2nd Quarter 2010 Commentary
The remarkable rally in U.S. equities that began in early March of 2009 experienced its first major correction after peaking on April 23, 2010. Continuing apprehension about sovereign debt problems combined with growing concerns that any revival in jobs would prove insufficient to sustain economic recovery led investors to reduce expectations for global economic growth for the second half of 2010 and into 2011. As a result, the equity markets sold off for the quarter, with the Russell 1000 Growth Index declining 11.7% and the S&P 500 Index dropping 11.4%. The Fund modestly trailed both indices overall, with the underperformance occurring in April when the markets were still rallying. The portfolio outperformed both indices during the decline from the market peak through the end of the quarter. The Fund remains ahead of both benchmarks for the past three- and five-year periods.
Weakness in Tech
Stock selection within the Technology sector was the largest detractor from performance, despite strong returns from top-10 holding Apple. Research in Motion delivered an earnings report that beat expectations for earnings per share and margins, but fell short on handset units, average selling prices and revenue, causing the stock to underperform. We remain confident in the outlook for the firm as additional new products incorporating an upgraded operating system and web browser are on the way and should help attract new customers interested in upgrading their standard cell phone to a smart-phone with enhanced data capabilities. Visa was weak due to the unexpected passage of an amendment to the broader financial reform bill that moves to control debit interchange rates. Qualcomm's lagging performance for the year continued during the second quarter as a result of average selling price erosion. Until investors gain greater clarity and confidence that average selling prices are at least stabilizing, the stock could remain stuck in a narrow trading range. As a result, we reduced the size of the position in the portfolio.
Holdings within Financials, Energy, and Materials also detracted from performance. Charles Schwab & Co. was weak as ongoing fee waivers for the company's money market mutual funds, due to near-zero short-term interest rates, continued to pressure earnings—causing us to trim the position. Stock selection in Energy suffered as the near-term outlook for oilfield service companies diminished following the moratorium on deepwater drilling in the aftermath of the Gulf of Mexico disaster. The Fund's sole Materials holding, Monsanto, recalibrated profit and growth expectations lower, hurting returns. Management does not believe they will be able to get the levels of pricing on key upcoming product launches that they previously assumed, necessitating a reset of their targets. The Fund subsequently exited the position.
Relative performance benefitted from an overweight position in the Consumer Staples sector, as high-quality growers such as Kellogg Co. and Coca-Cola held up well during the correction. Kellogg's, a manufacturer of ready-to-eat cereals and convenience foods, was a new position added to the portfolio during the quarter. Kellogg's high quality management team is focused on shareholder value creation, and we think the company has multiple levers to drive future earnings growth. Coca-Cola is on schedule to close the acquisition of the North American bottling business toward the end of the third quarter or early in the fourth quarter, and the company continues to benefit from strong demand in emerging markets. Holdings in the Consumer Discretionary sector, notably TJX Companies, also held up better than the market as did stocks within Industrials, such as 3M.
Adding to Consumer Names
During the quarter, the Fund added to a number of consumer standouts, including Costco, Wal-Mart, and Nike. Twice we bumped up the stake in Costco on the belief that the company has many positive factors in its favor going forward, including a large cash position and accelerating stock buybacks. In addition, the firm stands to benefit from the ongoing recovery in discretionary merchandise, the gradual recovery in California—their largest market—plus a slowing in healthcare expense headwinds, acceleration in store growth next year, and a likely membership fee increase next year. After initially reducing the portfolio's stake in Wal-Mart as a source of funds on concerns about higher unemployment rates among the company's core, lower-income consumers, we added back to the position as management is doing an excellent job controlling costs and technology investment has now peaked. We think the company still has significant international expansion opportunities as well as further compelling domestic opportunities. Furthermore, Wal-Mart's valuation is at historically depressed levels. Following a recent earnings report that showed that global demand remains solid, we increased the position in Nike on general market weakness.
Other additions to current holdings came from the Healthcare arena, notably Abbott Labs, Allergan, and Stryker. Despite having superior long-term earnings growth prospects, Abbott's stock was trading below the price/earnings multiples of its peers. Allergan reported better than expected earnings for the first quarter, demonstrating broad-based sales strength across product lines. Stryker was increased several times during the period given its attractive valuation and in anticipation of what we think will be positive news on the company’s pipeline products. The shares offer relative strength in the sector, with new products coming on line during a recovery cycle.
