• Read the Small Cap Growth Fund Quarterly Review, June 30, 2010

After a strong first quarter, the US equity market reversed course during the second quarter to finish in negative territory for the first half of the year. 

While the year started off on a positive note on the heels of better-than-expected corporate sales and earnings, macro concerns across the globe instilled fear and volatility back into the markets.  European sovereign debt downgrades and fiscal austerity measures, the Gulf of Mexico oil catastrophe, US state budget woes and expiring stimulus programs all contributed to investor skepticism.  More importantly, given the significance of job growth to a sustainable economic recovery, stubbornly lackluster employment and housing data have stoked fears of slipping back into a recession.  Given these negative developments and with the 2008 downturn fresh in investors’ minds, stock prices corrected as they once again succumbed to macro factors rather than specific company fundamentals.

During the second quarter, all sectors within the Russell 2000 Growth Index finished well into the red.  The Consumer Discretionary (-11%) and Energy (-14%) sectors were the worst performing sectors given the macro concerns discussed above.  Industrials and Consumer Staples posted the “best” returns in the down market, finishing -6% apiece. 

For the year-to-date period, sector returns were more dispersed.  Energy was the outlying loser at down 13% for the six-month period.  Consumer Discretionary and Consumer Staples performed well over the period, finishing up 3% each.  Most of the other major economic sectors such as Information Technology, Industrials, Financials and Health Care were each down 2-3%.   

The Small Cap Growth Fund’s underperformance during the second quarter is primarily attributable to negative stock selection.  This was most pronounced in Consumer Discretionary, Financials and Materials.  On the other hand, positive stock selection in Telecom, Energy and Information Technology each buoyed relative results.    

For the first half of the year, the Fund’s narrower underperformance was the result of mixed stock selection across sectors.  While stock selection was good in Information Technology, Telecom and Energy, stock selection in Consumer Discretionary, Materials, Industrials and Health Care outweighed and brought relative performance below benchmark for the six-month period overall.      

Two specific stocks detracting from return were Cenveo and Healthways.  Cenveo is a specialty printing company.  The company operates in two segments: Envelopes, Forms and Labels and Commercial Printing.  The stock was a leading detractor from return during the second quarter and year-to-date period as investors became increasingly nervous about the economic sensitivity of Cenveo's business.  However, we added to our position in the stock as we continue to believe the stock offers an attractive reward-to-risk ratio given a solid management team (many of whom have bought stock recently), its leading position in a higher growth segment of the printing industry and an unjustifiably low valuation. 

Healthways is a healthcare services firm that provides disease management solutions.  The company's services are implemented by managed care companies, governments, employers and hospitals in order to reduce both short term and long term healthcare costs within their patient populations.  The stock detracted from return during the second quarter and the year-to-date period overall in part due to skepticism toward the healthcare reform bill's impact on managed care, Healthways' primary customer base.  Also, lackluster employment data hurt investor sentiment as Healthways' business model benefits as the employed base increases.  We maintained our position as we believe disease management solutions and Healthways specifically will be a partial solution to lower healthcare costs.  Nearer term, we believe data on new contract wins, contract renewals and the new business pipeline are encouraging.      

Two specific stocks boosting relative performance were Lionbridge Technologies and Stanley Inc.  Lionbridge Technologies is a market leader in language translation for online content, software manuals, and training for leading global companies.  The stock was the Fund's number one contributor during both the first quarter and second quarter, and therefore the year-to-date period as well.  Lionbridge's business momentum has been driven by new business wins from large companies such as Caterpillar and a new contract with IBM to provide its translation technology.  The company has also benefitted from existing customers such as Microsoft and Google restarting projects after the recession.  We continue to hold the stock as we believe the company is well positioned for additional new customers wins and will benefit from the secular increase in cross-border business activity. 

Stanley Inc. is a government information technology services company.  The stock was one of the leading contributors to return during the second quarter and the year-to-date period as it was announced to be acquired by CGI Group, one of the largest independent information technology and business process services firms in the world.  We liquidated our position on the rally following this announcement. 

Looking forward, while the economic recovery may have a different trajectory (less steep) than some were expecting earlier this year, the market’s decline has improved valuations and lowered expectations.  Corporate financial discipline and balance sheets remain strong while inventories are lean throughout most industries.  This should lay the ground work for operating margin expansion, likely beyond prior peak margins, and drive continued earnings growth over the intermediate term.  However, investor pessimism is understandably high given the expiration of stimulus plans and diminished appetite for additional programs, US state budget crunches, still absent employment growth and likely further consumer deleveraging. 

We consider the impact of these economic scenarios into our stock-specific risk/reward assessments, and focus our time analyzing business models and managements of growth companies who “control their own destiny” to a greater degree and are less dependent on broad economic growth.  We continue to find solid investment opportunities across sectors.  We believe the Fund consists of great companies with solid competitive positions whose stock prices are trading at attractive valuations.