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 stocks during the early stages of a bear market as investors flock to stocks they believe can maintain their earnings momentum. When the slowdown broadens, however, even the hottest growth stocks inevitably experience diminished expectations—as seen during the first quarter of 2008. Although relatively modest with large-cap stocks, the advantage for value investors was more noticeable among small- to mid-caps as the Russell 2500 Value Index (the Fund's benchmark) outperformed the Russell 2500 Growth Index by nearly 400 basis points. Within the Russell 2500 Value itself, stocks with long-term earnings growth rates in excess of 20% declined -13.2%, while those with growth rates of less than 10% declined 5.4%.
Booming Energy
During the quarter, the Fund beat its benchmark by more than two percentage points. Only Energy managed to post positive absolute returns in the portfolio, along with providing the most significant contribution to relative performance. An overweight stake in the sector combined with substantial outperformance in the stocks the portfolio held 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. Greater production towards the end of 2007 and increased production estimates for 2008, along with rising natural gas prices, served to silence critics and boost the shares of Cimarex as well.
Industrials also had a significant positive effect on relative performance, with four of the Fund's holdings posting 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 delivered impressive growth and announced the tax-free spin-off of its home security business, which should unlock tremendous value in this under-appreciated asset.
Boston Private
Only two sectors had a negative total effect on relative performance—Financials and Consumer Staples. The portfolio's Financials stake suffered from poor stock performance and being underweight the better performing subsectors within the index, namely commercial banks and REITs—which represent nearly 18% 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 they rarely meet our discount to valuation criteria and we typically avoid them in our pure equity strategies. The most disappointing individual holding was Boston Private Financial Holdings, which announced an impairment to goodwill related to two affiliates and that the firm held inadequate reserves for mortgages they underwrote at a Los Angeles-based bank. After trimming our position several times, we ultimately sold it from the Fund due to poor execution and a lack of transparency.
With regard to Consumer Staples, we were a bit surprised with the poor performance from this typically defensive group of stocks. The worst performing holding was Midwest convenience store operator Casey’s General Stores. 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 also disappointed during the quarter, as it suffered from a weakening US economy and lower advertising revenue. While we believe the firm's magazines have considerable franchise value and have confidence in the management team, we found it prudent to reduce the Fund's position significantly.
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