Westport Funds Third Quarter Letter
Dear Fellow Shareholder:
The U.S. major market indices posted solid returns in the third quarter despite strong headwinds in the form of decelerating corporate earnings growth, lack of clarity on key fiscal issues in both in the U.S. and Europe, and signs of weaker global economic growth. The clear driver of these market gains was the expectation that the Federal Reserve would continue to take steps to stimulate the economic growth. On September 13, 2012 the Federal Reserve announced the initiation of a new program of quantitative easing (QE3) which would include the purchase $40 billion per month of government agency mortgage-backed securities. The third quarter closed with the Dow Jones Industrial Average, the S&P 500 Index, and the Nasdaq Composite Index experiencing gains of 5.02%, 6.35%, and 6.54% respectively.
The Westport Select Cap Fund-Class I shares fell by 0.92% during the third quarter trailing their Russell 2000® Index benchmark, which gained 5.25%. For the first nine months of 2012 the Fund significantly underperformed with a return of 1.24% versus the Russell 2000® Index's return of 14.23%. Since inception fourteen and one half years ago the Westport Select Cap Fund-Class I shares have outperformed the Russell 2000® Index by nearly 300 basis points a year with an average annual return of 8.43% compared to 5.64% for the index. The Fund's third quarter underperformance relative to its benchmark can be attributed to price declines in three stocks – DeVry, Inc. (DV), ITT Educational Services, Inc. (ESI), and Big Lots, Inc. In total these three positions declined the equivalent of 691 basis points, more than the 617 basis points that the Fund underperformed. The two for-profit education stocks, DeVry, Inc. and ITT Educational Services, Inc., continue to be hurt by issues impacting the entire sector: a decline in new student enrollments caused by regulatory changes, negative publicity, and student concerns over taking on loan debt during a period of employment uncertainty. The case for holding these stocks is based upon their current depressed valuations, their ability to generate significant free cash flow, and the belief that the for-profit education stocks play an important role in upgrading jobs skills of undereducated young adults. The key catalyst for price appreciation for the two stocks will be an increase in new student enrollments. Big Lots, Inc. (BIG), an off-price retailer, is clearly struggling in a very difficult retail environment. Most recently, the sell-through of its summer seasonal merchandise was disappointing and necessitated substantial price mark-downs in the seasonally weak third fiscal quarter. The company needs to re-focus on its strength of selling close-out merchandise at very attractive prices. The Fund's relative performance was also hurt by three large positions, Universal Health Services, Inc. Class B shares, Precision Castparts Corp. (PCP), and Willis Group Holdings plc (WSH), which together account for 27% of the portfolio but which individually averaged a price gain of only 2.1%, some 315 basis points under the benchmark returns. Each of the companies has been impacted by short-term problems which we believe are likely to dissipate during the next six months. The final issue impacting the Fund's relative performance is the fact that the portfolio managers generally avoid investing in certain industries either because they are viewed as separately investable sectors or because of a lack of adequate expertise. For these reasons, real estate investment trusts and some small health care companies are not in the portfolio. Real Estate Investment Trusts, and Health Care, have been among the best performers in the Russell 2000® Index so far this year. Although not evident in the over-all numbers, the Fund had excellent performance in the quarter from many of its positions. In fact 12 of the Fund's 32 holdings outperformed the Russell 2000® Index. Particularly noteworthy were IPG Photonics Corp., a producer of precision laser tools, which gained over 31%, Banner Corp., a Pacific North-west banking company, up nearly 24%, General Communication, Inc., Class A Shares, an Alaska-based telecom service provider, up 18%, and Forest Oil Corp., an independent E&P company, up over 15%. In conclusion, neither Fund's investment style nor the portfolio management approach has changed. Since its inception, the Fund has been managed utilizing a concentrated portfolio (presently 32 holdings) and a long-term time horizon. The consistency of this approach has enabled the Fund to out-perform the Russell 2000® Index for fourteen and one-half years. Finally, the Westport Select Cap Fund has experienced periods of weak performance in the past and has recovered with strong subsequent gains. Looking back to 2003 and 2004 the Fund trailed the benchmark by a combined 22.34 percentage points. It outperformed over four of the next five years.
