3rd Quarter 2010 Commentary
Stocks Rally on Prospect of More Fed Easing
The rollercoaster trading pattern that has defined U.S. equity markets throughout much of 2010 continued during the third quarter. Stocks ground their way higher in July following the release of generally better-than-expected earnings results. By early August, however, earnings euphoria had faded and public comments from the Obama administration suggesting that they would not support a temporary extension of the Bush tax cuts for all taxpayers weighed on the market. By the end of August, stocks had ceded nearly the entire July advance.
On August 27, Federal Reserve Chairman Ben Bernanke made a speech at the Kansas City Federal Reserve Symposium in Jackson Hole, WY. In his comments, Chairman Bernanke indicated that the economy was weak and that the Federal Reserve stood ready to take additional action. While investors initially focused on Bernanke's comments about a weak economy, sending the market lower, their focus ultimately shifted to the prospect of additional quantitative easing. Paradoxically, the rally strengthened on weak economic data, as the probability of easing increased following comments by other Fed officials supporting Bernanke. In what has historically been the worst month of the year for equity markets, the S&P 500 Index rallied 8.8%—posting its best September since 1939. The Russell 2000 Index soared 12.5%, easily surpassing its best September on record.
Investors continued to focus on high-quality stocks. Unfortunately, higher-volatility (beta) stocks also outperformed during the period thanks to the market comeback in September. Small-cap stocks marginally trailed large-caps during the quarter and growth outperformed value across all market-cap segments, with the margin being most significant among small-caps. For the year-to-date through the end of September the Russell 2500 Growth Index continued to outpace the Fund's Russell 2500 Value Index benchmark by one and a half percentage points.
The Fund lagged its benchmark during the quarter, and continues to trail the benchmark for the year-to-date through quarter end. The Fund was actually leading the index for the year through the end of August, but fell behind in the strong, beta-led September rally. Overall, stock selection within the Consumer Discretionary and Financials sectors were the biggest detractors from relative returns during the quarter as the portfolio's low-beta holdings did not keep up with the high-beta outperformance in these groups.
Two of the largest negative individual performers were for-profit education providers Lincoln Educational Services and Corinthian Colleges. Early in the second quarter, the Fund built positions in both stocks as we believed that Congress and the Department of Education (DoE) would encourage vocational training at these and other institutions in a high unemployment environment. In late July, however, draft legislation issued by the DoE sought to limit the availability of government funding in the for-profit education industry under a proposal called ‘Gainful Employment.’ Despite these regulatory headwinds, we mistakenly believed Lincoln's higher-quality status in the industry and Corinthian's ranking as the #1 provider of entry-level healthcare employees would support our thesis. Still, we decreased our Absolute Value estimates on both firms due to the legislative pressures and trimmed both positions. On August 16, the DoE released unfavorable repayment rate statistics for the two companies, along with most of the industry. In response, we eliminated both of these holdings from the portfolio.
Mississippi-based BancorpSouth reported disappointing second quarter results, posting a loss compared with solid earnings a year earlier. Loan problems for the firm continued to increase after having delayed its 2009 annual report filing earlier in the year when auditors questioned the credit quality of some of its loans. The quick resolution of the disagreement with auditors led us to believe the firm was aggressive in identifying and reserving for problem loans. The recent earnings report, however, indicated that either the bank did not have an accurate assessment of its loan problems or credit deterioration in the Southeast, its primary area of operation, is not moderating with the rest of the country. In either case, our conviction in the stock declined and we eliminated the position from the portfolio.
Other notable negative contributors included Stepan and Knight Capital Group. Stepan, which produces specialty chemicals used in products like detergents, shampoos, toothpastes, and body washes, sold off after reporting second quarter earnings that highlighted impressive double-digit top-line growth, but shrinking operating profits. Investors are concerned that the margin expansion which occurred in 2009 will revert back to the lower levels of the previous five years. Our valuation assumes margins continue to fall to more normalized levels, and it should be noted that the company is due for its 43rd annual dividend increase in October. Knight Capital provides electronic and voice trade execution services and has underperformed as low equity volumes and declining volatility caused sell-side analysts to pull back their earnings estimates for the entire industry. Despite these near-term headwinds, our longer-term investment thesis on the company remains unchanged. Knight continues to repurchase shares at attractive prices and has a seasoned management team to navigate through a tough operating environment.
The sectors with the highest contribution to relative performance during the quarter were Technology and Industrials. Solid stock selection aided returns within Industrials, while Technology benefited largely from the performance of Hewitt Associates. Global HR services provider Hewitt agreed to be acquired by insurance broker Aon in mid-July for $50 a share compared with our assessed Absolute Value through April of $49. We later revised the multiple higher, but in retrospect that revision was too aggressive given the weak economic backdrop. We sold the Fund's entire position on the news.
Other top individual contributors included AptarGroup, PetSmart, and Americo. Specialty dispensing systems manufacturer and top-holding Aptar reported outstanding second quarter results in July. The strong results came from all business segments. In addition, the stock benefited from heightened merger and acquisition activity in the packaging industry as Pactiv, which we view as comparable to Aptar's Beauty & Home and Closures segment, agreed to be acquired. Furthermore, Aptar substantially increased its annual dividend during the period.
PetSmart reported excellent second quarter results driven by an increase in average ticket size, the introduction of flea and tick medication in the store aisles, and solid performance in premium brands. Management increased guidance on an improved outlook. The company also announced a new exclusive partnership with GNC to offer a line of vitamins and dietary supplements for dogs and cats that demonstrates management's ability to innovate and differentiate the PetSmart brand. Rental truck and storage unit provider Amerco, operating under the U-Haul brand, reported a strong quarter as the company experienced positive organic growth in both volume and pricing, and operating margins increased due mostly to lower maintenance expense. While we believe potential upside remains for UHAL, we reduced the Fund's position as it approached our Absolute Value.
