July 0 Commentary The U.S. stock market, along with most other global markets, has been very volatile in the first six months of 0. After rising significantly in Q 0, the U.S. market gave back some of its gains in Q amidst a widening debt crisis in Europe, weakening growth worldwide and mounting fears of the fiscal cliff at home. The S&P 00 had a total return of -.7% during the second quarter. For the year, the S&P 00 has had a total return of +9.%. The gold price also retreated in the first half of 0, and yields on U.S. Treasuries declined to historic lows. Portfolio Thoughts Most of your portfolio companies generated solid but slowing earnings growth in the first half of 0. As global economic fears have mounted, the outlook for the second half has become somewhat more clouded. With the dampened outlook, volatility has risen. While unsettling to many investors, this volatility has presented us with a number of attractive opportunities. During the second quarter, we trimmed some larger positions where we felt valuations were extended, and we redeployed proceeds into other companies where valuations, in our view, had returned to attractive levels, including those in the energy and technology sectors. In addition, we continued to monitor several prospective new ideas that we have identified as promising companies. As is often our practice, we will be ready to purchase these names when we believe the valuation is as attractive as the companies themselves. In volatile market times, we attempt to spend even more time on the road meeting with management teams, asking them about the current state of their markets. More importantly, we ask about their strategies to address existing and future market conditions. We ask ourselves, Does this management team have the leadership qualities, the strategy, and the operational excellence to grow the company s revenue and earnings over the long run in variable market conditions? In recent visits with management teams, we have focused on how they are dealing with the most recent manifestations of the European debt crisis and the slowing global economy. We have been impressed that, despite economic clouds, these companies are aggressively investing in initiatives to become more efficient, to innovate, and to widen the moats that surround their businesses. Here are a few prominent examples: One portfolio company is using geographic routing technology to reduce both its transportation cost, the company s biggest cost line item, and its carbon footprint. This company also sees many potential acquisitions outside of the U.S. that are owned by entrepreneurs who, fearful of the current economic environment, are now willing to sell their businesses at fairly reasonable prices. The company is actively pursuing discussions with such acquisition targets. Another portfolio company is using the European uncertainty as a catalyst to accelerate restructuring initiatives. The economic fears in Europe have made it easier for the company, an industrial manufacturer, to secure employee and union buy-in to the company s drive to reduce costs and improve competitive positioning. This company s stock is currently down owing to fear about a certain portion of its business, but we believe the fear is disproportionate to the impact on the company s earnings power. The management team feels the same way and is being opportunistic with share repurchases. Several of your portfolio companies have designed and implemented mobile applications which allow their customers to access critical information (e.g., healthcare diagnostics, commercial real estate
data) from mobile devices like smart phones and ipads. These investments in innovation have widened the companies technology leads over their competitors. As economic fears have mounted, growth expectations for the global economy have come under pressure. In the face of this pressure, it gives us confidence that your companies continue to strengthen their businesses and invest for the future. Market Thoughts We have tried to put the last decade of U.S. equity under-performance into some historical perspective. Broadly speaking, the 90s was the decade of the growth stock, epitomized by the Nifty 0 and the conglomerate craze. The 970s was the decade of inflation assets, characterized by the sharp rise in gold, silver and oil. The 980s was the decade of the Japanese stock market and real estate, with the Imperial Palace in Tokyo at one time being valued more highly than all of California. The 990s was characterized by the tech bubble and the later bursting of that bubble. The 000s was known for a commodity boom, the asset allocation into emerging markets, and a financial crisis. Investors fled from U.S. equities and piled into U.S. bonds, especially Treasury securities. What will be the preferred asset class of the second decade of this century? In our January 0 Commentary, we noted that many investors have not wanted to deal with the risk of U.S. equity markets. Between the 008 financial crisis, the flash crash, the Madoff scandal, the insider trading scandals and the overall volatility, investors have displayed little appetite for U.S. equity risk. While we appreciate that significant risks to the market will always exist, and they can never be fully discounted, we also feel that the U.S. stock market may present unique opportunities at present, not fully appreciated by investors who have exchanged their U.S. equity holdings for fixed-income investments, international equities and cash. Today s low interest rates present risk to fixed-income instruments should the rates rise. In addition, the European banking crisis has