Westport Funds Semi-Annual Letter
As set forth in the Funds' prospectus dated May 1, 2012, the actual Total Annual Fund Operating Expenses for Class R shares of the Westport Select Cap Fund and the Westport Fund were 1.36% and 1.25%, respectively, at December 31, 2011. Total Annual Fund Operating Expenses for Class R shares include shareholder servicing fees. During the fiscal year ended December 31, 2011, the Class R shares of the Westport Select Cap Fund and the Westport Fund both paid shareholder servicing fees of 0.13%. Please see the Funds' Financial Highlights on pages 19 and 21 for the actual Total Fund Operating Expenses paid for the six-month period ended June 30, 2012. Westport Advisers, LLC has also contractually agreed to waive a portion of its advisory fees and/or assume certain expenses so that Total Annual Fund Operating Expenses do not exceed 1.50% for any class.
# Performance of the Class R shares of the Westport Fund reflects certain waivers and expense reimbursements. Without such waivers and expense reimbursements, performance would have been lower.
The following pertains to the chart above as well as to the letter to shareholders on the following pages. Performance data quoted represents past performance; past performance is not indicative of future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. The Funds' current performance may be lower or higher than the performance data quoted. Investors may obtain current year-to-date and as of last month end performance information, within 7 business days, at www.westportfunds.com or by calling 1-888-593-7878.
Dear Fellow Shareholders:
Domestic equity markets started 2012 well with most indices recording double-digit gains in the first quarter. These markets have been supported by large injections of liquidity from the Federal Reserve (“Fed”). The Fed has expanded its balance sheet 250% since 2008 with the purchase of $2.35 trillion of Treasuries and mortgage-backed securities under its quantitative easing programs. When these programs were completed on June 30, 2011, it continued its support of the long term Treasury market through the purchase of long duration government bonds and the sale of short duration government notes from its balance sheet. This “Operation Twist,” originally scheduled for completion at the end of June 2012, was extended to December 31, 2012. The Fed’s actions have taken short term Treasury rates nearly to zero and, together with flight capital coming into the U.S., have reduced the interest rate on 10-year Treasuries to 1.5%. Low long term interest rates support asset prices and encourage investors to search for yield but seem to have little lasting impact on economic activity. Economic growth has averaged 2.4% since the recession ended in mid 2009 through this year’s first quarter. Diminished growth after a financial crisis is consistent with historical findings of Reinhart and Rogoffi. First quarter economic performance undoubtedly was helped by better weather and a key statistic, non-farm payrolls, showed an average gain of 256,000 workers per month. Short cycle economic statistics began to signal a slowing of economic growth in the U.S. and in many Eurozone countries late in the first quarter. Non-farm payroll additions slumped to 91,000 workers per month for the second quarter. Investors, fearing earnings disappointments, sold domestic equities pushing markets lower in April and May of 2012.
During the first half of 2012, the Westport Select Cap Fund provided a return of 2.03%, trailing the benchmark Russell 2000® Index’s 8.53% gain by 650 basis pointsii. Since inception 14 ½ years ago, the Westport Select Cap Fund has outperformed the Russell 2000® Index by 343 basis points per year with a compound annual gain of 9.03% compared to 5.60% for the Index. For the first half of 2012, 17 of the Fund’s positions rose in price, 12 declined and 3 were unchanged. Oddly, the declining stocks were not the principal reason for the Fund’s significant underperformance relative to its benchmark. In fact, the only meaningful negative contributors were the for-profit education company DeVry, Inc. (NYSE:DV), which declined 19% and cost 73 basis points in performance; the four energy stocks - Forest Oil Corp. (FST), Lone Pine Resources, Inc. (LPR), Plains Exploration & Production Company (NYSE:PXP), and Stone Energy Corp. (NYSE:SGY) - which cumulatively cost 113 basis points in performance; and insurance broker Willis Group Holdings plc (WSG), which cost 31 basis points in performance. The other 6 declining stocks depressed performance by 67 basis points in total. Also holding back performance was the fact that a number of underweighted positions appreciated without the desired positive impact. For example, Carter’s, Inc., the children’s clothing producer and retailer, which was the largest percentage gainer, appreciated over 32%, but contributed only 32 basis points to performance due to its 1.4% weighting. IPG Photonics Corp., the specialty laser manufacturer, gained 29% but, because of its 3.8% weighting, contributed 55 basis points to performance. Brown & Brown, Inc., one of three domestic insurance broker holdings, appreciated 21% and added 33 basis points to performance. Encouraging was the fact that Universal Health Services, Inc. (Class B shares), the Westport Select Cap Fund's largest position, gained 11.1% in the half and contributed 74 basis points to performance helped by the U.S. Supreme Court's finding that the majority of the Affordable Care Act was constitutional.
