 |
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“At this point in the cycle, we believe owning a
diversified portfolio of companies with a high return
on equity, strong balance sheets, and above market
earnings growth is a prudent strategy.”
|
Market Overview
After rallying during April and May to erase much of the markets’ first-quarter
declines, the markets experienced one of the worst (if not the worst for certain
indexes) monthly returns in history for the month of June. The markets continue
to be affected by the slowing economy, persisting credit problems, and rising
inflation. For the quarter, the Russell Midcap Index rose 2.67%, outperforming
both the Russell 2000 Index (+0.58%) and the S&P 500 Index (-2.73%). Growth
significantly outperformed value during the quarter, with the Russell 2000 Growth
Index up 4.47% versus the Russell 2000 Value Index down 3.55%. Year to date
through the second quarter, all equity indexes, regardless of asset class, were
down in the high single-digit to low double-digit range.
Reflecting record high oil prices, energy was the strongest performing sector by a
wide margin, increasing more than 30% in every small and mid-cap Russell
index. Financial services was among the worst performers, continuing the trend
experienced for several quarters, along with transportation and consumer staples,
which were both impacted by higher commodity prices.
Low-quality stocks, as measured by S&P Quality Rankings, held up substantially
better than high-quality stocks during the quarter (See chart: Performance by
S&P Quality Rankings). Although high-quality should intuitively outperform in
this type of market environment, high quality underperformed due to the large
weighting of banks in the high-quality segment of the benchmarks, which were
down considerably during the quarter. Excluding financials, the performance
between high and low quality appeared more balanced. However, in the sectors
where low quality outperformed, it was by a greater magnitude than in the sectors
where high quality outperformed.
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Data is obtained from FactSet Research Systems and is assumed to be reliable.
Past performance is no guarantee of future results. Data is for the second quarter 2008.
High Quality — Stocks in the Russell Midcap® Index with an S&P quality ranking of A- or higher.
Low Quality — Stocks in the Russell Midcap®Index with an S&P quality ranking of B or less. |
Portfolio Overview
The Mid Cap Core Portfolio underperformed the Russell Midcap Index for
the quarter. The underperformance was driven by the aforementioned
performance of low quality during the quarter and by the strong performance of
the energy sector. However, year-to-date, the portfolio is outperforming the
benchmark.
The companies that contributed the most to performance during the quarter
included CARBO Ceramics and Devon Energy. CARBO Ceramics is the world’s
leading producer of ceramic proppants, which are high strength, spherical
pellets used in hydraulic fracturing of natural gas and oil wells to accelerate rates
of production. The company achieved a new quarterly record in revenue and
proppant volumes due, in large part, to its new product, HYDROPROP, that is
effectively capturing share away from resin-coated sand that is used with slick
water fracturing in drilling in sandstone formations. As the company’s volume
increases, the company is able to leverage its excess capacity. Additionally, the
company is benefiting from the strong energy prices that are increasing drilling
activity and well completions. Devon Energy is one of the largest independent oil
and gas producers, with operations in the Texas, Oklahoma, Gulf of Mexico, Rocky
Mountains, western Canada, and West Africa regions. The company delivered
another solid quarter of strong double-digit production growth in the Barnett
Shale. Also in the quarter, Devon divested all of its African properties and will use
the proceeds to reduce short-term debt, as well as likely resume its share
repurchase program. In addition, Devon expects that its deepwater project in the
Gulf will begin production in mid-2010.
Companies contributing the least to performance during the quarter included
Cincinnati Financial and Choice Hotels International. Cincinnati Financial, a
property and casualty (P&C) insurance company, faced challenges this quarter
brought about by several factors. First, the P&C market, in general, was hurt by a
“soft” market, characterized by increased competition and lower pricing. Second,
and compounding the first problem, was Cincinnati Financial’s geographic
concentration in the Midwest, where several large storms and floods led to high
catastrophe losses for the company. Finally, the company saw substantial declines
in their investment portfolio due to considerable exposure to the financial-services
sector. Choice Hotels International, a worldwide hotel franchisor of such brands
as Comfort Inn, Quality Inn, and Econo Lodge, had its shares decline in the
quarter despite posting solid results, as the perception that higher gas prices could
impact future demand for lodging at its facilities. While we believe that the entire
hospitality industry is suffering from the impact of higher inflation, we expect that
the lower end of the hotel industry should hold up better than the high end. That
said, the rates of decline in some areas are unprecedented. However, operators, rather
than franchisors, should face greater hardships, thus giving us more confidence in Choice’s
franchise-only model.
Purchases and Sales
In the Mid Cap Core Portfolio, we purchased Ares Capital (Ares), Choice Hotels
International (Choice), and sold our positions in The Cheesecake Factory and
State Street.
