Market Commentary as of 3/31/2008
Multiple Headwinds
Although several of the Fund's investments posted significant positive returns, our strategy faced multiple headwinds during the quarter. The economic slowdown caused investors to place a premium on near-term earnings visibility and severely discount any uncertainty. While not unusual during an economic downturn, it's not conducive to positive relative performance for long-term oriented investors such as Cardinal. In addition, there was little merger and acquisition activity during the quarter as the credit crisis removed financial buyers from the marketplace. Despite the market becoming cheaper as valuations declined, few value creating events occurred to boost the performance of the portfolio. Temporary headwinds aside, we are confident that the companies in the portfolio are fundamentally sound and present excellent value for the long-term.
The Fund underperformed its Russell Midcap Value Index benchmark by more than a percentage point during the quarter. Overweight stakes in the Technology and Telecommunications sectors fared poorly relative to the index on concerns about their economic sensitivity. Stock selection within Industrials and Consumer Discretionary served as the main detractor from performance, however. Jackson Hewitt declined sharply after the IRS said that it was reviewing its regulations relating to refund anticipation loans and the company announced an earnings shortfall owing to a lack of a key early tax season financial product this year—a mistake management does not intend to repeat. Nevertheless, the Fund sold the position as the firm's market capitalization no longer meets its mid-cap threshold. Within Consumer Discretionary, Speedway Motorsports lagged due to issues unrelated to its long-term business fundamentals and R.H. Donnelley saw its business deteriorate faster than expected, and was sold.
Tech Ideas
At Cardinal, we focus on finding companies with solid fundamentals at opportunistic valuations. Lately, that approach has led us to two standout Technology companies. Convergys is a leading provider of outsourced billing, customer care and human resource services to the Global Fortune 500 companies. By securing long-term commitments, the company has been able to leverage its overhead and global scale to provide better quality services at lower cost to its customers. Many companies have chosen to outsource all but their core competencies as a means of remaining competitive. The Fund took advantage of recent volatility in the stock to buy Convergys at a depressed price. With solid free cash flow generation and accelerating earnings growth expected next year, we think the firm's stock price will eventually move higher, reflecting its increasingly diverse customer base and more visible financial results.
Checkpoint Software is one of the largest pure-play internet security vendors. It sells hardware, software, and services that allow secure Internet communication to protect customer networks from internal and external threats. The firm has recently revived its revenue growth by introducing new products, penetrating new distribution channels, and entering new vertical markets through acquisitions. Although it has repurchased more than a billion dollars of its own stock during the past four years, the company still has 25% of its market capitalization in cash. With high operating margins, little capital reinvestment required, and a structurally low tax rate, Checkpoint generates significant free cash flow relative to its market capitalization.
Cautious and Optimistic
Overall, we are cautious about the prospects for the US economy for the balance of 2008, but optimistic about the equity market. Despite an accommodative monetary policy, we believe that muted economic growth will persist due to ongoing weakness in housing, dislocations to the credit markets, and higher energy prices. Equity valuations appear to have discounted this weakness through the rest of the year, though not any potential pick-up in the economy or any increase in mergers and acquisitions as strategic buyers move to purchase companies at depressed prices. Regardless, we believe the management teams of the companies within the portfolio are committed to delivering solid financial results and enhancing shareholder value through intelligently reinvesting their free cash flow.
Cardinal Capital Management
Greenwich, CT
Note: 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.
As the fund is actively managed, the securities as presented do not represent the current or future composition of the portfolio.
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.