Westport Fund Class R shares provided a return of 6.58% in the first half of 2012 compared with 7.97% for the Russell Midcap® Index. Two portfolio positions were used to insure against the occurrence of certain geopolitical and macroeconomic events. The difference between the return of the Westport Fund and that of the benchmark Russell Midcap® Index in the first half was the cost of these hedge positions. First, a significant position in Oil and Gas Production companies provided protection against disruptive geopolitical events in the Middle East. Penalties have been introduced by a number of nations to force customers for Iranian oil to scale back their purchases. This would normally lead to higher oil prices but Saudi Arabia increased its production of crude to balance the market. Faced with a severe reduction in revenue, Iran might retaliate militarily by closing the Straits of Hormuz or by having surrogates undertake terrorist acts. So far no meaningful supply disruption has occurred and oil prices have declined. Energy was the only industry sector in the benchmark with a negative return for the first half of 2012 and the energy position in the Westport Fund reduced performance by 105 basis points relative to the benchmark. Second, the Eurozone has experienced continuing economic deterioration while economic growth in the United States and China is slowing. The Fund increased its cash position from 5% at year end 2011 to 8% at June 30, 2012 to cushion the impact of slowing economic activity on earnings but the cost of this insurance was approximately 54 basis points in performance. The combined impact of the energy and cash hedges more than accounted for the divergence between the Westport Fund's returns and the benchmark in the first half of 2012. Westport Fund has had an average annual return of 10.17% for the 14 ½ years since the Fund's inception. This compares favorably to the 7.42% average annual return for the Russell Midcap® Index and the 4.39% average annual return for the Lipper Multicap Core Index over the same period. The Lipper Index is a useful reference for the Westport Fund as the Index is composed of mutual funds with holdings in large, medium and small capitalization categories.
The Westport Fund's holdings in the Energy sector include six Oil and Gas Producers, which declined in reaction to continuing weak natural gas prices and somewhat lower oil prices in the second quarter. Natural gas prices have bounced back from recent lows due to electricity demand and a sharp reduction in rigs drilling for natural gas. The portfolio companies most leveraged to natural gas are Forest Oil Corp., and its spin-off, Lone Pine Resources, Inc. In addition Forest Oil was hurt by the effects of some questionable asset allocation decisions. The two companies cost the portfolio 62 basis points in performance for the first half of 2012.
There were no other industry sectors with negative results and the only individual holding outside the Energy sector that subtracted a meaningful amount from performance for the Westport Fund was Varian Medical Systems, Inc. (radiation therapy), which reduced performance by 38 basis points. On the positive side, the Business Products & Services and Consumer Products & Services sectors added 291 basis points and 219 basis points to portfolio performance in the first half, respectively. A diverse array of individual companies contributed to first half results - Teradata Corp. (NYSE:TDC) (database management), FMC Corp. (NYSE:FMC) (diversified chemicals), Ross Stores, Inc. (NASDAQ:ROST) (off-price retailer), and Lender Processing Services, Inc. (mortgage processing) adding 109 basis points, 85 basis points, 78 basis points and 78 basis points to performance, respectively.
Fractional reserve banking, where only a portion of deposits are backed by liquid assets, is the structure that is pervasive in market based capitalist economies. These economies won't function properly unless the associated banking system is adequately capitalized. Arguably the single most important action taken to stabilize the U.S. economy and financial system after the housing bubble collapsed in 2008 was the passage of the Troubled Asset Relief Program ("TARP") by Congress to recapitalize the U.S. banking system. Four years later the U.S. economy is healthier as exemplified by: positive but less than desired Gross Domestic Product ("GDP") growth; a stabilized housing market; and new oil and natural gas production from unconventional sources. However, a number of important negatives remain: very high debt levels in both government and private sectors; and high unemployment with a low level of new job additions. The U.S. economy is also influenced by slowing economic activity in other large economies such as China, India and Brazil, and recessionary conditions in many European countries.
