Dear Fellow Shareholder, Equity markets continued their momentum from the second quarter of 2012 and rose sharply during the third quarter, ending an impressive trailing one-year period where the S&P 500 Index and the Russell 2000 Index each climbed over 30 percent. The strong move in equities lifted the entire market, with all ten economic sectors producing positive results for the quarter and over the past year. These results were impressive in light of concerns about the fiscal cliff, the sovereign debt crisis, and unsettling developments in the Middle East. With just three months left in the calendar year, the S&P 500 index is up over 16 percent. The dominant story during the third quarter proved to be the role of central banks, both in the U.S. and in Europe. In early September, the European Central Bank (ECB) announced a bond purchase plan designed to help boost the struggling European economies. This was soon followed by the Federal Reserve’s extensive plan to purchase mortgage backed securities. These announcements provided a boost to housing-related stocks and also could favorably impact job growth. The news sent risk assets higher, and caused a sharp decline in the yields on troubled Spanish debt. Elsewhere, some notable economic reports during September included a large revision to second quarter Gross Domestic Product (GDP). Although the GDP growth of 1.3 percent was somewhat disappointing, it does not necessarily mean that a new recession is looming. The U.S. economy, however, remains well below its long-term trend. Meanwhile, estimates for third quarter GDP, which will be released on October 26th, average a tepid 1.8 percent. Despite this data, there were a number of other indicators demonstrating the possibility of a healthier economy. Housing prices and sales volume, for example, are both up in double-digit percentages from a year ago. Consumer confidence is at a four-month high. On the jobs front, unemployment is still high, but the unemployment rate has declined this year, as has the number of people filing for new weekly unemployment claims. And, importantly, the stock market has risen steadily and nearly hit a five-year high. All of these developments on the economic front combined with an extremely skeptical equity investment landscape give us optimism that the strength in equities that we experienced over the past year may be sustained over the long-term.
Over the past year, we have been pleased with our relative and absolute performance, and even more pleased with the improvements our Funds have made in a difficult economic environment. Our portfolio companies have effectively navigated some of the headwinds of a slow growth environment and maintained impressive margins through effective cost cutting and other strategic initiatives. Corporate restructuring is the cornerstone of our investment process and in slow growth environments we expect companies to consider restructuring and other forms of financial engineering to manufacture growth. A good example of an industry that has experienced massive restructuring is homebuilders. From a macroeconomic perspective, the long-awaited housing recovery has finally arrived with improvement in a number of measures, such as increases in prices and permits, a substantial decline in inventory, and momentum in new and existing home sales. Each of these developments have a direct benefit to the homebuilding industry, where the larger, publicly traded companies have gained significant market share due to the loss of smaller local players during the peak of the downturn. At a company specific level, we have been impressed with PulteGroup (PHM
), Toll Brothers (TOL
) and Lennar (LEN
). The swift collapse in demand forced each of these companies to undergo significant restructuring. Like many of our holdings in this low interest rate environment, many companies in this industry have beneficially refinanced a substantial amount of debt and strengthened their capital structures. They have also improved their inventory of homes by liquidating poorly performing holdings, and strengthened the performance of many existing communities. With a leaner structure, reduced costs, and an increase in demand, we continue to believe the industry has substantial upside. Lastly, after a substantial plunge in 2008 and 2009, new home starts are beginning to climb off decade lows, which we believe is a significant catalyst for future gains and momentum. However, despite our long-term enthusiasm for the industry, near-term valuations are stretched at current earnings levels, and we responded by reducing exposure to some positions during the most recent quarter. Continue Reading »