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. The Russell 2500 Index stayed in positive territory, reflecting the positive contributions of its mid-cap constituents, but is only slightly outpaced the Russell 2000 Index for the year-to-date through June 30. Growth stocks performed relatively well across the capitalization spectrum. For example, the Russell 2500 Growth Index gained 3.6% during second quarter compared with -1.2% for the Russell 2500 Value Index.
Size Does Matter
Within the small-to-mid cap universe, a consistent theme throughout 2008 has been the outperformance of ‘larger’ small-cap stocks. Within the Russell 2500 Index, the largest capitalization quintile returned -4.1% for the year-to-date, versus -22.7% for the smallest quintile. Similarly, within the Russell 2500 Value, the largest quintile returned -3.8% compared with -25.0% for the smallest. This trend has presented a bit of a headwind for our SMID Cap 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 post a positive return for the quarter in outperforming its Russell 2500 Value Index benchmark by more than four percentage points. It is not surprising that an overweight position in energy-related holdings significantly aided performance as oil and natural gas prices skyrocketed. Seven of the Fund's top-10 performing holdings—including Encore Acquisition, Swift Energy, and Cimarex Energy—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. Spending billions of dollars ramping up its production infrastructure finally paid off for Cimarex, which had been stagnant since its 2005 merger with Magnum Hunter. The firm maintains one of the strongest balance sheets in the E&P industry, and successful horizontal drilling in New Mexico and Texas has boosted results.
A severe underweight position in Financials also contributed greatly to second quarter performance. As of June 30, 2008, Financials represented only 7.5% of assets in the portfolio compared with 28.7% for the Russell 2500 Value. (Even ex-REITs, which the index treats as financial companies but which we consider a separate asset class, the Fund is 11.6% 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 to 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 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 Benihana. 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 and liquidate a similar operator—Bob Evans Farms. Similarly, Benihana has suffered from rising costs and decreased traffic. Management issued disappointing guidance for fiscal 2009 in anticipation of higher labor and food costs, and decided against implementing price hikes given its geographic concentration in the areas hardest hit by the real estate downturn. We are less confident than management that this strategy will pay off, and significantly reduced the Fund's position in an effort to trim overall consumer exposure.
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 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 Cal Dive International. Chemed operates two wholly distinct businesses, Vitas and Roto-Rooter, both of which are leaders in their respective markets. Cal Dive is a marine contractor that provides manned diving, pipe laying, and platform installation and salvage services to oil and natural gas customers. Diving can be both a risky business and occupation—the former affected by short-term contracts that can hinder earnings visibility. In the current high-demand environment, however, we believe the firm's leading position in the industry and discounted valuation make for an attractive investment.
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. There is value in the portfolio, though not at the bullish levels seen at the trough of the January correction. 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.
River Road Asset Management
As of June 30, 2008, Encore Acquisition Company comprised 3.31% of the portfolio's assets, Swift Energy - 2.96%, Cimarex – 3.20%, Coca-Cola Bottling Company Consolidated - 0.45%, CBRL Group - 1.14%, Benihana – 0.30%, Chemed Corp. - 0.96%, and Cal Dive International - 0.97%.
Note: Investors should be aware of and understand the risks associated with mutual funds. Mutual funds are intended to be long-term investments and will fluctuate daily with market conditions. Small and Mid-cap stocks are generally riskier than largecap stocks due to the greater volatility and less liquidity.
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.