3rd Quarter 2010 Commentary
Pick Up in M&A Activity Boosts Sentiment
Market volatility increased during the quarter as the glacially slow expansion of the global economy and lack of an obvious trend created an environment where sentiment changes had an exaggerated effect on stock prices. While certainly not a smooth ride, sentiment towards equity markets improved considerably in September, helping to drive a significant move higher in stock prices.
Acceleration in merger and acquisition activity (M&A) dominated headlines during the period. The consolidation news was not limited to any one industry and was a global phenomenon, noted by large premiums offered at above market prices and bidding wars from leading companies for must-own services. A pick-up in M&A activity is significant because savvy corporate bidders tend to identify real value in their industries before investors in general. With mid-term elections only a month away, investors could very well be looking forward to clarity on the future outlook on taxes and regulations. This reduction in uncertainty may create a tailwind from fiscal policy that could join forces with the existing tailwind of monetary policy. We remain optimistic with regard to the economy and the stock market. Business and consumer sentiment has been soft for quite a while and we could be seeing the spark that puts a smile on people's faces. Stocks may be signaling such an event.
3Par and Netezza
The Fund significantly outperformed its Russell 2000 Index benchmark during the quarter. Portfolio results were dominated by stock selection within Technology, highlighted by take-out offers made on two positions: 3PAR and Netezza. 3PAR received an offer from Dell of $18 per share which was quickly countered by a higher offer from Hewlett Packard. Hewlett Packard ultimately won out with its $33 per share all-cash offer. As the bidding war heated up for 3PAR, the Fund took profits and used the proceeds to fund other opportunities. Netezza received a $27 offer from IBM. In addition, stock selection within Industrials and Financials further aided returns, while Healthcare and Materials were the main detractors from relative performance.
Importantly, the trend in increased capital investment in the corporate enterprise segment, where cloud computing is capturing much of corporate spending, figured prominently in the portfolio's five strongest stocks (NETGEAR, Acme Packet, and RightNow Technologies, along with the two take-outs mentioned above) during the quarter. Cloud computing allows companies to utilize the Internet as the medium to access information that historically had been stored in a company's data center. Given the increased complexity of information flow and storage, cloud computing technology saves money and provides more efficiency. We believe we have identified the leading innovators in this area. We also believe cloud computing is at a nascent stage and is one of the most revolutionary changes in corporate IT in 30 years.
The Fund maintained a broadly diversified portfolio with a similar profile to the prior quarter. Companies we categorize as Leaders and Innovators comprised 81% of assets in the portfolio while Laggards, or companies undergoing restructuring, made up 19%. Technology, Consumer Discretionary, and Financials comprised the largest sectors in the portfolio, whereas we maintained the smallest weights in Utilities (no holdings), Telecommunications, and Energy.
Four stocks became full positions in the portfolio during the period, including athenahealth, ESCO Technologies, and Harman International. Athenahealth provides software and services that automates small physician offices. Intensifying competition—driven by both vendor attempts to gain market share amid the stimulus boom and changes in physician/hospital relationships tied to healthcare reform—has raised uncertainty about the sustainability of the company's historically strong revenue growth. We think the firm's highly ranked products, delivered on a software-as-a-service basis, are well suited for the small physician space and will likely continue gaining market traction.
A spin-off of Emerson Electric, ESCO provides complete smart metering solutions that support water, gas, and electric utilities, and is now the undisputed global leader in that field. We expect ESCO to build on its recent momentum to drive additional project wins throughout the U.S. and abroad, which should result in above-average revenue and earnings growth. Harman International designs, markets and manufactures audio and electronics and is the global market share leader in automotive infotainment, automotive audio and professional audio (in addition to being the number two player in consumer audio). The management team overextended itself a few years ago, an issue further exacerbated by the onslaught of the global financial crisis. New leadership began assuming control in 2007, however, and has embarked on reducing the company's cost structure and enhancing global competitiveness. We find early results encouraging and believe further gains in profitability and market share can be achieved.
The Fund sold two positions from the portfolio during the period in addition to 3PAR. Amedisys, a home health care company, reported quarterly earnings below expectations. This weakness, in addition to government inquiries into the company's Medicare billing practices, led us to sell the stock. Although we still view MDC as a consolidator in the housing industry, we made the decision to reduce the portfolio's exposure to housing and diversify toward the auto industry, which has global opportunities.
TAMRO Capital Partners
As of September 30, 2010, 3PAR comprised 0.00% of the portfolio's assets, Netezza – 2.67%, NETGEAR – 2.31%, Acme Packet – 2.34%, RightNow Technologies – 2.24%, athenahealth – 2.20%, ESCO Technologies – 1.60%, and Harman International – 2.49%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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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