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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 Credit Ratings, held up substantially
better than high-quality stocks during the quarter (See chart: Performance
by S&P Credit Ratings). 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¨ Growth Index with an investment grade S&P credit rating.
Low Quality - Stocks in the Russell 2000¨ Growth Index with a below investment grade S&P credit rating. |
Portfolio Overview
The Small Cap Sustainable Growth Portfolio underperformed the Russell
2000 Growth Index for the quarter. The underperformance was driven
primarily by the aforementioned performance of low quality during the
quarter.
The companies that contributed the most to performance during the quarter
included CARBO Ceramics and Tesco. 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. Tesco
is a global leader in the design and delivery of technology-based solutions for
the drilling industry through its Top Drives and Casing Services offerings.
The company announced strong performance after several quarters of
disappointing results due to missteps and high costs. However, Tesco
mended those issues and now is back on track for strong growth. High
energy prices spurring additional drilling prospects and the tight labor
market in the energy industry are playing right into the company’s business
model of providing technology solutions to the industry.
Companies contributing the least to performance during the quarter
included ScanSource and K-V Pharmaceutical. ScanSource, a leading
two-tier distributor of specialty technology products, continues to produce
healthy profitability, driven by the application of its unique distribution
model to additional product categories and geographies. However, the stock
suffered during the quarter when one of its partners mismanaged a product
launch, while another mismanaged pricing in Europe. We view the issues as
temporary in nature and not reflective of a change in the quality of the
underlying business. Additionally, the company expanded its opportunities
in telecommunications and security with the acquisition of MTV Telecom in
Europe and the new vendor relationship with GE Security. Shares of K-V
Pharmaceutical, a specialty pharmaceutical company with unique drug delivery
capabilities, suffered from a competitor’s patent challenge to one of
its key branded products. While the pharmaceutical industry is inherently
litigious, we believe K-V’s portfolio of differentiated delivery technologies and
relationships with specialist doctors in its niche markets remain intact and
provide long-term competitive protections.
Purchases and Sales
In the Small Cap Sustainable Growth Portfolio, we increased our position in
Quality Systems during the quarter. Quality Systems operates NextGen
Healthcare Information Systems, a wholly-owned subsidiary that provides
practice management computer systems and electronic medical records
software to mid and large-sized medical practices. The shares weakened
after the company reported sluggish fiscal Q4 2008 system sales growth of
2% in its core NextGen division. However, these growth rates can be volatile
as customers grapple with the high up-front expenditure required for a new
software platform. Importantly, NextGen’s intermediate-term sales pipeline
remains robust and the long-term outlook is healthy. We took advantage of
the weakness to increase our position given the business’ exceptional
financial character, its durable competitive position, high customer
switching costs, and positive organic growth outlook as governmental and
industry efforts to increase the efficiency of the health-care system intensify.
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.
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