Market Commentary as of 9/30/08
Global Credit Crisis
Global equity markets fell dramatically during the third quarter as the year long global credit crisis led to a series of unprecedented events in September, including the US government's takeover of Freddie Mac and Fannie Mae and rescue of insurance giant American International Group (AIG). In addition, toxic mortgage debt saddled prominent investment banking firms in the US resulting in one firm filing for bankruptcy, another being acquired, and two attempting to stay afloat.
Central banks across the world have taken swift and decisive measures to ease credit conditions and allay fears regarding the health of the global financial system. Actions included asset injections as well as curbs on the short selling of shares of financial institutions. The US Treasury's sweeping $700 billion proposal to stabilize the domestic financial system underscores the necessity to restore investor confidence and lending capacity. A return of confidence in the financial system is of critical importance and we believe achievable over the next 18 to 24 months as regulators make clear new policies and safeguards. While we do not expect these measures to cure the credit crisis, we believe these steps will minimize the underlying risks to the global economy and the financial system.
Of all the sectors and geographic regions of the Fund's MSCI EAFE SMID Index benchmark, none offered relief from the decline in worldwide markets. Cyclically oriented sectors such as Industrials, Energy, and Materials sectors dropped sharply. Energy stocks more than gave up the gains achieved during the second quarter of 2008, as the price of oil retreated considerably. Defensive sectors such as Healthcare and Consumer Staples fared slightly better, though they too posted negative returns. On a country basis, Japan fell only 16% compared with more severe weakness in Europe, where Austria, Ireland, and Norway posted declines of roughly 40%. During the third quarter, the Fund lagged the benchmark by more than four percentage points, in an environment where small-to-mid cap indices experienced slightly larger declines than large-caps.
Winners and Losers
Stock selection within the Industrial sector suffered due to sharp declines in the marine segment, which included Singapore-based Neptune Orient Lines and Danish dry-bulk shipper D/S Norden. Both companies' emphasis on Asia-Europe routes hurt, as they have come under increasing pressure as growth in Europe has weakened. This was somewhat offset by Japanese names within the sector, such as mining machinery firm Hitachi Construction Machinery, that benefited from its greater focus on emerging market demand.
Expectations of a global economic slowdown substantially affected valuations of the portfolio's Consumer Discretionary holdings in developed markets, most notably in the UK, Japan, and Germany. Similar to the plight of US consumers, tightening credit conditions exacerbated the negative outlook on spending in the consumer retail, restaurant, and leisure segments. Hard hit real estate markets affected expectations in homebuilding related businesses as well, including Japanese power tool manufacturer Makita Corp. and Germany’s Praktiker AG, a do-it-yourself home improvement retailer.
The portfolio's increase in Utilities exposure earlier in the year, especially electric utilities, proved well timed. Drax Group PLC, the largest coal-fired station in Western Europe, delivered modest positive returns during the quarter. Spice Plc, the UK's largest reader of utility meters and International Power PLC, an independent electricity generator with operations in 20 countries, both outperformed on a relative basis.
The Fund's slightly underweight stake in the Financial sector also provided a boost. Non-US financial firms typically had less exposure to the mortgage security market at the heart of the credit crunch, and small-cap non-US financial firms had even less. Investments in select bank positions less exposed to the ongoing credit issues such as Japanese-based Seven Bank, which earns more than 95 percent of its revenue from fees received from its ATM network, aided returns. Diversified financial companies like Acom, Metropolitan Holdings, and Sanlam also contributed on a relative and absolute basis.
Outlook
As of the end of September, we continue to see global markets experience further declines. Amid the turmoil, we are encouraged by the recognition on the part of governments around the globe that "systematic planning" is required instead of just "crisis intervention." Fewer calls for panic and more calls for calm are in order. While waiting for a more rational reaction to set in, we have addressed the increased volatility by stepping up our fundamental reviews to include keeping a watchful eye on debt levels across the portfolio and by increasing diversification in terms of the number of holdings and number of industries held.
We continue to adhere to our investment process, as we believe the consistent application of a disciplined approach to stock selection and portfolio construction will serve investors best in the long run. While the financial crisis seems far from over, we feel that our investment process based primarily on company fundamentals and a disciplined quantitative process should perform well in an environment where strong fundamentals are needed to ride out a weak credit market environment.
Strategic Global Advisors (SGA)
Newport Beach, CA
As of September 30, 2008, Neptune Orient Lines comprised 0.96% of the portfolio's assets, D/S Norden – 0.39%, Hitachi Construction Machinery – 1.51%, Makita Corp. – 1.40%, Praktiker AG – 0.29%, Drax Group – 1.21%, Spice – 1.42%, International Power – 0.78%, Seven Bank – 0.72%, Acom – 1.43%, Metropolitan Holdings – 0.88%, and Sanlam – 0.54%.
Note: Risks of investing in international markets include but are not limited to social and political instability, market illiquidity and currency volatility. Small and Mid-cap stocks are generally riskier than large-cap stocks due to 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.