Market Commentary as of 6/30/08
Not All Gloom and Doom
While there have been many forecasts predicting a recession, the US economy has continued on a path of weak but positive real Gross Domestic Product (GDP) growth. Housing activity and inventory accumulation likely subtracted from growth during the second quarter, while trade, consumer spending, and capital expenditures offset those weak areas. The Federal Reserve has been very aggressive at easing monetary conditions by providing liquidity to the financial system and lowering its targeted short-term interest rate by 325 basis points. Combined with a Federal stimulus package of $150 billion in tax rebate checks and business investment incentives unveiled in May, both consumer and business spending should benefit.
To be sure, the ongoing and formidable deleveraging of the financial and household sectors and the dramatic surge in energy prices has the potential to offset these positive forces. Higher than expected food and energy prices will likely cause calculated inflation to increase to about 4% in 2008. Still, with the economy growing—albeit at a modest rate—we believe there will be limited pass-through of higher energy and raw material costs into consumer goods and service prices, and that inflation could be back in the area of 2.0% to 2.5% in 2009.
After a healthy rebound in April and May, the market corrected sharply in June down to its first quarter lows on continuing economic uncertainty. Although share price volatility may heighten as companies report second quarter earnings and potentially give conservative guidance, we think the market is near a bottom. Stock prices have already declined significantly and in our opinion are discounting a good amount of the economic and corporate profit weakness that is likely to develop. While individual stocks will decline in reaction to negative earnings surprises, the S&P 500 Index is, on average, reasonably priced even if earnings remain unchanged in 2008. We believe that a major rotation into large-cap growth stocks now appears to be underway, as the Russell 1000 Growth Index has outperformed the Russell 1000 Value Index during 13 of the last 14 months.
Energy and Technology
The Fund has participated fully by holding up better amid this year's decline, as it
continued to benefit from its overweight allocation to Energy during the quarter—led by holdings Halliburton and Cameron International. We took the opportunity to increase the position in Cameron on weakness in the stock early in the period. Cameron's outlook improves as we progress through 2008 and into 2009, amid an expected rise in offshore activity levels. Considerable improvement in US natural gas fundamentals and continued momentum in international areas also led us to increase the Fund's stake in Halliburton.
Technology was another strong area of performance for the Fund as Apple, Google and Qualcomm were all up strongly during the quarter. In addition, we initiated a position in MasterCard and added to stakes in Electronic Arts and Juniper Networks. MasterCard is a leading credit and debit network processor that should continue to benefit from the secular shift to electronic payments and the rise of the middle-class consumer in emerging markets. We expect earnings momentum will accelerate meaningfully during the next year for Electronic Arts due to the strength of the company's upcoming new title slate and as the industry enters the sweet spot of the gaming cycle. Juniper delivered the second consecutive quarter of better than expected margins and it is our conviction that management will continue to execute the company's strategy of improving profitability ratios. After initially increasing the portfolio's stake in Hewlett Packard on the belief that the company would continue to benefit from their substantial international exposure, we subsequently trimmed it back following the company's announcement of its intention to acquire EDS—which creates some uncertainty to expected earnings growth trends over the intermediate-term.
The Fund's overweight position in Consumer Staples had a negative impact on performance. A number of holdings in the sector declined as investors became concerned that higher input costs would adversely affect profit margins. Discounters such as Wal-Mart and Costco, however, bucked the trend in delivering positive returns. We trimmed the Fund's stake in Costco as it appreciated close to our estimated fair value, but established a new position in Wal-Mart at a discount to our estimated present value. Wal-Mart has slowed its square footage growth in order to focus on existing stores, including a move to remodel roughly half of its domestic stores in an effort to provide customers a better shopping experience. This strategy, as well as the firm's status as a leading discount retailer, should allow the company to retain customers amid the weak economic environment.
The absence of any holdings in the Materials, Telecommunications, and Utilities sectors detracted from relative performance as these sectors were up strongly during the quarter. An earnings miss at General Electric caused primarily by weakness in its Commercial Finance unit didn't help either, and we subsequently eliminated the position. We also sold Merck on diminished earnings momentum resulting from the achievement of cost reductions ahead of schedule and news that the FDA issued a "not-approvable" letter for a key cholesterol drug in the company's new product pipeline.
Early Stages
We believe that the rotation into large-cap growth stocks is in its very early stages, and that the outlook for your holdings remains good. These shares are attractively valued, have solid balance sheets (they are less dependent on bank financing), and we think their above-average earnings growth will become increasingly attractive in a more challenging corporate profit environment. In addition, due to their product mix the domestic-based earnings of these large-growth firms should do relatively well in a slower growing US economy, where they are well positioned to benefit from better growth prospects abroad and a lower dollar. Overall, we continue to favor issues in the Energy, Technology, Healthcare, and Consumer Staples sectors, all of which have significant global reach and benefit from healthy global economic conditions.
Montag & Caldwell Investment Counsel
As of June 30, 2008, Halliburton comprised 4.91% of the portfolio's assets, Cameron International - 3.11%, Apple - 4.14%, Google - 4.37%, Qualcomm - 4.28%, MasterCard - 1.62%, Electronic Arts – 2.43%, Juniper Networks – 2.07%, Hewlett Packard – 3.62%, Wal-Mart - 3.82%, and Costco - 2.17%.
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.