The Rescue that Morphed into a Slow Motion Train Wreck
A wild third quarter began with equity markets setting new lows in mid-July before staging a brief rally sparked by the government bailout of Fannie Mae and Freddie Mac and pledges from Congress and the US Treasury to support troubled homeowners and, effectively, the beleaguered mortgage industry. Fueled by a rising dollar and sharply falling energy prices, the rally established new 52-week highs for some indices, including the Russell 2000 Value Index. By mid-August, however, the market started to become unglued as rumors regarding the health of large US financial institutions began to intensify, premiums on bond insurance (i.e. CDS or Credit Default Swaps) rose and stock prices fell. The vicious circle threatened credit ratings of financial institutions that, in turn, led to a fresh round of devastation.
By early September, the crisis was claiming a broader swath of victims in the US, as everyone from hedge funds to retail accounts began to pull funds from the weakest institutions. Lehman Brothers, unlike Bear Stearns, was denied Federal assistance and declared bankruptcy. The nation's largest savings and loan, Washington Mutual, collapsed, while other institutions—like Wachovia—appeared to be on the brink. Insurance companies, many of which had written insurance against the defaulted bonds of banks and brokers, began to wobble eventually resulting in Federal authorities stepping in to provide the necessary capital to rescue AIG—effectively wiping out shareholders in the process.
Following an announcement by a money-market fund manager in mid-September that they would "break the buck," the yield on 30-day US Treasuries, considered the ultimate safe haven, reached an all-time low. Despite the introduction of a $700 billion plan by US Treasury Secretary Henry Paulson to buy troubled debt from ailing financial institutions that was initially cheered, the dominoes continued to fall. The rally faded, the proposal failed to pass a vote, and investors around the world dumped equities—exacerbating problems for financial institutions as their ability to raise additional capital at a reasonable price diminished. Even after a bloated version of the Paulson proposal passed the Senate, investors increasingly lost confidence in the market. The Fed and other central banks stepped-up their efforts and began injecting hundreds of billions of dollars of liquidity into the global financial system. By quarter-end, most indices were down. The sell-off intensified into the first week of the fourth quarter and, as of this writing, most major indices are at multi-year lows.
Small-Caps Outperform
Against this backdrop, small-cap stocks performed surprisingly well. The Russell 2000 Index declined only slightly compared with mid- and large-cap indices, with the Russell 2500 Index falling in between in losing 6.7%. Much of the difference in performance between market-caps centered on the Financials sector. Within the Russell 2000, Financials represented an average weight of 19.5% and returned 16.8%, compared with only a 14.9% average weight and return of just 2.3% for the Russell 1000 Index. The sharp decline in Energy stocks also had a greater negative impact on the relative performance of large-caps, as did the temporary ban on short sales implemented by the SEC at the end of the quarter. A much higher percentage of shares outstanding are held short in small-caps than large-caps, and the short-ban forced managers to cover their positions, thereby boosting stock prices. Indeed, some of the best performance during the period came from sectors with the largest short positions.
While Value outperformed Growth across the capitalization spectrum, small-cap value in particular trounced other equity classes during the quarter. That said, according to figures from Lipper Analytics and Merrill Lynch, fewer than 5% of active small-value managers beat the index during the third quarter (Lipper does not actively track small-mid cap manager performance). This compares with 72% during the second quarter of 2008, and marks one of the worst quarterly performances by active managers on record!
Active Management Headwinds
Several trends made it difficult for managers to outperform during the recent period. These intertwining headwinds included the sharp bounce in the Financials sector, huge index inflows into the index ETF to cover short positions, and record volatility. Investors should keep in mind that these forces are largely counter-fundamental and the inverse actions provided a tailwind for active managers throughout 2007 and much of first half of 2008.
Financials and Energy are currently the most volatile sectors in the market. Within Financials, diversified small-value managers are torn between the lack of transparency, relatively high valuations, and its 37% sector weighting within the index. Thus, even if a manager found the fundamentals in the Financials area attractive, they would effectively become a sector fund by overweighting the group. Consequently, when Financials lead the index higher, as they did in the third quarter, active managers are likely to underperform. (It is important to note that after the annual Russell index rebalancing in June, Financials actually increased in weight. According to Merrill Lynch analyst Steven DeSanctis, the difference in third quarter performance between the "old" Russell 2000 Value Index and the new was an astonishing 5 percentage points!)
The short-sale ban and heightened volatility also worked against active managers. It should be noted that with the enactment of when the new short covering rules, managers were forced to buy-in their short positions in Financials resulting in the most highly shorted financial stocks outperforming the lowest by a wide margin within the Russell 2000. Volatility does not favor most small-value managers either. To succeed in such an environment, one has to employ a trading strategy—something abhorrent to most successful value managers. While our value discipline makes it easy to decide when to sell a stock, on many of these whipsaw days stocks are not often at their values long enough to liquidate an entire position.
Winners and Losers
From a sector perspective, performance was mixed. Four sectors produced positive returns for the quarter and six produced a positive effect relative to the benchmark. The most positive contribution by far came from the portfolio's Consumer Staples holdings. While we generally consider these holdings defensive, this has not been the case throughout most of 2008. As commodity prices declined during the quarter, however, the prices of many staples-related stocks rose significantly and two of the Fund's top-three performers—Casey's General Stores and J&J Snack Foods—came from the group. Another top-performer, Fred's, though classified as a Consumer Discretionary company, could be considered a Staples holding. The firm is an operator of discount general merchandise stores, focused on selling low-priced staple items in a convenient, small store format. Successful execution of its strategic plan for fiscal 2008 created positive operating leverage during the quarter, boosting margins despite increases in shipping and utility expenses. Management remained disciplined with its use of cash flows in eliminating $33 million of debt for the year-to-date.
