3rd Quarter 2010 Commentary
The third quarter saw a continuation of the "de-risking" trade right up until September, as the threat of a double-dip recession started to gain momentum in July, and especially in August. That all changed, however, with Ben Bernanke's speech in Jackson Hole, Wyoming stating that the Federal Reserve was prepared to do whatever it took, including implementing Quantitative Easing II (QE2), at the next Federal Open Market Committee (FOMC) meeting in November. Equity markets turned in their best September since 1939 as the Fund's Russell 2000 Growth Index benchmark gained 14.2%. The Fund itself bested the index in September. Unfortunately, August was miserable, and the Fund lagged the benchmark by more than four percentage points overall during the quarter.
In retrospect, the portfolio skewed towards names that were levered to a better economic environment. One example was Rubicon Technology, a maker of sapphire substrates that goes into the manufacturing of LEDs. For the time being they are used in flat screen TVs and back lighting for computer monitors, but may represent the ultimate in Holy Grail technology in the manufacturing of LED light bulbs. The stock was down 24% during the third quarter on a report calling for margins to compress. We don’t see that happening and our contacts at Best Buy see no price compression in LED TVs just yet. It will happen at some point, but we feel unit volume will more than make up for any margin compression. A number of other holdings had a similar experience—where earnings estimates moved up in recent quarters only to be punished by a macroeconomic call.
The Fund's position in Technology lagged the benchmark as well, as the portfolio tilted more heavily toward hardware than software. A lot of takeover talk surrounded several names within software, boosting that group. One example in the portfolio was Riverbed Technology, a network optimization company with a heavy software component, which rose substantially during the quarter. We took profits most of the way up during the period.
We find it very difficult for the Fund to delineate itself when correlations within the market spike like they did during the third quarter. Correlations not only spiked, they went above the levels seen in November 2008 after the Lehman Brothers crisis. The only time that correlations have been higher in the past 50 years was during the Crash of 1987. This basically means that 80% of all stocks moved in the same direction—in this case down. After peaking at 81% on August 24, 2010, correlations have collapsed to 64% as we write this letter. The portfolio has been geared towards the more cyclically oriented part of the economy since the spring of last year, namely in Consumer Discretionary, Technology, Industrials and some Financials holdings. Although this positioning has provided a significant boost for the 12 months ending June 30, these areas were the first to suffer in the most recent downturn—though they are also the ones still showing the greatest earnings revisions to the upside.
In summary, the third quarter saw a big downdraft that was followed by an outstanding September ignited by the Federal Reserve hinting at a newer and bigger round of quantitative easing. We remain confident that earnings are going to come through again as expectations have been reset lower. As the mid-term elections loom and with stocks at generational low valuations, we feel very good about the rest of this year and 2011. We have stated that this market is very analogous to what we saw in 2004 and it is playing out very closely to that scenario. We are staying with the Fund's early cyclical exposure as that is where the greatest earnings revisions to the upside are occurring.
B. Anthony Weber
Charles F. Mercer, Jr. CFA
Michael E. Johnson, CFA
12 October 2010
As of September 30, 2010, Rubicon Technology comprised 1.72% and Riverbed Technology – 1.24%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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