Market Commentary as of 6/30/08
Stagflation
Stagflation is a word created during the late 1970s to describe an economy with high inflation and minimal growth brought about by the rising cost of energy. That word again came to the forefront in June as the price of energy continued its dramatic ascent in the face of a weakening US economy. Stock prices, which had risen strongly in April and May, gave back most of that performance in June. Overall, small- and mid-cap stocks managed to hang on to minor gains for the quarter, while large-cap stocks sank into negative territory. The Fund managed to regain significant ground against its Russell 2000 Index benchmark after a challenging first quarter.
Many of the stocks that detracted from performance at the beginning of the year bounced back during the second quarter. By early June, the Fund had made up its deficit relative to the benchmark, though the weakness in the final weeks of June again dropped it modestly behind its benchmark for the year-to-date. Outperformance relative to the benchmark during the second quarter owed primarily to stock selection in the Financials, Consumer Discretionary, Industrials and Technology sectors. Weak stock selection in Healthcare slightly offset this positive attribution.
Top-holding Willbros Group and Whiting Petroleum were among the biggest contributors—in absolute terms—as both benefited from strength in the Energy sector. Willbros moved higher on positive trends in natural gas, and its position as the infrastructure leader. Investors rewarded Whiting with higher valuations for its substantial North American oil and gas assets. As the price of oil prices rise, the extraction of oil from these assets becomes more economical. In addition, Corinthian Colleges—one of the biggest detractors from performance during the first quarter—rebounded on reports of continued strong enrollment trends, affirmed guidance from management, and the lifting of fears about the availability of loans to students by recent Congressional legislation.
Among the portfolio's disappointments during the quarter were OraSure Technologies, Hain Celestial, and Emulex. A patent infringement lawsuit and concerns regarding too many false positive results for its HIV test weighed heavily on shares of OraSure, a manufacturer of oral diagnostic products. Shares of Hain Celestial dropped on fears that strapped consumers may shy away from natural and organic products to help reduce the sting of rising food prices. Storage and networking firm Emulex suffered from general weakness in the storage market and its product transition cycle as it awaits the launch of the next version of its core product. Deteriorating company fundamentals and better relative opportunities led to the sale of OraSure and Emulex (on July 1, 2008) from the portfolio.
Buys and Sells
Other sales during the quarter included Alpha Natural Resources, Massey Energy, and Helmerich & Payne, all because they reached the Fund's market capitalization limit of $5 billion. Coal companies Alpha Natural Resources and Massey both gained tremendously during the period as the price of coal soared. Sadly, the time has come for us to say farewell to oil and gas driller Helmerich & Payne. The long-time holding proved to be a profitable investment since its original purchase as a Laggard in 2003. The company executed its strategy brilliantly by making tough but correct decisions when the industry was under severe stress. Irrespective of commodity prices, and before the price of oil took off, management focused on their core business and developed a product that would differentiate the company from its peers—a new flexi rig that was a hit with customers. HP is an excellent example of how a Laggard can turn into a Leader in its industry—the Holy Grail of our strategy.
Also during the quarter, we initiated and built up full positions in a number of Consumer Staples and Technology stocks. Riverbed Technology and THQ are both new additions purchased after recent setbacks. Riverbed is the world’s leading Wide-Area Network (WAN) product provider, and innovator in the field. Although the stock sold off on disappointing revenues and fears of a tech spending slowdown, the market for the WAN optimization industry is poised to grow more than 30% per year and Riverbed has been gaining market share. THQ produces licensed and owned video games, and has relationships with Pixar, WWE, Nickelodeon, UFC, Dreamworks, and Marvel. After a disastrous past 12 months, management has refocused on offering higher-quality games into a video game market that remains robust, and we believe that they are on the right track to improved execution and profitability.
Within Consumer Staples, the Fund added to niche producers such as Lance, Prestige Brands Holdings, and TreeHouse Foods. New management teams at both Lance, a regional snack food company, and Prestige Brands, a leading maker of over-the-counter remedies Chloraseptic, Compound W, Clear Eyes, and Murine, are seeking to improve stagnating operations. We believe both are on the right track with plans to increase efficiency and marketing effectiveness. TreeHouse Foods is a private label foodservice manufacturer spun out of Dean Foods in 2005 that makes numerous products, including pickles, non-dairy creamer, soups, jams, salad dressings, and infant feeding products. With a veteran management team that proved their mettle at Keebler, we expect that the firm will successfully navigate what can be a competitive and volatile industry.
Outlook
Looking ahead it is difficult to discern whether the recent reversal in market-cap sentiment that lifted the Russell 2000 Index above large-cap stock indexes during the quarter is a sign of a long-term change in trend. Global economies are currently stronger than the US, which favors larger firms with a global reach, but rising commodity costs and dampened domestic demand for imports other than energy could bring parity to global economic growth. The fear of higher inflation (financial assets' worst enemy) has neutralized improvements in valuation. Near-term, neither monetary nor fiscal policy options will likely change sentiment. The most significant event needed to bring about a positive course would be a downward shift in energy and other commodity prices brought about by slowing world economies or a geopolitical resolution to Iran, neither of which is predictable, though valuation tilts in favor of giving that outcome a higher probability.
Portfolio positioning during the quarter reflects a slight shift in this direction. We have reduced our weighting in the energy sector. This change is more about valuation and market-cap constraints than in our prowess to forecast macro events. In addition, our traceable increase towards the consumer reflects a better balance between fundamentals and valuation that we observed initially in our quantitative model. We are gradualists by nature, and always cognizant that the economic headwinds tend to blow fiercer than presumed.
TAMRO Capital Partners
Alexandria, Virginia
As of June 30, 2008, Willbros Group comprised 3.63% of the portfolio's assets, Whiting Petroleum - 1.74%, Corinthian Colleges - 2.63%, Emulex – 0.94%, Hain Celestial - 2.33%, Riverbed Technology - 1.86%, THQ - 2.31%, Lance – 1.44%, Prestige Brands Holdings – 1.53%, Treehouse Foods – 1.84% .
Note: Small company stocks may be subject to a higher degree of market risk than the securities of more established companies because they tend to be more volatile and less liquid.
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.