As discussed over the past three quarters, we remain focused on high-quality companies that we believe are well-positioned for a period of modest economic growth. We like dividend-payers in this environment, as well as companies that are showing clear operating momentum. As economic growth moderates, we like firms that can continue to generate top-line growth. We also continue to search for opportunities in the attractively priced Healthcare space, as a number of current holdings have reached, or are close to, their assessed Absolute Values.
The largest new position added during the quarter was Regis, the world's largest owner, operator, and franchisor of hair salons. Its concepts include Regis Salons, Jean Louis David, Vidal Sassoon, MasterCuts, Supercuts, SmartStyle, and Cost Cutters. Hair care is a relationship business that can't be outsourced. Clients often develop long-term relationships with their individual stylists, creating loyalty that enhances repeat business, contributes to add-on product sales, and generates sustainable cash flows. In a highly-fragmented industry, Regis is 10 times larger than its nearest competitor and is the industry's primary consolidator. River Road has owned Regis in the past and has followed the company for many years. Despite Regis trading significantly below our Absolute Value in the past 24 months, our concerns with the management team kept us from re-purchasing the stock. In August, however, the Board of Directors hired the Peter J. Solomon Co. to explore strategic alternatives, including the potential sale of the company. This news restored our confidence that the team is focused on enhancing shareholder value and we subsequently initiated a position.
Where Will the Fed Lead Us?
Our market outlook is currently based upon an assessment of five factors. These factors include valuations, sentiment, monetary policy/credit trends, fiscal policy, and a "wildcard" of other key trends we believe may materially impact stock prices over the following six to 18 months. The time frame of our outlook aligns with our company valuation models, as well as the period we believe any investor can reasonably make assumptions about the future.
As fundamental investors, our approach emphasizes valuations above all else. When stocks are cheap, we get excited. When stocks are expensive, we get worried. Last quarter, we stated that the decline in equities had created more value in stocks, setting the stage for additional upside. Since we made that statement on July 13, small-cap stocks have rallied about 9%. As a result, our discount-to-value indicator for the portfolio has moved from slightly below average to near the high end of its historical 65% to 82% range. Our valuation models currently incorporate only modest expectations for growth and margin expansion in 2011. Unless growth reaccelerates or companies are able to further reduce costs, this signal indicates that value has again become increasingly scarce.
Regarding sentiment, we consider the outlook and economic assessment offered by trusted and insightful CEOs of the companies we follow. We will also consider the sentiment of investors, taking a contrarian approach to the consensus opinion. When investors are ebullient, we are cautious, and vice versa. By mid-October, investors were once again bullish enough to warrant a cautious approach to the market. Additionally, CEOs across a broad range of industries and market caps continue to sound a cautious tone.
Monetary policy is an important variable. Since the end of World War II, the Federal Reserve's monetary policy has made a significant impact on both economic growth and financial bubble formation. Since neither fiscal stimulus nor the previous monetary stimulus was successful in jump-starting a healthy recovery, the Federal Reserve has indicated it would pursue another round of quantitative easing (QE).
Whether you believe the Fed's next round will be effective in stimulating growth probably depends on whether you believe we are in a typical, post-war recession or a period of longer-term structural deleveraging, akin to that of the 1930s. The former camp believes this recession is like most others in the past 50 years, and that by lowering interest rates the Fed will spur credit demand and, ultimately, jump-start a sustainable recovery. The latter believes that lowering rates will do little to stimulate growth. In a period of sustained deleveraging, there is simply less demand for credit by both consumers and businesses. There is also less desire to lend by banks, which have significantly raised their credit standards. The deleveraging camp further believes that any additional stimulus might further devalue the dollar and/or create bad inflation. Bad inflation creates greater liabilities (higher commodity costs such as energy and food), but does not increase assets or income (home prices, income, etc.).
While the ultimate outcome probably lies somewhere in-between, with interest rates near zero and the Fed's efforts thus far having generated little growth, we are leaning toward the structural deleveraging camp. Furthermore, we see a major risk for value equity investors if the Fed inflates demand for stocks without an underlying improvement in the economy. This is the definition of a financial bubble and as most investors today are aware these end very, very badly.
Fiscal policy remains a significant uncertainty and one that will not be fully answered until well after the November elections. Among the "wildcard" factors, we are closely monitoring merger and acquisition (M&A) activity, which at its current heightened level has been bullish for stocks. We expect the broader trend will continue as companies seek to acquire growth and private equity firms seek to invest their abnormally high levels of cash before they are required to return it to their investors. On a more bearish note, we are closely monitoring the trends in housing and employment, which remain negative.
As most of these factors would indicate, we are cautious on the market at these levels. While we cannot say that stocks are over-priced, our measures indicate they are near the high end of our historical valuation range. Given this, if the Fed does induce another risk rally in stocks we would urge investors to stay focused on high quality investments. We further believe the chances of the Fed inducing bad inflation are alarmingly high.
Fortunately, we believe the portfolio is well positioned for the current environment. We remain steadfastly focused on stocks with stable growth, attractive valuations, and healthy balance sheets and continue to focus on identifying companies that we believe will make attractive acquisition targets.
River Road Asset Management
18 October 2010
As of September 30, 2010, Stepan comprised 0.89% of the portfolio's assets, Knight Captial Group – 0.94%, AptarGroup – 4.43%, PetSmart – 5.02%, Americo – 1.50%, and Regis – 1.02%..
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity. Value investing often involves buying the stocks of companies that are currently out of favor that may decline further.
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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