4th Quarter 2011
In 2011, the market experienced the third year out of the past four where the correlations of stocks within the broad market S&P 500 Index to the overall index spiked above the 80% level. This is unprecedented. Prior to the great recession of 2007 to 2009, this had only happened once since 1974—during the Crash of 1987. Furthermore, according to Jason Goepfort of sentimentrader.com there were 44 days in 2011 in which 90% of the trading volume in the market was either up or down. That was the most since 1946, when there were 46 occurrences. To our surprise, it was worse than 2008, which had only 35 occurrences. To put that into perspective, there were only 29 such days in the entire decade of the 1990s! Such an environment is difficult for our strategy.
In an environment where the instantaneous “risk on/risk off” mindset has taken hold, and Utilities are delivering 20% plus gains as the best performing sector, it’s not going to be a good year for this Fund. In our view, 2011 will be looked back on as an outlier. The mistake we made was to think that the double-dip recession scenario was off the table based on almost every measure of economic data. In retrospect, we were right, but that didn’t matter.
The Fund substantially trailed its Russell 2000 Growth Index benchmark during in the fourth quarter as November saw a resumption of the downward trend after the big move up in October, only to be followed by a flattish to down December both by the portfolio and the market. The biggest loser during the period was Rovi, the fully integrated digital entertainment company, which lowered guidance in November due to the fall off in some legacy business from Sonic Solutions. We had cut this position back in September to reduce risk, but a 43% loss during the quarter still hurt. The Fund still holds this position because we believe the core digital business is still growing at the healthy clip, with robust margins. It is an $800 million revenue company that has more than $1billion in advertising potential as the source of interactive programming guides for TVs across America. Rovi also earned the distinction of being the worst name in the portfolio for the year as well.
The biggest contributor to relative performance during the quarter was Akorn, a generic pharmaceuticals company that is the second largest holding in the Fund. It has continued to put up solid quarters and enjoy a deep pipeline of drugs coming to market.
Whatever sectors worked in 2009 and 2010 were relegated to the basement in 2011. The market theme was defense, as many feared the potential for a double dip recession that didn’t come. Nevertheless, we did an extremely poor job investing in Technology in the Fund during the year. The portfolio was positioned more for economic expansion with semiconductors as opposed to the more-defensive software-related area that was up modestly. Semiconductor holdings were down more than 40% for the year, costing the Fund more than 10 percentage points in performance versus the benchmark. Performance within Industrials was also down, as anything the least bit economically sensitive seemed to be out-of-favor. Financials was a mixed bag, with the chief culprit to the downside the portfolio’s exposure to various hotel REITS. One bright spot was Post Properties, a multi-family apartment operator, which enjoyed one of its best years ever.
On the positive side for the full year, the portfolio’s Healthcare positions were up strongly, and holdings in Consumer Staples, Energy, and Materials contributed positively to results. Elizabeth Arden and Hain Celestial are the two Staples holdings that both delivered. Returns within Energy were driven by exposure to the oil fracking phenomenon, with names like Basic Energy and Key Energy the primary drivers. Materials benefited from Zagg, the maker of protective materials for electronic devices, and Kronos, a producer of titanium oxide producer that was in short supply last year.
Although 2011 was a disappointing year, it has not tempered our enthusiasm for 2012 and beyond. We feel the Fund is positioned in several fast growing areas with the overall portfolio trading at 16 times next year’s earnings, which are forecasted to grow significantly. This compares to 20 times for the index and earnings growth at a much slower pace. The $64,000 question is whether markets will in some sense move back to a state of normality, and what that means for correlations.
B. Anthony Weber Charles F. Mercer, Jr. CFA Michael E. Johnson, CFA
January 11, 2012
As of December 31, 2011, Rovi comprised 0.96% of the portfolio's assets, Akorn – 3.10%, Post Properties – 2.56%, Elizabeth Arden – 3.14%, Hain Celestial – 1.73%, Basic Energy – 1.40%, Key Energy – 1.18%, Zagg – 0.00%, and Kronos – 0.00%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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