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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.”
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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.
High Quality - Stocks in the Russell 2500™ Index with an S&P quality ranking of A- or higher.
Low Quality - Stocks in the Russell 2500™ Index with an S&P quality ranking of B or less. |
Portfolio Overview
The Small-Mid Cap Core Portfolio underperformed the Russell 2500 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.
Besides the portfolio’s underweight in energy, the Small-Mid Cap Core Portfolio’s
energy holdings did not keep pace with those in the benchmark due to the types of
energy companies that we own. Given our high-quality orientation, we own
companies that have less direct exposure to the underlying price of the commodity
in order to protect the portfolio against the price volatility. In this environment, these
types of energy companies did not perform as strongly as those with more direct
exposure to the commodity, such as oil producers and drilling companies.
The companies that contributed the most to performance during the quarter
included Eaton Vance and Digital River. Eaton Vance, an investment management
firm, reported strong growth in assets under management during the quarter,
allaying investor concerns about the challenging financial-market environment, in
general, and disruptions in the closed-end fund market, in particular. The company
also took aggressive steps to mitigate its exposure to the auction-preferred securities
problems that negatively affected the closed-end fund market. Digital River builds
and operates online stores on an outsourced basis. The company is a key beneficiary
of the shift within the software industry to online distribution, currently only 19% of
software sales to consumer and small and medium-size businesses. As the largest
player in the industry, serving over half the electronic-software download market,
Digital River generates additional growth by leveraging its expertise into areas such as
online consumer electronics sales and internet computer games.
Companies contributing the least to performance during the quarter included UCBH
Holdings and Pediatrix Medical Group. UCBH reported highly disappointing first
quarter 2008 results, driven by a dramatic deterioration in loan quality. We initially
entered the stock when UCBH primarily acted as a lender to the low-risk commercial
real estate market (apartment, owner-occupied, and income producing properties)
and boasted a long track record of serving an attractive, fast-growing niche segment
of the ethnic Chinese population. Recently, however, UCBH rapidly expanded into
higher risk construction within the commercial and industrial segments.
Construction loans advanced 50% between the first quarter of 2007 and the first
quarter of 2008, sourcing the company’s dramatic deterioration in problem loans.
The shares of Pediatrix Medical Group, the largest neonatal practice management
company in the nation, suffered due to weakening birth rates. Nonetheless, we
believe the important advantages of the business, particularly the hospital-derived
patient relationship, as well as its ability to generate superb returns on capital remain
intact.
Purchases and Sales
In the Small-Mid Cap Core Portfolio, we purchased Landstar System, RPM
International (RPM), and increased our position in Teleflex, while we sold our
positions in Bemis Company, Jackson Hewitt Tax Service, and Zebra Technologies.
Landstar System is a leading non-asset based business services company that
provides transportation solutions to shippers throughout the Unites States. These
services are delivered through a network of independent sales agents and
independent truck owner operators that Landstar calls business capacity owners
(BCOs) linked together by a series of innovative technological applications utilizing
the Internet and wireless communications. Landstar is differentiated by its unique
capability to arrange a wide range of specialized transportation services quickly
through its people and technology network. Due to its overall asset-light business
model, Landstar achieves a very high return on equity. The company has also been
a consistent repurchaser of its own stock. The company generates very strong free
cash flow and should be able to continue share repurchases at similar paces going
forward.
RPM provides specialty coatings encompassing over 100 brand name products for
general maintenance, waterproofing, roofing systems, sealants, floor coatings, and
corrosion control. Leading consumer brands include Rust-Oleum, Bondex, Zinsser,
Testors and Bondo. Leading industrial brands include Day-Glo, Carboline, Mathy’s
Mohawk, and Tremco. The company has been a consolidator in the industry and has
been able to leverage the acquisitions through their distribution channel, including
the do-it-yourself channel of Home Depot and Lowe’s. Initially, RPM had left their
acquisitions as independent operating units. This left the benefits of scale economics
unharvested. RPM is now integrating their acquisitions with good success. The
operating business continues to do well with double-digit earnings growth with
continued good demand for its well-known name products, despite the commodity
price headwind that RPM and the rest of the industry faces. RPM’s well-known brand
names give the company more pricing power than others in the industry. Trading at
an attractive valuation, we decided to purchase the stock.
Teleflex declined year to date (as of the initiation of the increase) as the company’s
integration of its acquisition, medical-device company Arrow, that closed in October
last year is ongoing. Once complete, the acquisition will transform this industrial
company with a small medical-device business to a medical-device business with a
small industrial segment. Longer term, we believe that investors will come to
appreciate the potential of Teleflex for its majority medical-device business that has
a higher recurring revenue component due to its disposable nature and higher profit
margin. In addition, the company will be better able to weather economic downturns
due its smaller industrial business.
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*Includes 10-year liability reserve.
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. |
Bemis is a global manufacturer of flexible packaging and pressure sensitive
materials. The rapid rise in energy prices over the past 18 months hurt Bemis’
margins because oil-derived resin prices, one of the largest input costs for the
company, quickly escalated. Bemis will face continuing headwinds from high input
costs, along with curtailed end customer demand, as consumers have migrated to
lower value-added packaging from high value-added packaging due to the weakening
economy along with inflationary pressures for food costs. Consequently, we sold
Bemis to fund the purchase of RPM.
Jackson Hewitt is a leading provider of tax-preparation services to the general public
in the United States. On January 3, 2008, the IRS issued an advance notice of
proposed rulemaking relating to Refund Anticipation Loans (RALs). The notice
indicated that the IRS is considering restricting tax preparers’ ability to market RALs
to clients. Jackson Hewitt gets approximately 25% to 30% of its revenues and a higher
percentage of profits from such financial products. Further, the company reported
earnings that were well below consensus in Q1 with lower returns prepared, partially
due to a lack of pre-season loan product that had been a key customer retention tool
for the company. At the same time, industry office expansions have lowered the total
returns per office. Theses statistics indicate that despite aggressive expansion efforts,
the three large industry competitors are not gaining share from independents, but
rather are cannibalizing from existing stores. The whole tax-preparation industry is
facing competition from the Free File Alliance, a group of private companies that
offers free federal tax filing to tax payers below a certain income threshold as well as
the increasing use of software vendors, such as Turbo Tax and Tax Cut. With limited
upside potential, a majority of our original reasons for purchasing the stock
deteriorated in validity, and the franchise value of Jackson Hewitt diminished, we sold
our position.
Zebra Technologies is the worldwide leader in thermal bar code printers. The stock
rebounded from a low reached earlier in the year as the result of a new management
team, margin improvement, and the growth of sales from new products.
Nevertheless, we remain concerned that the core business that produces high
margins and return on capital has matured. We sold our position to fund the
purchase of another technology company that will be completed during the third
quarter.
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.
| Portfolio Characteristics |
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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.
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