From both a relative and absolute perspective, Energy clearly accounted for most of the Fund's disappointing performance during the period. Seven of the eight worst performing stocks during the quarter were energy-related, including Helix Energy Solutions, Encore Acquisition, and Swift Energy. We began to decrease the portfolio's Energy exposure in late June and early July even though none of the stocks had achieved our assessed absolute values (based upon $85/barrel oil at the time). The rapid rise in oil to more than $140/barrel resulted in our energy holdings appreciating to the point where we became uncomfortable with our total exposure. Unfortunately, we did not trim fast enough. The speed and magnitude of the decline in oil prices was unprecedented and, frankly, caught us by surprise. Additionally, the shares of oil-related companies sold off at a level that was far ahead of the decline in the underlying commodity price.
We maintain a favorable longer-term bias on energy-related investments (most oil related companies are currently trading at valuations assuming $40 to $50/barrel oil), though it has become evident that energy markets are likely to remain extremely volatile. Given the unique dynamics of the current environment, including the massive unwinding by hedge funds, we are also less confident about where the intermediate-term bottom may be for oil and related investments. Consequently, as a manager that seeks to minimize volatility in the broader Fund, we have significantly reduced our energy-related investments.
Despite their positive performance on an absolute basis, the Fund's substantial underweight in Financials negatively affected relative returns. We are still actively scouring the sector for attractive opportunities. It remains a challenging task. Within the banking industry, balance sheets are generally not transparent enough for us to arrive at a reasonably confident valuation. In the absence of that, we have searched for banks that are buying-in shares, that have key insiders buying shares, and/or that are continuing to raise their dividend. That said, we believe the recent actions by the Federal Reserve, Congress, and Treasury will ultimately lift the sector, and thought it was prudent to begin selectively adding exposure to the group. Many of the new positions we established during the third quarter were in Financials-related companies, including Associated Banc-Corp, Unitrin, White Mountain Insurance, American Capital, and People's United Financial.
Outlook
Last quarter we summarized the macroeconomic forces that kept us from becoming more positive. We concluded that, "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 continue to decline across a broad swath of the economy." While a broad group of commodity prices did decline significantly during the third quarter, the housing market did not stabilize. As every American citizen is now painfully aware, financial intermediaries around the world also greatly deteriorated.
While we are still concerned about the short-term macro environment, a number of things have changed for the better. First, commodity prices have declined, which should aid businesses and consumers. Second, monetary and legislative authorities around the world are doing everything possible to get the credit markets functioning again. Third, and most important, the market has disengaged from fundamentals and is now trading on psychology or, more simply, fear—a necessary ingredient for major market bottoms and a potentially exploitable inefficiency.
How big is this opportunity? As of the market close on October 9, 2008, the discounted value of the top-20 holdings in our small- and SMID-cap Composite Portfolios was approximately 63% of our assessed absolute value. The historical "bottom" for this indicator in Small Cap Value is generally around 66%. One of the reasons we were negative on the small-cap asset class throughout 2007, and even more recently, was that this indicator remained stubbornly high—at its historical top-end of 80% to 82%. This indicated to us that despite the weakness in stock prices earlier in the year, fundamentals were deteriorating just as fast. If the indicator remains at or below its current value, it will be the first time since 2002—a year that marked the beginning of an exceptional period of performance in smaller-sized stocks. Keep in mind that we have been actively adjusting the assumptions behind these valuations downward to reflect the current economic and earnings landscape.
Of course, there is a disclaimer. The current environment is very different from 2002. The secular forces weighing upon the markets are profound and it may take many months, even years, to repair our financial system fully. We are confident, however, that given the current level of interest rates and liquidity flooding into the markets, equities will recover. Despite what some people are saying, this is not 1974 (when interest rates and inflation were obscenely high) and our economy does not fundamentally mirror that of Japan during the 1990s.
Are we calling a bottom? No. Frankly, we're not that good. We also have some near-term concerns. Analyst estimates for 2009 seem unrealistically high, and as those estimates decline over the next six-to-nine months, stocks could remain under pressure. We also don't have a clear picture of the next administration's tax policy. Additionally, credit spreads are at historic highs (a negative for small-cap performance) and small-cap stocks appear overvalued relative to large- caps. We also know that unwinding the many problems that contributed to our current situation could be a long and bumpy process. Trumping these concerns, however, is the value we see in the Fund and the fact that interest rates are near historic lows. If that is not enough, we can point to the past: While no two bear markets are alike, stocks historically have tended to bounce back quickly once confidence in the economy and the markets have been restored.
Thus, amid the fear and panic of a global market meltdown, we conclude with the belief that given an appropriate time horizon, this will prove to be an exceptional buying opportunity for the Fund.
River Road Asset Management
As of September 30, 2008, Casey's General Stores comprised 3.71% of the portfolio's assets, J&J Snack Foods – 1.76%, Fred's – 1.15%, Helix Energy Solutions – 1.55%, Encore Acquisition – 1.61%, Swift Energy – 0.93%, Associated Banc-Corp – 0.80%, Unitrin – 0.31%, White Mountain Insurance – 0.77%, American Capital – 0.98%, and People's United Financial – 0.53%.