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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. Data is for the second quarter 2008.
High Quality — Stocks in the Russell 2000® Value Index with an S&P quality ranking of A- or higher.
Low Quality — Stocks in the Russell 2000® Value Index with an S&P quality ranking of B or less. |
Portfolio Overview
Despite the low-quality headwind, the Small Cap Quality Value Portfolio
outperformed the Russell 2000 Value Index for the quarter due to strong
stock selection.
The companies that contributed the most to performance during the quarter
included Syntel and Lincoln Electric Holdings. Syntel, a leading provider of
outsourced IT services, benefited from added capacity in India and strong
demand for its high-margin business processing outsourcing (BPO) services.
The company performed well despite economic worries, as more than 65%
of its revenues come from “keep the lights on” types services, such as
maintenance. Lincoln Electric Holdings is the world leader in arc welding
equipment and consumables. The company continues to prosper from the
strong industrial economies worldwide and the global infrastructure capital
spending. Despite the commodity-cost headwind, the company has aptly
improved on operating margins due to its ability to push through price
increases along with good operational cost control.
Companies contributing the least to performance during the quarter
included Cathay General Bancorp and Cherokee. Cathay General is the
holding company for Cathay Bank, the leading California bank serving the
ethnic Chinese community. With the Southern California housing market in
turmoil, the stock suffered, along with those of other commercial lenders,
with an exposure to the state’s troubled residential construction segment.
Although many expect credit costs to continue to rise after a number of years
of above-average asset quality, charge-offs should remain manageable. In
addition, because most of the lender’s funding is variable and with deposit
costs bottoming out, we expect net interest margin to increase in 2008.
Importantly, with its core California footprint seeing a distinctive slowdown,
the company is well positioned to benefit from its recent geographic
diversification efforts. Cherokee, a marketer and licensor of several retail
apparel brands, saw its shares slump in the quarter after outperforming
during the first quarter of the year. Despite announcing in early 2008 a
renewed a licensing agreement of its Cherokee brand to Target stores through
2012, results showed that the brand’s sales at Target have declined over the
past year. Although international retailer Tesco is becoming a larger piece of
Cherokee’s business, Target’s decline hurt overall growth because the retailer
has diversified its merchandise offering and seen overall weakness in its own
sales. Still, with its low capital requirements and lack of inventory risk, we
continue to admire Cherokee’s business model in a volatile retail
environment.
Purchases and Sales
In the Small Cap Quality Value Portfolio, we increased our positions in
Chattem, Entertainment Properties Trust (EPT), and WD-40 Company, and
sold our positions in Corus Bankshares and Jackson Hewitt Tax Service
(Jackson Hewitt).
Chattem manufactures and markets a portfolio of over-the-counter healthcare
products, toiletries, and dietary supplements. The stock declined year to
date (as of the date of the purchase program), driven primarily by investor
concerns over ACNielsen’s reports indicating negative revenue growth trends
for the company as well as the recall of the Icy Hot Heat Therapy product in
February. However, Chattem is seeing faster growth in more defensive
Wal-Mart and club store channels that are not tracked by ACNielsen. Further,
there are no indications that the Icy Hot Heat Therapy recall is affecting other
products within the Icy Hot brand, with the brand showing increases in the
first quarter and continuing to perform well in the second quarter. Chattem
shows strong financials with profitability supported by the company’s
exposure to price-inelastic, over-the-counter, health-care categories coupled
with its relatively limited exposure to rising commodity costs. With the stock
trading at an attractive valuation, we added to our position in this solid
consumer products company.
Created in 1997 as a spin-off from AMC Entertainment, EPT is the only
publicly traded real estate investment trust (REIT) that focuses on the
attractive niche market of high-quality single tenant megaplex movie theaters
and entertainment themed retail centers located in the U.S. and Canada. EPT
reported strong Q1 2008 results and increased its quarterly dividend 10.5%.
EPT’s balance sheet remains strong, with the company's recent capital
markets activity serving as proof of the REIT’s financial flexibility. With the
stock down from its highs in February 2007 and trading at an attractive
valuation, we increased our position.
WD-40 Company produces and markets lubricants, hand cleaners, and
household cleaners worldwide. The stock declined following the company’s
2Q08 reports of lower-than-expected top-line growth, primarily attributable
to softening in promotional activity and retailer inventory reductions ahead
of the launch of the WD-40 Smart Straw product, and overall weakening of
the U.S. economy, which was offset by strong growth internationally.
Importantly, the Smart Straw product will allow for a roughly 30% unit price
increase and longer term profitability enhancement. With its highly efficient,
primarily outsourced manufacturing model, WD-40 generates substantial
free cash flow that it has used to buy back stock and execute occasional
strategic acquisitions. With the stock down and trading at an attractive
valuation, we increased our position in the company.
Corus Bankshares, Inc., is a bank holding company for Corus Bank, N.A., a
commercial real estate lender focused on condominium construction and
conversion projects located throughout the United States. In the quarter
ended March 31, 2008, Corus saw earnings-per-share decline and the
company continued to suffer from an industry-wide problem of heightened
deposit costs. The combination of pressured interest income due to nonperforming
loans, alongside heightened deposit costs, led us to expect a
protracted recovery process. We sold our position in the quarter.
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 preseason
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.
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./td>
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As always, we endeavor to manage your portfolio with the highest quality
businesses, outgrowing their markets, purchased at discount values.
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