3rd Quarter 2010 Commentary
The stock market, as measured by the S&P 500 Index, showed a nice rebound during the third quarter, increasing 11.3% during the period. Markets appeared to focus on the potential impact of both an anticipated second round of quantitative easing (purchases of fixed-income securities by the Federal Reserve Bank) and a possible extension of current tax rates beyond 2010. In this environment, equities continued to be led largely by momentum-oriented issues.
The benefits of fiscal stimulus and the inventory cycle are fading, however, and economic growth continues to be constrained by the ongoing financial deleveraging of the private and public sectors both domestically and in other parts of the developed world. Below trend growth is not unusual after a financial crisis given the time it takes the economy to de-leverage. Importantly, we expect at least moderate growth to be sustained given that the economy has sufficient forward momentum along with pent-up demand and low interest-rates to allow for some degree of growth. In addition, the economy stands to benefit from robust growth in the Emerging Markets, which accounts for roughly 35% of global Gross Domestic Product (GDP).
Although the Fund generated a solid absolute return during the quarter, it trailed its composite benchmark as many of the more-speculative themes that have driven the markets over the past 18 months remained in place. Materials and Telecommunications were among the market's strongest sectors, and thus the Fund's lack of any holdings in these sectors detracted from relative performance.
An overweight position in Healthcare detracted from relative performance as the sector lagged the broader market. Solid gains from Botox-maker Allergan were offset by weakness in medical device maker Stryker. Although stronger sales from Stryker's Medical/Surgical division made up for slower than expected Reconstructive sales and gross margins far exceeded expectations, the stock declined as some analysts were expecting better sales growth from the Reconstructive division despite announced results within the normal range of management guidance. We had added to the Fund's position in Stryker due to the stock's attractive valuation and expectations of solid earnings growth through 2011, and increased it again after the decline following the earnings report.
Stock selection within Consumer Staples negatively affected relative performance as well, as returns from Colgate-Palmolive, Kellogg, and Procter & Gamble lagged the overall sector. Fundamentals appear to be weakening at Colgate due to competitive pressure and missteps by management, such as the mispricing of the company's Hill's products. The position was reduced as a source of funds for more compelling opportunities. Kellogg suffered from a recall of a number of its cereal products announced towards the end of the second quarter. We view the recall as a one-time event, and added to the portfolio's position as the firm completed its inventory reductions, ramped up Eggo Waffle manufacturing capacity, and accelerated its stock buyback program. Despite its lackluster third quarter performance, we increased the stake in Procter & Gamble several times during the quarter as the uncertainty surrounding a potential recall on the company's largest product line (Pampers) faded and the scope of the problem seemed limited. We are encouraged by evidence of increasing market share in more than 60% of its product categories versus just 20% during the recession, better than expected cost savings, and strong Emerging Market trends in Asia and Latin America.
On the plus side, stock selection in the Technology sector aided relative performance during the quarter as Juniper and Qualcomm delivered strong gains. We trimmed the Fund's stake in Juniper as the stock traded in excess of our estimated present value. Qualcomm was reduced due to concerns that average selling prices could once again be weaker than expected this quarter, limiting the potential for overall upside results.
Within Energy, oil and natural gas equipment supplier Cameron International posted significant gains as it became evident that the company's liability in the Deepwater Horizon explosion is negligible. Indeed, Cameron benefitted somewhat from the fallout of the accident, with rig operators going back to original equipment manufacturers for parts and service on blowout preventers and other subsea equipment. Following commentary from Schlumberger's CEO that the accident in the Gulf would not have much of an impact on deepwater activity we increased the position in Cameron.
We initiated three new positions in the Fund during the quarter—Kraft, Oracle, and American Express. Kraft completed its acquisition of Cadbury in 2010, providing synergies that should allow the firm to produce earnings growth in the mid-teens over the next couple of years. The acquisition has also provided greater scale for the company within Emerging Markets and Europe. Software developer Oracle has assembled a formidable collection of assets that puts them in an enviable strategic position to sustain growth going forward. With the addition of former Hewlett-Packard CEO Mark Hurd as a top executive, the company has hired one of the most talented executives in the industry, providing additional confidence and visibility that Oracle can continue to execute.
