3rd Quarter 2011
The third quarter delivered the worst market returns (as measured by the broad market S&P 500 Index) since the first quarter of 2009, and the Fund’s worst quarterly returns since its inception, eclipsing even the third quarter of 1998. Volatility and correlations spiked as the European debt crisis was front and center, but Washington’s inability to come to a final compromise regarding the debt ceiling—leading to the downgrade of the U.S. debt rating—also didn’t help. In this type of environment it is difficult to keep one’s head above water, and stock picking goes out the window. It then becomes every man for himself and macroeconomic issues, along with market technicals, take over in a shoot first ask questions later mentality.
Correlations between stocks within the S&P 500 and the overall index itself have spiked above 80% three times since the fall of 2008. No one, especially us, would have guessed that we would experience this kind of anomaly. To make matters worse, this latest spike in correlations hit an all-time high even though the S&P 500 is up 65% from its 2009 low.
In our opinion, the macroeconomic data concerning the U.S. economy is just not that bad. It's not good, but it’s not that bad! The U.S is in far better shape today than it was in September of 2008. Back then, the economy was already contracting and the housing market was in free fall. The banking system became woefully undercapitalized once it started writing down bad loans. Major counterparty risks emerged as the system froze up and credit became unavailable. This is not the situation today, at least not in the U.S.
We feel this was an old fashioned financial panic driven by sovereign debt worries that spilled into the currency markets. If the policy makers address this problem, if only in the short run, with all of the short interest and cash on the sidelines we could see a very large rally into the end of the year much like what we witnessed in 1998.
As for the Fund, it was a miserable quarter. Anything that was tied to an economic recovery was punched in the face. The portfolio didn’t have any outsized sector bets relative to its Russell 2000 Growth Index benchmark, by design. Holdings within Technology, where we had a couple of earnings snafus, Consumer Discretionary, Energy, and Industrials proved to be a serious drag on performance during the period.
Vocus, an on demand software provider for public relations management, announced its intention of moving into the Social Media Business, which is going to require a much larger incremental investment—clouding the visibility for the company and sparking to a major sell-off in the stock. Mobile game designer Glu Mobile dropped more than 60% during the quarter after rising more than 100% going into August, despite no fundamental issues with the company that we could discern. Fortunately, we had cut this position in half for no other reason in that it was breaking down. Valuevision Media also dropped more than 60% as it missed top line revenue targets and, more disturbingly, the number of new customers fell—a complete reversal from the first part of the year—leading us to sell the stock from the portfolio.
The lone bright spot was Healthcare, an area where the Fund dropped less than the benchmark. The four greatest individual contributors to performance all came from that sector. Caliper Life Sciences was acquired by Perkin Elmer. Molecular diagnostic testing company Cepheid, orthopedic robotics device company Mako Surgical, and generic pharmaceutical company Akorn all reported great quarters.
In summary, we feel this market has discounted a fairly solid recession and a huge hit to S&P 500 Index earnings. Since 1974, U.S. equity markets have declined more than 20% seven times, five of which correctly forecasted a recession and two that did not—1987 and 1998. We just don’t buy into it this time. Yes, problems remain—housing hasn't rebounded and the lack of new jobs is disturbing. The banking system is over-capitalized now that it has written down the bulk of its bad loans, as evidenced by the huge hit to earnings in 2009. Our point is we don't think the ball has that far to fall anymore. Thus, we think if the country does slip back into recession, it should be a mild one. What if we do get some action out of the super committee, however, and Europe is successful at kicking the can down the road? On a relative basis, we think stocks are as cheap as they have been in our lifetimes and U.S. assets will attract a mountain of money from around the world. The only caveat is if the Germans decide to bail on Europe, but the credit markets are not saying that right now. This sure looks a lot like 1998.
B. Anthony Weber Charles F. Mercer, Jr. CFA Michael E. Johnson, CFA
October 12, 2011
As of September 30, 2011, Vocus comprised 0.00% of the portfolio's assets, Glu Mobile – 0.39%, Valuevision Media – 0.00%, Caliper Life Sciences – 1.12%, Perkin Elmer – 0.00%, Cepheid – 2.82%, Mako Surgical – 1.26%, and Akorn – 2.38%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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