already reduced trade financing, which in turn has curtailed exports from emerging markets. In contrast, corporate balance sheets of U.S. companies are generally very strong, allowing them to allocate capital efficiently. Energy prices have declined, particularly natural gas, and this decline has allowed U.S. companies to operate and manufacture at lower cost. Some U.S. companies which previously manufactured overseas are now sourcing domestically to save on transportation costs and to accelerate delivery schedules. Even U.S. banks, part of an industry that we have largely avoided over the last five years, are much better capitalized than most other global banks, which should provide a measure of stability for the rest of the economy to grow. The housing market, which drives so many other areas of the U.S. economy and which has been a significant drag on the economy for several years, is showing some signs of bottoming. Finally, in our view, the dysfunction of the U.S. political system has been a significant headwind to U.S. equity prices. Can political dysfunction get much worse? No matter what the outcome of the elections in November, we think (perhaps naively) that the U.S. political environment is likely to get incrementally better as opposed to worse. In summary, as we have seen numerous times in the last few years, in times of market panic, investors do not seem to want to hold equities of any sort, including U.S. equities. However, in times characterized by less panic and more rationality, equities of U.S. companies may stand out among global investment opportunities. Of course, upcoming debt ceiling negotiations and the looming fiscal cliff in the U.S. could make U.S. equity markets as volatile as European and other global markets over the short run. Despite all the worry by U.S. equity investors, the U.S. stock market has outperformed most global equity markets over the last eighteen months, and the much maligned U.S. dollar has gained against many global currencies. We are not predicting that the 00s will be the decade of U.S. equities, but it seems doubtful that the decade-plus outperformance of fixed income and international equities will repeat itself. The table below details the ten-year periods in the past when U.S. bonds outperformed U.S. stocks and then
provides historical returns over the following ten-year periods, when the equity underperformance reversed itself, with equities outperforming bonds in every observation. In our January 0 Commentary, we cited the flows into and out of U.S. domestic equity mutual funds and fixed-income mutual funds. We noted that while there had been several short periods of exception, the overall trend of flows out of U.S. equity funds and into U.S. bond funds has been very pronounced and readily apparent. Over the past six months since that Commentary, the trend has continued. The chart below illustrates that continuing pattern and includes an additional line representing foreign equity mutual funds, which have also benefitted from outflows from U.S. equity mutual funds. Can this pattern continue? Certainly, it can continue for some period of time (longer than what we had expected originally), but we believe that the trends will slow significantly or will reverse at some point in the future.
Why do we believe that the trends will slow significantly or will reverse at some point in the future? Because the earnings yield from stocks relative to bond yields is the highest it has been in the past twentyfive years (as shown in the following chart entitled S&P Earnings Yield vs. 0-Year Treasury Yield ) and because the outperformance of bonds over stocks (on a nominal and real basis) over the past decade plus is historically unprecedented (as shown in the Nominal Returns and Real Returns table following the chart). 0 9 8 7 0 - - - - Monthly Data 9-0- to 0-0- S&P 00 Earnings Yield vs. 0-Year Treasury Yield Earnings Yield Minus Treasury Yield 0-0- =.9% S&P 00 Earnings Yield (est.) -- Solid Blue Line 0-0- =.7% 0-Year Treasury Yield -- Dashed Red Line 0-0- =.80% 0 9 8 7 0 - - - - 9 98 970 97 97 97 978 980 98 98 98 988 990 99 99 99 998 000 00 00 00 008 00 0 Copyright 0 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. S798 See NDR Disclaimer at www.ndr.com/copyright.html For data vendor disclaimers refer to www.ndr.com/vendorinfo/
Personnel Update D.F. Dent and Co. builds professional staff only when we come across someone who we believe will make us a substantially better firm over the course of many years. Getting the right people on the bus, in Jim Collins Good to Great parlance, is a critical objective to us as an investment firm. In June 0, we added our eighth investment professional, Dr. Gary Wu. Gary grew up and graduated from college and medical school in China. He then received a Ph.D. in Molecular Biology from Columbia University. Gary started his business career after graduate school and gained experience in management consulting, investment management and private equity. Gary s analytical skills and investing acumen will be a wonderful asset to our firm. We expect Gary to challenge all of us, and we will challenge him, in formulating opinions about companies investment merits and the quality of their management. We are so happy to welcome Gary to our D.F. Dent team. ***** We appreciate the confidence you have placed in D.F. Dent and Co. We continue to work diligently on your behalf. This commentary can be found on our website (www.dfdent.com). We encourage you to refer to our website for other information about our firm and our investment products, including our new mutual fund, the DF Dent Midcap Growth Fund (DFDMX).