Market Commentary as of 6/30/08
The second quarter of 2008 marked another volatile period for equity performance, with stocks rallying sharply during April and May only to decline precipitously in June. Investors grappled with the dual threats of weaker economic growth and higher inflation, and the fear that central bankers' hands may become increasingly tied in their ability to support flagging economic activity.
Still, we continue to find the economic backdrop conducive to growth stock investing. Despite many forecasts calling for a recession, the US economy has followed a path of positive—albeit weak—real Gross Domestic Product (GDP) growth, that we expect to continue through the second half of the year. The ongoing and formidable deleveraging of the financial and household sectors, plus the dramatic surge in energy prices could restrain growth going forward, however. In this environment, investors will likely seek the more visible, consistent earnings growth offered by high-quality growth stocks.
Early Stages of the Growth Rotation
A year ago, we made the case that a combination of historically low relative valuations and the onset of a more challenging economic and corporate profit environment would lead to a period of relative outperformance for growth stocks versus value stocks. According to the Russell indices, that rotation seems to be already well underway, as growth stocks of all sizes have outperformed their value counterparts during the past year. Within mid-caps specifically, the Fund's Russell Midcap Growth Index benchmark has outgained the Russell Midcap Value Index during 13 of the last 15 months.
We continue to believe that we are only in the early stages of this rotation. Despite their recent run of outperformance, mid-growth stocks still significantly lag mid-value stocks when looking all the way back to the last major rotation in 2000. During the eight-year period from June 30, 2000 to June 30, 2008, the Russell Midcap Value cumulatively outperformed the Russell Midcap Growth by more than 137%.
To be sure, it has still been a rough year for the Fund, which despite delivering positive returns for the quarter lagged its benchmark. Poor stock selection within the Consumer Discretionary and Energy sectors were the biggest detractors to performance. Consumer-oriented firms, such as Dicks Sporting Goods and Sonic Corp., that held up relatively well during the early stages of the downturn finally succumbed to the macroeconomic pressures. Despite an overweight allocation to Energy and strong performances from Forest Oil, Southwestern Energy, Smith International, and Core Labs, it wasn’t enough to compensate for a lack of exposure to some of the sector's strongest performers during the quarter, many of which were coal stocks.
The portfolio was not completely devoid of coal-related holdings, however, as a sizable position in coal mining equipment supplier Joy Global performed admirably during the quarter. Other winners during the period included networking firms F5 Networks and Akamai Technologies, take-out target Wm. Wrigley, and asset manager Eaton Vance.
Positive Outlook
Despite the recent market volatility, we continue to have a positive outlook for the shares of high-quality mid-growth companies—particularly those with strong balance sheets that lessen the need for bank financing, exposure to healthier overseas economies, and pricing power that allows them to offset rising input costs. Valuations remain attractive on our work, and we expect the superior earnings growth for the stocks in the portfolio to shine through amid the more challenging corporate profit environment. Currently, we favor issues within the Energy, Technology, and Healthcare sectors, where we see the most attractive combination of earnings growth and compelling valuation.
M. Scott Thompson, CFA
Andrew W. Jung, CFA
As of June 30, 2008, Dicks Sporting Goods comprised 1.23% of the portfolio's assets, Sonic Corp. - 0.00%, Forest Oil - 1.60%, Southwestern Energy - 2.14%, Smith International - 2.76%,Core Laboratories – 2.05%, Joy Global - 2.04%, F5 Networks - 1.33%, Akamai Technologies - 2.70%, Wm. Wrigley - 2.74%, and Eaton Vance - 1.60%.
Note: Small and Mid-cap stocks are generally riskier than large-cap 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.