Third Quarter 2008
Since the first large-scale announcement of subprime-related credit issues from HSBC in February 2007, equity market performance has been subject to fits and starts. Every indication of a light at the end of the tunnel has been quickly snuffed out by a contradictory statistic or event. This was again the case in the third quarter, as falling commodity prices, which briefly engendered confidence that inflation concerns were waning, soon led to worries about slowing global growth. Compounding this concern was the first tacit acknowledgment by the Federal Reserve and the U.S. Treasury of how dire the credit situation had become. Initially, this too had a positive impact, based on the belief that it would be accompanied by a rescue for the nation’s struggling financial institutions. However, when Congress failed to rubber stamp the $700B package before quarter-end, hopes for a near-term resolution were temporarily dashed. As a result, the S&P MidCap 400 Index suffered its worst quarterly decline in six years, falling 10.87%. Remarkably, the financial sector, which has been at the center of this crisis, rallied sharply, but these gains were not sufficient to offset steep declines in energy, materials, and industrials.
With such high-profile events as the demise of Lehman Brothers and Washington Mutual and the failure of Congress to pass the financial rescue package fresh in everyone’s minds, many investors have run for cover. At Rorer, we acknowledge the challenges faced by a wide variety of industries, ranging from the lack of available credit to faltering consumer demand. Nevertheless, as we have opined previously, the greatest opportunities arise not when all indicators point toward clear sailing ahead, which can serve as a signal that investors have become too complacent, but rather when the conventional wisdom points unequivocally toward darker days ahead. With that in mind, we are vigorously pursuing the uncommon opportunities that the current pullback has afforded us in terms of high-quality businesses trading at steep discounts to their intrinsic valuations. As always, in addition to employing our rigorous valuation and earnings growth screens to cull the universe of potential prospects, our efforts are focused on companies that appear well-positioned to benefit from strong secular demand themes. Examples of such themes include greater frugality and reduced credit availability for consumers, outsourcing of the management of a rising prison population, and the improved opportunity for well-capitalized, conservative banks to gain share from their weaker brethren. Together with our exposure to other themes highlighted in earlier editions of this commentary, we believe the Rorer Mid Cap Equity Portfolio is well positioned to outperform the market over the long-term.
The third quarter proved challenging for the Rorer Mid Cap Equity Portfolio, as some of the trends and themes that have served us well in prior quarters reversed, causing our returns to lag those of the Index. Our underweight in financials worked against us as the sector was the strongest in the MidCap 400 Index by a wide margin. We favored brokers and asset managers while eschewing credit-sensitive banks, which kept us out of position when the latter jumped sharply in anticipation of the rescue plan. While we have modestly increased our exposure to the regional banks during the quarter, we continue to avoid those with significant credit problems. We believe only those with the rare combination of superior credit management and capital strength are likely to sustain their recent performance. The complex of energy, industrials, and materials also saw a significant reversal of its long-running trend of strength. The dramatic decline in commodity prices, reflecting the perception that the U.S. economic slowdown is spreading globally, put severe pressure on these sectors. While we had trimmed back on many names earlier in the year at higher prices, our exposure remained elevated relative to the benchmark. Despite these short-term cyclical setbacks, we continue to believe that secular demand from emerging economies will sustain earnings growth and that valuations in the group have fallen to very attractive levels. Therefore, though we have strategically reduced our aggregate exposure to these three sectors in an attempt to limit our risk during this period of economic uncertainty, we remain confident that our names are well-positioned for future outperformance. More favorably, our increasing exposure to both the consumer discretionary and consumer staples sectors boosted our returns. In the discretionary space we remain underweight, given our concerns surrounding consumer spending, but have still found several attractive names. Apollo, operator of the University of Phoenix, was our best performer given its steady earnings growth characteristics. Meanwhile, our positions in consumer staples, such as McCormick, successfully passed through price increases and saw resilient demand. We intend to remain defensive in our stock selection but opportunistic when great franchises become available at bargain prices.
With the pullback in the market, we found attractive opportunities to initiate several new positions as well as add to many existing positions at what we believe are favorable prices. We ramped up our consumer exposure with Wynn Resorts and Burger King in the discretionary space, while also adding two positions in consumer staples, Chattem and Central European Distribution Corp. (CEDC). Chattem has a long history of generating strong growth from products that consumers rely on everyday, such as Gold Bond powder and creams. With similarly reliable demand, CEDC is Poland’s largest distributor and second largest producer of vodka. Given significant consolidation opportunities and its recent penetration of the huge Russian market, CEDC’s profitability has expanded rapidly, a trend we expect to continue. We added three names in the industrial space: Geo Group, an operator of prisons, Expeditors International, the premier airfreight logistics company, and Kansas City Southern, a regional railroad with a dominant position in the Southwest. In all cases, these companies are not as dependent on economic growth as the industrial space as a whole, instead relying on company-specific drivers or larger secular themes, which we expect to be sustained. In financials we invested in two companies, Cash America and People’s United Financial. Cash America is the leading U.S. pawnshop operator, which should benefit in the tight credit environment as consumers find it tougher to make ends meet, while People’s is the largest New England-based regional bank, demonstrating both of the key characteristics for new bank investments that we noted above. In health care we purchased Henry Schein, a leading dental equipment distributor, while in technology we bought MEMC Electronics, a semiconductor industry supplier with exposure to the burgeoning demand for solar panels. Additions to existing positions were also diverse. In health care we lifted our weightings in Express Scripts and PPDI; in energy we added to Consol and Newfield; and in technology, financials, and industrials, we added to Activision, Janus (after trimming the position on price strength earlier in the quarter), and Bucyrus, respectively. We funded these purchases with several sales. Despite recent market weakness, we were able to take advantage of longer-term strength to pare back sizeable positions in Dril-Quip, Synaptics, Ameritrade, and Kaydon, while selling Ion Geophysical at our target price. Our stop-loss discipline was triggered four times, leading to the sales of Lam Research, Terex, Healthways, and Foster Wheeler. Manpower, Tiffany, and Parker Hannifin were sold due to signs of weakening fundamentals.
The views expressed represent the opinions of Rorer Asset Management as of September 30, 2008 and are not intended as a forecast or guarantee of future results.
Disclosure
Any sectors, industries, or securities discussed should not be perceived as investment recommendations. Any securities discussed may no longer be held in an account’s portfolio. It should not be assumed that any of the securities transactions discussed were or will prove to be profitable, or that the investment recommendations we make in the future will be profitable.
The S&P MidCap 400 Index is the most widely used index for mid-size companies and covers approximately 7% of the U.S. equities market. Unlike the Fund, the S&P MidCap 400 Index is unmanaged, is not available for investment, and does not incur expenses.
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