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The 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 Fund's current performance may be lower or higher than the data quoted. Investors may obtain performance information year-to-date the following business day and to last month-end, within 7 business days, at www.westportfunds.com.
The Westport Fund-Class R shares underperformed their benchmark in the third quarter with a return of 3.47% compared with the 5.59% return of the Russell Midcap® Index. The performance differential was not due to bad results from the Fund's portfolio holdings. During the third quarter 35 of 50 portfolio holdings provided positive returns. The maximum negative return among portfolio companies was just 16 basis points from Albemarle Corp. (ALB) and the negative impact from the 15 decliners totaled 92 basis points. The differential was due to differences in sector weighting in the Westport Fund versus the Russell Midcap® Index. The selection of companies for inclusion in the Westport Fund's portfolio is dependent on insulation from competitors and undervaluation as foundational elements. These factors often lead to sector weightings that are quite different from those of the Index. The largest influence on performance in the third quarter was the Consumer Discretionary and Services sector whose contribution to the Russell Midcap® Index exceeded that to the Westport Fund by 97 basis points. This breaks down to 68 basis points from underweighting in the Westport Fund portfolio and 29 basis points from stock selection. While the three portfolio holdings in this sector comprise over 6.0% of the Fund's portfolio assets and have done quite well, the sector weighting is 17.4% in the Russell Midcap® Index. The Materials and Processing Sector was the second largest contributor to underperformance at 55 basis points. During the quarter none of the Fund's six holdings in this sector performed well with three recording small negative returns even though second quarter earnings improved year over year for all six. The price earnings multiples contracted on concern for continued economic slowing. Finally the Fund's cash holdings and lack of real estate investment trusts accounted for more than the remaining 60 basis points of the performance differential. For the first 9 months of 2012 Westport Fund Class R shares returned 10.28% compared to 14.00% for the Russell Midcap® Index with underweighting in the Consumer Discretionary and Services sector the main cause of the differential. Long term performance for the Westport Fund Class R shares is an average annual return of 10.25% for the 14 ¾ years since the Fund's inception. This compares favorably to the 7.68% for the Russell Midcap® Index and the 4.75% for the Lipper Multi Cap Core Index. The Lipper Multi Cap Core Index is a useful reference as the Index consists of mutual funds with holdings in the large, medium and small capitalization categories. On the last webcast discussing second quarter and first half results we noted the desirability of retaining a position in oil exploration and production companies given the significant unrest in the Middle East even with economic growth slowing in a number of important geographies. While no shots were fired between Iran and Israel during the quarter, European sanctions on Iranian oil continue to pressure that country's economy. This coupled with unrest in Syria, Libya and Yemen and central bank support for risky assets including commodities saw the futures contract for West Texas Intermediate crude rise from under $80 a barrel in late June to over $92 a barrel at the end of September. Higher crude oil prices supported the energy sector of the Russell Midcap® Index allowing it to report the best return among the ten industry sectors for the third quarter. The energy holdings of the Westport Fund outperformed the Energy Sector of the Index by 14 basis points. Among individual portfolio holdings, EOG Resources, Inc. (EOG), primarily an onshore domestic exploration and production company, provided the largest return in the quarter at 70 basis points. EOG Resources, Inc. is the third largest holding in the Fund and has substantial holdings in the new tight formation domestic onshore oil fields. On its second quarter earnings call it indicated that various technological adjustments would allow it to recover more oil from its holdings in the Eagle Ford field in Texas. Pall Corp., a technology leader in filtration and purification technologies is undergoing a restructuring under the supervision of a new CEO. This appears to be progressing satisfactorily and the company added 44 basis points to the Fund's performance in the quarter. The third largest contributor was Synopsys, Inc. (SNPS) which provides software to create and support the commercialization of advanced integrated circuits. Many of the new electronic devices we take for granted such as smart phones and tablets would not be possible without the design and verification software and intellectual property from Synopsys, Inc. During the quarter positions were increased in Checkpoint Software Technologies Ltd., Lender Processing Services, Inc. (LPS), Trimble Navigation Ltd. (TRMB), and Varian Medical Systems, Inc. (VAR) The underlying theme for all of these additions is product uniqueness, attractive valuation and lower than average sensitivity to the economic cycle. Shares also were added to the Willis Group Holdings plc position. Willis Group is an insurance broker that is finishing a restructuring which should improve its profitability at the same time the property casualty pricing cycle is starting to improve. Finally, a position in Nordson Corp. was initiated in the quarter. The company is a leader in the design of systems that apply adhesives and sealants in a wide range of industrial and consumer applications. Known for many years as a premier supplier of spray painting systems for cars and trucks, this highly cyclical activity is now a minor portion of the company's business. The majority today is adhesive systems in applications as diverse as electronics and medicine.