In addition to the previously mentioned Kellogg's, communications semiconductor designer Broadcom was a new addition to the portfolio during the quarter. Growth in wire-line and wireless internet protocol traffic is driving demand for higher performance silicon, and we think the company is well positioned in multiple growth segment opportunities.
Two Energy positions, Cameron International and Schlumberger, were reduced as the moratorium on deepwater drilling will likely result in a 5% to 10% reduction in 2010 earnings, and could extend into 2011. The moratorium isn't necessarily bad for all energy firms, however. We added to the portfolio's stake in Occidental Petroleum as any reduction in offshore drilling is likely to have a meaningful impact on oil supply and therefore oil prices. As a low-cost, onshore producer, Occidental should be less exposed to regulatory restrictions but benefit from the potential of higher prices.
Two consumer names bucked the general trend and were trimmed during the quarter. Walt Disney was trading near the high end of its relative price/earnings multiple range and was trimmed given a more challenging economic environment. The position in Procter & Gamble was also reduced due to concern that the company's new innovation in its Pamper's brand, DryMax, is causing diaper rash and may result in a product recall.
Lastly, within Healthcare, Gilead was eliminated as a source of funds following disappointments in some of the company's pipeline products, reducing the company's longer-term growth profile.
Risk-averse Investors aggressively bought Treasury bonds during the second quarter resulting in positive returns and very low yields for Treasuries. Looking to the third quarter, we believe that interest rates will fluctuate in a narrow range. Short-term interest rates are likely to be anchored by a Federal Reserve currently on hold, and while longer-term interest rates are susceptible to increases given their current very low levels and rising fiscal deficits, the more moderate GDP growth rates and low inflation we are forecasting should work to temper any increases. With interest rates at such low levels, the risk/reward trade-off in the bond market is not favorable. Accordingly, we are maintaining a duration in the bond portion of the portfolio that is approximately 15% shorter than that of the Fund's fixed-income benchmark. Among bond market sectors, we continue to favor intermediate high-quality corporate bonds. Although the yield differential, or spread, between Treasury and Corporate bonds may widen further in the near term as investors continue to avoid risk, the spreads exceed long-term averages, and we believe investors will soon seek out the higher yields Corporates offer given the low interest rates available on Treasury bonds.
The summer months could continue to be volatile as investors discount what is likely to be slowing economic growth. We do anticipate a recovery in share prices, however as it becomes evident that even though more moderate economic growth is probable, growth should be sustained for the foreseeable future. Generally, economic recoveries from recessions last about four years, and we are only through the first year of the current recovery.
Given their unusually attractive valuations, financial strength, and global diversification the high quality growth stocks in the Fund seem well positioned in an environment of moderate but sustained economic growth. We particularly want to highlight the Fund's multinational holdings with strong global franchises that will benefit from what we believe will be robust growth in consumer spending in emerging markets. Emerging market consumer spending now accounts for about 35% of global consumer spending, up 10 percentage points over the last 10 years. The shares of these relatively defensive global franchises also have a consistent record of above-average dividend growth and currently offer unusually attractive dividend yields in an environment of very low interest rates for both short-term and longer-term fixed income investments.
Montag & Caldwell Investment Counsel
As of June 30, 2010, Apple comprised 2.40% of the portfolio's assets, Research in Motion – 2.01%, Visa – 2.28%, Qualcomm – 1.88%, Charles Schwab & Co. – 0.58%, Kellogg Co. – 1.73%, Coca-Cola – 2.44%, TJX Companies – 1.84%, 3M – 1.58%, Costco – 2.61%, Wal-Mart – 1.94%, Nike – 1.74%, Abbott Laboratories – 2.92%, Allergan – 2.29%, Stryker – 2.17%, Broadcom – 0.51%, Cameron International – 0.99%, Schlumberger – 1.28%, Occidental Petroleum – 1.84%, Walt Disney – 1.28%, and Procter & Gamble – 0.98%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its dividends.
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.
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