Ares is an externally managed business development company/registered
investment company (BDC/RIC) that provides long-term investment capital to
support the expansion of growing middle-market businesses with limited access
to alternative sources of funding, operating primarily in less cyclical, less capital intensive
industry segments (e.g., consumer products, health care, business
services). Ares targets an attractive niche market of small to medium-size privately
held companies with EBITDA between $5 million and $50 million (a group that is
becoming an increasingly significant part of the U.S. economy), with a proven
history of stable cash flows, sustainable competitive positioning, and experienced
management teams. Both the company and its typical customer are operating in
highly fragmented markets where pockets of opportunity exist for an experienced
player like Ares. The company’s seasoned lending team with its profound industry
expertise, extensive deal sourcing network, and solid track record, further aided
by the BDC’s affiliation with the highly reputable Ares brand, provides it with a
sustainable competitive advantage and pricing power. Structured as a BDC/RIC,
Ares is required to distribute at least 90% of its taxable income in dividends,
providing an attractive dividend yield. RIC’s exemption from federal and state
income taxes enables the company to achieve strong equity returns with a limited
(by the BDC status) one-to-one leverage. The stock traded at a meaningful
discount to the company’s net asset value at the time of purchase, as the company
has suffered along with that of other financial-services companies due to an
ongoing turmoil and risk re-pricing in the credit markets. However, we believe that
with Ares’ careful deal selection, industry expertise, and conservative balance
sheet structure, coupled with its focus on lower risk senior debt securities, the
company is well positioned to navigate the current environment and should, in
fact, benefit from the recent dislocation in the credit markets.
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*As of 1Q08. Company IPO’d in October 2004.
†Dividends per share are used as a proxy for Ares as EPS includes unrealized gains and losses.
Company data as of the date that the purchase program was initiated. Benchmark data as of
March 31, 2008.
Source: Major consulting firm, Bloomberg, and FactSet Research Systems
Past performance is no guarantee of future results. |
Choice operates as a hotel franchisor worldwide. The company franchises lodging
properties under the brand names of Comfort Inn, Comfort Suites, Quality,
Clarion, Sleep Inn, Econo Lodge, Rodeway Inn, MainStay Suites, Suburban
Extended Stay Hotel, Cambria Suites, and Flag Hotels. As a pure-play lodging
franchisor, Choice has achieved some of the highest returns in the lodging
industry as sustained growth in a variety of economic conditions and industry
cycles provides favorable financials. The company adds value to the franchise
system in several ways: Brand awareness, national marketing, central
reservations, services, and technology. The franchising model has been difficult to
duplicate due to the capital required to generate scale as well as long-term
contracts that provide a barrier to entry. Given the franchise business model with
low capital requirements, Choice creates high return generation due to the
economies of scale. The strong free cash flow that also comes from this model has
been used to buyback shares and increase the dividend over the years. Choice has
a solid balance sheet and operating margins have been in the 30% range
consistently. The company has also been an aggressive purchaser of its own shares
over the past four years given the strong free-cash-flow characteristics.
The casual dining restaurant industry has seen its fortunes fall due to the outfall
from last year’s credit crunch and housing market weakness. Guest counts at The
Cheesecake Factory have been lower for the past six to nine months due to this
change in consumer behavior. This, coupled with rising operating costs, such as
food commodities and labor wages, have lowered profitability throughout the
industry. Given the ongoing weakness in the economy (no international exposure)
combined with lasting high prices in such goods as produce and poultry, we
believe a turnaround at the company will take longer than current expectations.
We sold our position in State Street during the quarter, as the company has a large
market capitalization ($27 billion at the time of the sale), and is facing a variety
of risks in the future, including lawsuits alleging that the company inappropriately
invested money in risky securities. Further, State Street faces exposure in offbalance-
sheet conduits (instruments that sell short-term commercial paper to
fund the purchase of long-term assets). We used the proceeds to fund the
purchase of Ares.
Outlook
Inflationary concerns, driven by the cost of oil rising to over $140 per barrel, are
limiting the Federal Reserve’s ability to further lower interest rates to stimulate the
economy. Globally, higher inflation is leading policy makers to implement policies to
slow growth. This should lead to a decrease in demand for commodities over time
and, if past cycles repeat, lower prices. At this point in the cycle, we believe owning a
diversified portfolio of companies with a high return on equity, strong balance sheets,
and above market earnings growth is a prudent strategy.
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| Data is obtained from Bloomberg, FactSet Research Systems, and a major consulting firm, and is
assumed to be reliable. Other principal consultant firms may use different algorithms to
calculate selected statistics. Data is as of June 30, 2008. |
As always, we endeavor to manage your portfolio with the highest quality businesses,
outgrowing their markets, purchased at discount values. |
