Market Commentary as of 6/30/08
Spring Rally Collapses
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. Among US equities, large-cap stocks fared the worst. The S&P 500 Index plummeted 8.4% in June—ending the quarter with a return of -2.7%. Small-cap stocks performed somewhat better in retaining part of their early gains. After rising in April and May, the Russell 2000 Index declined 7.7% in June—its worst June performance on record—resulting in a quarterly return of 0.6%.
Aside from commodity-based indices, the only bright spots during the quarter were among mid-cap and growth stocks. The S&P Midcap 400 Index gained more during the rally and lost less during the sell-off than other indices. Growth stocks performed relatively well across the capitalization spectrum. Among small-caps, for example, the Russell 2000 Growth Index gained 4.5% during second quarter compared with -3.6% for the Russell 2000 Value Index.
Size Does Matter
Within the small-cap universe, a consistent theme throughout 2008 has been the outperformance of ‘larger’ small-cap stocks. Within the Russell 2000, the largest capitalization quintile has returned -3.9% for the year-to-date, versus -23.1% for the smallest quintile. Similarly, within the Russell 2000 Value, the largest quintile returned -5.5% versus -25.1% for the smallest. This trend has presented a bit of a headwind for our Small Value strategy, which we designed to have an average capitalization lower than its respective index. Fortunately, as value has migrated up the capitalization curve during the past few years, our bottom-up discipline has led to us to increase that average as well.
Overall, the Fund still managed to squeak out a positive return for the quarter in outperforming its Russell 2000 Value Index benchmark by more than three percentage points. It is not surprising that an overweight position in energy-related holdings significantly aided performance as oil and natural gas prices skyrocketed. All three of the Fund's top-performing holdings—Encore Acquisition, Swift Energy, and Complete Production Services—were energy-related. Oil and natural gas producer Encore added new territory for exploration in Texas, Louisiana, and Mississippi, and announced that it was exploring strategic alternatives, including a possible sale of the company, that boosted the price of its stock. The second quarter marked a turning point for Swift Energy. With the sale of its declining New Zealand assets, the company was able to reduce its debt and emerge as an attractive pure-play domestic oil and gas producer. Business improved notably for oil and gas equipment supplier Complete Production Services as overall drilling activity picked up significantly in the US land market during the spring, driving demand for its services.
A severe underweight position in Financials also contributed greatly to second quarter performance. As of June 30, 2008, Financials represented only 6.8% of assets in the portfolio compared with 32.6% for the Russell 2000 Value. (Even ex-REITs, which the index treats as financial companies but which we consider a separate asset class, the Fund is 15.6% underweight Financials.) One of our reasons for being index independent, and an advantage of being an active manager, is that it is difficult to consider an index structured with one-third of its allocation in a single sector as properly diversified. Recall what happened when the same problem existed with Technology stocks within the S&P 500 in 2000. We find few companies in the sector that meet our investment criteria, especially within the banking industry where the balance sheets are simply not transparent enough for us to arrive at a reasonably confident valuation. In addition, it's becoming apparent that the days of easy profits for banks and brokers have become luxuries of the past.
The Consumer Sting
The largest negative effect on performance during the quarter came from the Consumer Staples and Consumer Discretionary sectors. The weakness in these groups is largely a sign of the times and, unfortunately, Consumer Staples has not been the typically safe haven it has been in the past during downtrending markets. Rising energy and other commodity-related expenses has pressured a number of industries within the Staples sector. For example, long-time holding, and the biggest detractor during the quarter, Coca-Cola Bottling Co. Consolidated suffered from higher fuel and raw material costs along its distribution network that compressed margins. While we trimmed the Fund's position just before the recent correction, the stock only offers modest liquidity at this stage and we found it imprudent to trim additional shares in the current market given the company's stable balance sheet and long operating history.
Other disappointing performers during the quarter include CBRL Group and Oppenheimer Holdings. CBRL Group, which operates the Cracker Barrel restaurants, missed quarterly earnings estimates and narrowed guidance to the lower-end of its previously announced range. The modest miss was a result of margin compression from higher food costs, retail product costs, and worker compensation expenses. Given the margin pressure on the overall restaurant industry and our sell discipline, we decided to trim the position. Like most firms operating in the capital markets, Oppenheimer reported disappointing quarterly results. Given the Fund's minimal stake in Financials, and the firm's limited exposure to Auction Rate Securities and lack of any sub-prime exposure, we believe the risk of holding on to the company is relatively low compared with its prospects in the event of a rebound in the capital markets.
New Additions
We directed much of our work during the quarter to striking a balance between our Consumer and Energy exposure. While we continue to find attractive values in the Consumer Discretionary sector given the virtually unabated rise in energy prices, we believed that our overall exposure to the US consumer was too high. We also think it is especially important in this environment to identify stocks that are not highly correlated to any particular sector. Thus, we strove to find special situation companies that can prosper in a difficult economic environment. Many of these companies fall under the classification of Industrials, though few would fit the classic definition of an industrial firm.
The two largest additions to the portfolio were Chemed and Jakks Pacific. Chemed operates two wholly distinct businesses, Vitas and Roto-Rooter, both of which are leaders in their respective markets. Jakks Pacific designs, produces, and markets toys, craft activities, and pet products. The co-founders established the company to create a vehicle that could consolidate the highly fragmented toy market. The firm’s first big success was establishing a relationship with World Wrestling Entertainment to develop and market action figures based on WWE wrestlers. Today, Jakks’ diverse toy licenses include WWE, Pokemon, RC Racers, Plug It In & Play TV Games, Eye Clops Bionic Eye, Pentech, and a host of other licensed products.
The Economy's Ball and Chain
With regard to providing an outlook for small cap stocks, we find ourselves in a quandary. 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.
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 and overall valuations are attractive even though large-cap stocks are still cheaper than small-caps. Unfortunately, the macro overhang is such that until we see a significant reduction in commodity prices, and perhaps 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.
In response, we will continue to balance as best we can the dueling forces affecting energy and consumer stocks. We will continue to scour the financial wasteland for hidden gems that meet our critical investment criteria. Finally, and perhaps most importantly, we will continue to search for value off the beaten path—opportunities that are undiscovered or misunderstood by Wall Street—and, if we are fortunate, companies that can prosper in what could be a very difficult economic environment.
River Road Asset Management
As of June 30, 2008, Encore Acquisition Company comprised 3.76% of the portfolio's assets, Swift Energy - 2.63%, Complete Production Services - 0.92%, Coca-Cola Bottling Company Consolidated - 1.20%, CBRL Group - 1.11%, Oppenheimer Holdings – 1.00%, Chemed Corp. - 1.04%, and Jakks Pacific Inc. - 0.74%.
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.
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.