We thank you for your continued investment in The Westport Funds. Please visit our web site, www.westportfunds.com, for additional performance and portfolio information. As always, should you have any questions regarding The Westport Funds, please feel free to contact us at 1-888-593-7878.
The Westport Funds
Investors should consider the investment objectives, risk, and charges and expenses of The Westport Funds carefully before investing; this and other information about the Funds is in the prospectus, or summary prospectus, which can be obtained by calling 1-888-593-7878 or at our website www.westportfunds.com. Read the prospectus or summary prospectus carefully before you invest.
Westport Select Cap Fund's performance reflects Class I shares. Westport Fund's performance reflects Class R shares. For information about other share classes available, please consult the prospectus. Performance of fund classes will differ. Please see the prospectus for details.
*The S&P Index is an unmanaged capitalization-weighted index (weighted by the market value of the companies) of 500 stocks listed on the various exchanges.
*The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ.
*The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange.
*The Russell 2000® Composite Stock Index is an unmanaged index comprised of the 2,000 smallest U.S. domiciled publicly traded common stocks. The Russell Midcap® Index is an unmanaged index comprising the 800 smallest companies in the Russell 1000® Index. The Lipper Multi-Cap Core Funds Index represents the total returns of the funds in the indicated category, as defined by Lipper, Inc. You should note that The Westport Funds are professionally managed mutual funds while the indices are unmanaged, do not incur expenses and are not available for investment.
*Basis Point is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument. There are special risks associated with small and mid-capitalization issues such as market illiquidity and greater market volatility than larger capitalization issues.
** As set forth in the Funds' prospectus dated May 1, 2012, the actual Total Annual Operating Expenses for Class R Shares of the Westport Select Cap Fund and the Westport Fund for the fiscal year ended December 31, 2011 were 1.36% and 1.25% respectively. As stated in the prospectus "Total Annual Fund Operating Expenses" 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 equal to 0.13%. Total shareholder servicing fees and Total Annual Operating Expenses in 2012 may be more or less than the amounts paid in 2011. 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. The Adviser has agreed to maintain these expense limitations with regard to each class of each Fund through April 30, 2013. See the Funds' prospectus for additional information regarding the Funds' expenses.
***Performance data of the Class R shares of the Westport Fund reflects certain waivers and expense reimbursements. Without such waivers and reimbursements, performance would have been lower. Portfolio composition is subject to change at any time and should not be considered a recommendation to purchase or sell a particular security. On September 30, 2012, the following securities comprised these respective percentages of the Westport Select Cap Fund and the Westport Fund: DeVry, Inc. (3.83%, 0.00%), ITT Educational Services, Inc. (1.46%, 0.00%), Big Lots, Inc. (5.54%, 0.00%), Universal Health Services, Inc. Class B shares (10.0%, 1.84%), Precision Castparts Corp. (8.81%, 3.48%), Willis Group Holdings, plc (8.41%, 2.02%), IPG Photonics Corp. (4.75%, 0.00%), Banner Corporation (1.13%, 0.00%), General Communication, Inc. – Class A (0.65%, 0.00%), Forest Oil Corp. (1.39%, 0.42%), Albemarle Corp. (0.00%, 1.18%), EOG Resources, Inc. (0.00%, 3.41%), Pall Corp. (0.00%, 3.05%), Synopsys, Inc. (6.90%, 3.33%), Checkpoint Software Technologies Ltd. (0.00%, 3.10%), Lender Processing Services, Inc. (0.00%, 2.93%), Trimble Navigation Ltd. (0.00%, 2.02%), Varian Medical Systems, Inc. (0.00%, 3.03%), and Nordson Corp. (0.00%, 1.27%).