American Express has experienced a rapid recovery in credit-loss rates, slowing shrinkage in its loan portfolio, and more robust levels of capital and funding. Despite modest returns during the quarter, we think the firm could be a beneficiary of new regulations for interchange rates on debit cards. Similarly, we increased the portfolio's current position in JP Morgan, which demonstrated credit improvements and a leveling off of loan balance shrinkage, in addition to solid second quarter earnings results. Revenue trends were somewhat mixed this quarter, but investment banking trends should improve seasonally into the fourth quarter. The impact of regulatory reform will have a gradual impact, and thus recent adjustments we have made to normal earnings should prove conservative.
Other notable increases in current positions during the quarter included Broadcom, Occidental Petroleum, and Fluor. Broadcom was increased given its attractive valuation and on evidence that sales of baseband and other processors to Nokia continue to ramp up in addition to continued robust sales of the company's wireless connectivity chips. We added to Occidental on weakness after an operationally poor quarter and negative press surrounding CEO compensation. We believe the issues are transitory and continued modest economic growth should drive steady to moderately higher oil prices.
Finally, we added to Fluor early in the quarter as the stock was attractively valued on numerous measures, including price/book, price/sales, price/present value. The stock had pulled back from the mid-$50's in late April to the low $40's and appeared to discount the potential for macro-induced lumpiness in orders and backlog over the next few quarters. The position was further increased following a better-than-expected second quarter earnings report with stronger revenues, good expense control, and a lower tax rate all contributing to the upside. In addition, a sequential quarter upward inflection in the backlog should mark an important turning point for the stock's relative performance going forward.
Ditching HP and RIMM
We eliminated the position in Research In Motion (RIMM) after the disappointing launch of its Torch 9800 smartphone. We had increased the position after the release of comScore data early in the quarter showed the company had lost minimal North American market share. But with the company already facing growing domestic competition from the Apple iPhone and Google's Android operating system, RIMM was further affected by concerns about its devices' security features from governments in a number of developing countries.
After initially reducing the portfolio's stake in Hewlett Packard following the unexpected departure of the CEO Mark Hurd, we subsequently sold it entirely given anecdotal information from industry bellwether Cisco suggesting slow enterprise spending and the unusual level of economic uncertainty. Although the stock's valuation was attractive and HP's global brand positioning remains strong, we think the leadership uncertainty in combination with weakening macroeconomic trends warranted exiting the position.
Charles Schwab & Co. was also eliminated early in the quarter as earnings estimates for 2011 continued to come down due to the extended outlook for low interest rates as well as reduced market activity and lower assets under management. In addition, Visa was trimmed several times because we believe the stock will be range bound as the Fed begins the process of formulating new debit interchange rules.
We believe that interest rates will be range bound for the next several quarters due to persistently high unemployment, a downshift in GDP growth and the likelihood that inflation will remain low. Given this economic environment, it is unlikely that US Treasury yields will increase from the current low levels. We believe the Federal Reserve is likely to initiate another round of quantitative easing which should shift intermediate- and long-maturity Treasury yields lower.
Given the absolute low level of yields, however, we continue to view the risk/reward trade-off as unfavorable in the bond market and are accordingly maintaining a duration in the bond portfolio that is shorter than its Barclay's Government Credit Bond Index benchmark. In addition, as investors continue to seek out yield in this low interest rate environment, we continue to believe that Corporate bonds will outperform Treasury bonds and we are thus overweight high-quality intermediate-maturity Corporate bonds.
Although the economic environment suggests that there may be a consolidation or pullback of prices after the encouraging third quarter market performance, we do expect stocks to grind higher along with the sustained, moderate growth that we expect in the foreseeable future. The high-quality growth stocks in the Fund are well positioned in this environment. The portfolio's holdings have unusually attractive valuations and their earnings growth rates are more assured due to their financial strength and global diversification. We continue to highlight the Fund's multinational holdings with strong global franchises that will benefit from robust growth in consumer spending in Emerging Markets and that offer unusually attractive dividend yields and dividend growth prospects in an environment of very low interest rates.
Montag & Caldwell Investment Counsel
As of September 30, 2010, Allergan comprised 2.58% of the portfolio's assets, Stryker – 2.49%, Colgate-Palmolive – 1.20%, Kellogg Co. – 1.81%, Procter & Gamble – 1.80%, Juniper – 0.60%, Qualcomm – 2.06%, Cameron International – 1.55%, Schlumberger – 1.40%, Kraft – 1.19%, Oracle – 0.60%, American Express – 1.58%, JPMorgan Chase – 1.77%, Broadcom – 1.12%, Occidental Petroleum – 2.46%, Fluor – 2.02%,and Visa – 0.65%.
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.
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