Major uncertainties for the U.S. in the near term include the November elections and the "fiscal cliff". However, continued worsening of economic and financial developments in the Eurozone is a greater danger to the U.S. due to interconnections of the banking and financial systems. The first step to preserve the Eurozone economy is to ensure the national banking systems have adequate capital. Recapitalizing or closing individual banks where necessary to restore functionality to national banking systems must be accomplished without turning the associated sovereign debt into junk. Supervision and regulation at the Eurozone level and a Eurozone deposit insurance fund are needed to retain stability. In February 2012 the European Central Bank (ECB), acting in its role as lender of last resort to Eurozone banks, provided the second tranche of €1 trillion in a three year repo credit line, a Long Term Refinancing Operation ("LTRO"), against "acceptable" collateral. This action provided stability to debt markets for a time as it provided Eurozone banks funding to purchase sovereign debt and profit from the spread. The ECB can buy additional time by providing another LTRO using lower quality collateral.
A new fund, the European Stability Mechanism ("ESM"), which will be capitalized with €500 billion through pro rata contributions from the seventeen Eurozone members, has been authorized to supply needed rescue capital. An obvious problem is that a number of these members do not have the financial wherewithal for their contribution. Germany is to provide 27% of the funding while Portugal, Italy, Ireland, Greece, and Spain are responsible for 37% or €185 million. Germany has the largest and strongest economy in the Eurozone but its current debt/GDP ratio is 81%, limiting its funding ability. Germany could raise an additional €600 billion if it increased this ratio to 100%. However, this would lower Germany's credit rating and cause it to pay higher interest rates. Consequently, to have a reasonable probability of resolving the economic problems of overextended Eurozone members, the plan must include reductions in government spending and changes in labor regulation to enhance competitiveness. At present, progress is being made in Ireland and Portugal. Spain has made noteworthy changes to its finances and the regulation of its economy but there is no guarantee that deflating housing prices have reached a bottom. Italy is also working to restrain government spending so that interest rates on its sovereign debt will decline over time. The key question is will Germany run out of money or decide to stop subsidies to financially stressed Eurozone countries before efforts to lower deficits and improve competitiveness are successful.
If the banking and financial systems in the Eurozone continue functioning with the injection of additional capital, which seems likely for the near term, we believe that the Eurozone should hang together and not derail the U.S. economy. With this backdrop, economic growth in the U.S. is likely to continue at recent unattractive levels, weaker than most forecasters had anticipated just three months ago.
Domestic-based companies with a consumer orientation or relatively assured end market demand will likely be favored by investors in the remainder of 2012. The Westport Select Cap Fund portfolio is heavily weighted with such stocks and the portfolios of both Westport Funds offer a collection of companies, most of which provide some competitive insulation. We appreciate the continued confidence of our shareholders.
Edmund H. Nicklin, Jr.
Andrew J. Knuth
The Class R shares of the Westport Select Cap Fund and the Westport Fund commenced operations on December 31, 1997.
ii The Class I shares of the Westport Select Cap Fund commenced operations on February 16, 1998. For the total return and other information relating to Class I shares, see the Financial Highlights on page 20.
iii The Class I shares of the Westport Fund commenced operations on February 9, 2001. For total return and other information relating to Class I shares of the Westport Fund, see the Financial Highlights on page 22.
iv The Russell Midcap® Index is an index comprised of the 800 smallest companies in the Russell 1000® Index and represents approximately 31% of the total market capitalization of the Russell 1000® Index (an index of the 1,000 largest companies in the Russell 3000® Index (an index of the 3,000 largest U.S. domiciled publiclytraded companies representing approximately 98% of the investable U.S. equity market)). The Russell 2000® Index, also a subset of the Russell 3000® Index, is comprised of the 2,000 smallest U.S. domiciled publiclytraded common stocks in the Russell 3000® Index, and represents approximately 10% of the total market capitalization of that index. You should note that The Westport Funds are professionally managed mutual funds, which are subject to advisory fees and other expenses, while the indices are unmanaged and do not incur expenses. You cannot invest directly in an index.
v Lipper Multi-Cap Core Index represents the total returns of the funds in the indicated category, as defined by Lipper, Inc. Lipper is an independent ranking organization for the mutual fund industry.
The discussions included in this shareholder report may contain certain forward-looking statements about the factors that may affect performance of the Funds in the future, including the portfolio managers' outlook regarding economic, market, political, and other factors relevant to investment performance. These statements are based on the portfolio managers' expectations concerning certain future events and their expected impact on the Funds, and are current only through the date on the cover of this report. Forward-looking statements are inherently uncertain and are not intended to predict the future performance of the Funds. Actual events may cause adjustments in the portfolio managers' strategies from those currently expected to be employed, and the outlook of the portfolio managers is subject to change. Any opinions of the Portfolio Managers are intended as such and not as statements of fact requiring affirmations.
There are special risks associated with small and mid-capitalization issues such as market illiquidity and greater market volatility than larger capitalizations issues.