2nd Quarter 2012 SMA Mid Cap Value Quarterly Commentary
2nd Quarter 2012 SMA Commentary
U.S. economic growth remained positive but slowed markedly during the second quarter as the benefit of favorable weather faded, government spending declined, and international economies—particularly Europe—softened. Market volatility also rose as the risk of a domestic recession increased. The uncertainty associated with the fall elections and looming “fiscal cliff” is already depressing business activity in the U.S. Overseas, structural flaws in the financial and political agreements among euro-based countries has left many of the weaker ones vulnerable to increasing solvency and liquidity concerns. Even China faces challenges as tight monetary policy put in place to fight inflation has reduced growth to the slowest pace in three years.
Still, there are powerful forces supporting the equity market, including the Federal Reserve’s willingness to keep interest rates near zero, a meaningful decline in oil and gas prices, the strength of corporate balance sheets with record levels of cash, and the reasonableness of equity market valuations that remain below historic averages. The wildcard is a low level of investor confidence evident by the significant and consistent fund flows out of equities and into fixed income despite record low bond yields.
Most major U.S. equity indices declined during the second quarter amid the economic turmoil. Within mid-caps, the value and growth components of the Russell Midcap Index decreased 3.3% and 5.6%, respectively. Value held up better than growth within the index due to better performing Utility stocks and a greater weighting in Financials and lesser weighting in battered Energy stocks. Sectors perceived as defensive like Utilities and Consumer Staples outperformed more cyclical areas such as Industrials, Materials, Technology, and Energy, which is typical when fears of slowing economic growth arise. Atypical of most market corrections, however, was that lower quality and smaller market-cap stocks held up better on average than high-quality and larger stocks. The impact of this anomaly was apparent in the poor relative performance of most active small- and mid-cap managers during the quarter.
The strategy slightly underperformed its Russell Midcap Value Index benchmark during the quarter. Sector selection was the main detractor from relative performance due to the portfolio’s overweight position in the poor performing Technology sector, and the lack of exposure to more resilient Utilities. Stock selection within Energy also detracted from relative returns as shares of two exploration and production holdings fell with the drop in lower crude prices.
Stock selection within Consumer Discretionary and Technology was the key contributor on the positive side to relative performance. Shares of a theme park operator performed well on strong results, its defensive business characteristics, as well as an attractive dividend yield. Within Technology, a leading call center operator moved higher on solid results from its core business and the sale of its non-core billing business, which leaves the company with substantial net cash and a compelling valuation.
This quarter’s highlights focus on a leading student loan service provider and an airfreight charter company. Through acquisition and its role as a major originator of government guaranteed student loans, the first firm has become one of the largest servicers of student loans. The company recently improved its servicer ranking, entitling it to a larger market share of the government’s program for the next fiscal year. In addition, almost half of its loan portfolio earns a significant, legislatively mandated “floor” income in low interest-rate environments. With little corporate debt and predictable cash flow produced by its government guaranteed loan portfolio, we think the company has a solid financial base. Still, it trades at a modest valuation due to lackluster near-term growth expectations.
The airfreight company specializes in servicing base load cargo needs through three-to-five year take or pay contracts, but also devotes marginal capacity to demand from the spot market. This strategy has made the firm’s financial results much more consistent than the overall airfreight charter market, permitting the company to generate substantial free cash flow. The strategy first invested in the stock as the economy turned south in 2008 and the valuation became attractive when a hedge fund sold its 40% ownership stake. We added to the position in 2009 as the military needs for the Afghanistan war stepped up while its stock price remained depressed on concerns about a potential loss of business that we believed unlikely. Despite the current weak international airfreight market our conviction in the firm’s fundamentals remains high. As it delivers solid financial results and the international freight market tightens, we believe the stock’s valuation will eventually rise to reflect the value of its unique logistics platform and excellent long-term business prospects.
Despite a myriad of challenges, we expect U.S. economic growth to be moderate, short-term interest rates to stay low and inflation to remain benign. With respect to the equity market, we are cautiously optimistic for the remainder of the year as valuations are reasonable and most corporations are proactively taking actions to deal with issues both at home and abroad. We have factored the European debt crisis, the upcoming U.S. elections, and the “fiscal cliff” into our analysis, and believe that the portfolio is well positioned. Company management teams of holdings in the portfolio are actively deploying free cash flow through share repurchase, dividends, and opportunistic acquisitions.
Our approach of buying sound free cash flow producing businesses at inexpensive valuations achieved its 20th anniversary on the institutional side at the end of the second quarter. This common sense approach to equity investing remains as relevant today as it did when we developed it in 1992. At that time, a handful of value investors used free cash flow, fundamental research and discounted cash flow analysis—the tenets of our investment process—to produce exceptional long-term risk-adjusted returns. Their success gave us the conviction that we too could employ this approach to build wealth for investors.
We think our competitive advantage remains dependent upon quality work and disciplined execution that cannot be commoditized. Cardinal’s longevity as a firm is a testament to the talented investment professionals and the firm’s ability to retain them. From the beginning, we chose to put investor interests first by maintaining our investment focus and growing assets thoughtfully. We remain committed to meeting the investment needs of investors well into the future.
The Cardinal Capital Team