2nd Quarter 2012
As we stated in our first quarter commentary, we expected to see some choppiness during the second quarter and we weren’t disappointed as Europe’s woes refuse to go away, a growth slowdown in the U.S started to unfold, the fiscal cliff is getting closer, and the Supreme Court threw a haymaker as it upheld ObamaCare. We also noted that we thought that gasoline prices had peaked in April, earlier than the typical middle of the summer.
That happened, and now we think that a peak in the commodity cycle has occurred, as demand is down across the developed world and China is shifting gears more towards internal consumption. All in all, this would be very bullish going forward. Economically and politically we view this year is very analogous to the summer of 1980, the only difference being that era was dealing with inflation and now we are dealing with deflation. During that year, the market had an 18% correction from early February to April and then promptly rallied 40% off the bottom into the election. We are not saying that is going to happen. Our point is that a lot of bad economic news has already been priced into the stock market. Granted, some major issues will need to be resolved, specifically clarity on Europe and the election, for this to happen.
Naturally, Europe is the wild card and the news from across the pond isn’t getting any better with Spanish yields now more than 7%. The simple question to ask is why isn’t the market getting crushed more? It has been our view that Germany has more to lose than anyone as the largest creditor to the periphery of Europe. The playbook was written by the U.S. and the policy missteps with Lehman Brothers in 2008—policymakers know what they have to do and Europe will kick the can down the road and put in place policies that will buy them time to rewrite the European Union—which will take several more years.
The Fund did outperform its Russell 2000 Growth Index benchmark during a down quarter for the first time since the fiasco of 2008 created such high correlations and volatility. It is only one quarter, but the market certainly felt more bifurcated than it has in a long time. Hopefully, this is a start to the market getting back to the way things used to be—an emphasis on bottom-up fundamentals with only a little macroeconomic influence.
Holdings in Healthcare, Consumer Staples, and Industrials all contributed positively to absolute and relative performance during the quarter. Biopharma company Questcor Pharmaceuticals and generic drug maker Akorn led the way in Healthcare. Akorn benefitted from a plethora of new products coming to market. Hain Celestial Group and B&G Foods boosted returns, despite Consumer Staples comprising only a small part of the overall portfolio. The Industrials sector was almost entirely driven by the position in US Airways, which gained a remarkable 74% during the rocky period. The Fund’s position in airlines owed largely to our negative stance on energy and commodities. Airlines have been all over our screens and benefitted from our call to take the portfolio’s Energy exposure to virtually zero.
It would have truly been a great relative quarter had it not been for the portfolio’s Consumer Discretionary exposure. Holdings in the sector were down more than 15% as performance across the board disappointed—from auto related companies to footwear to specialty retail. One of the worst losers was bedding manufacturer Select Comfort which fell sharply on the heels of rival Tempur-Pedic International reducing guidance twice during the quarter. The good news is that we trimmed the position in Select Comfort, which had been the Fund’s top holding at the end of the first quarter, significantly after the first guide down from Tempur-Pedic. One area within Discretionary that did perform well was homebuilders. Yes, we are back involved with the homebuilders for the first time since the first quarter of 2006.
Although the second quarter was solid on a relative basis and our outlook is generally positive, our eyes are wide open to the potential risks of the current environment. That said, given how the market has digested bad news recently, many of those risks have already been discounted by the market barring another “Lehmanesque” bank collapse. From a company specific standpoint, we are not having problems finding good solid growth stories in Healthcare, specialty consumer areas, and Technology. From a contrarian standpoint, equity funds have seen hundreds of billions of dollars of outflows since the beginning of the financial crisis in 2007. We think this will revert to the mean in a positive way at some point. If it does it could happen rather quickly, catching investors off guard again.
B. Anthony Weber Charles F. Mercer, Jr. CFA Michael E. Johnson, CFA
July 11, 2012
As of June 30, 2012, Questcor comprised 2.71% of the portfolio's assets, Akorn – 3.47%, Hain Celestial Group – 1.03%, B&G Foods – 3.11%, US Airways – 1.51%, Select Comfort – 0.95%, and Tempur-Pedic International – 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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