial institutions are increasingly buying oil and other commodities to hedge against inflation. Even accounting for a large measure of speculative excess, a likely intermediate-term floor of $75 to $90 per barrel of oil is a range that presents a major hurdle for stocks and the broader economy. Hedges that many companies put on in 2007 are now rolling off at today's significantly higher prices, which may lead to cost increases for consumers and fuel higher core inflation.
While the Fed appears willing to take extreme measures to support both growth and the liquidity of the US financial system—setting the stage for possible positive small-cap performance—unless oil and commodity prices retreat from current levels we could be in for a protracted period of economic and market weakness.
River Road Asset Management
Louisville, KY
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.
Note: Small and Mid-cap stocks are generally riskier than large cap stocks due to the greater volatility and less liquidity.
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.