Meridian Fund Q3 Letter
GDP grew at 1.3% during the second quarter of 2012, down from a revised 2% in the first quarter. The increase in GDP came from personal consumption expenditures, exports and nonresidential and residential fixed investment, offset by declining inventory investment and state and local government spending. Earnings expectations for the S&P 500 fell during the quarter, as a rising number of companies forecast lower-than-expected profits and provided downward revisions to their guidance. We are troubled by the divergence between equity performance and fundamentals. In our experience such a divergence between stock prices and earnings can persist for a period of time, but is ultimately unsustainable. In light of this, we are approaching the market cautiously.
Long-term investment results, history clearly shows, are improved by buying good companies or mutual funds consistently over an extended period of time. We will continue to patiently execute our investment strategies.
We welcome those new shareholders who joined the Meridian Funds during the quarter and we appreciate the continued confidence of our existing shareholders.
Meridian Equity Income Fund® (MEIFX) The Meridian Equity Income Fund's net asset value per share at September 30, 2012 was $11.09. This represents an increase of 8.5% year-to-date. The Fund's total return and average annual compound rate of return since inception January 31, 2005 were 44.1% and 4.9%, respectively. At the close of the quarter, total net assets were $26,763,137 and were invested 3.5% in cash and other assets net of liabilities and 96.5% in stocks. At the close of the quarter there were 450 shareholders in the Equity Income Fund.
The Fund continues to invest in companies that we believe have the potential for capital appreciation and the ability to grow dividends. The Fund is diversified, with 50 holdings representing 45 different industry groups. At the end of the quarter ended September 30, 2012, the portfolio's average holding had a five-year average return on equity of 19.2% and an average dividend yield of 3.5%, both measures substantially higher than the average S&P 500 stock, with an average market capitalization of $46.5 billion and an average debt to capital ratio of 37.7%.
During the quarter we purchased shares of Baxter International, Black Rock, Enbridge Energy Partners, Flower Foods, Intel, Linear Technology and March & McLennan. We sold our shares in Allstate, Exelon, Federated Investors, General Electric, H&R Block, Hillenbrand, Home Depot, KLA-Tencor, Kraft Foods, Mercury General, Microchip Technology, NYSE Euronext, Pitney Bowes, Safeway, Staples, Time Warner Cable and Waste Management.
Time Warner, Inc. (NYSE:TWC), one of our largest holdings, is a leading media and entertainment company. Television represents over 75% of the company's operating profits and includes cable stations TNT, TBS and Cartoon Network, news network CNN, premium pay channel HBO and broadcast network CW. Other businesses include the Warner Brothers movie studio and magazine publishing including such titles as Time, People, Fortune and Sports Illustrated. As viewing of video content migrates from traditional distribution to internet delivery, we believe that the developers and owners of high quality content like Time Warner will fare better than traditional distributors such as cable television providers. The company has a strong track record of earnings and dividend growth fueled by its content and faster growth abroad. Additionally, the company generates substantial free cash flow and maintains conservative financial leverage. With a 2.3% dividend yield and trading at twelve times forward earnings, in our opinion, Time Warner represents an attractive investment.
Meridian Growth Fund® (MERDX)
The Meridian Growth Fund's net asset value per share at September 30, 2012 was $46.05. This represents an increase of 10.6% year-to-date. The Fund's total return and average annual compound rate of return since inception August 1, 1984 were 2,656.9% and 12.5%, respectively. At the close of the quarter, total net assets were $2,284,677,867 and were invested 6.9% in cash, cash equivalents and other assets net of liabilities and 93.1% in stocks. At the close of the quarter there were 87,179 shareholders in the Growth Fund.
Despite macroeconomic worries, there are reasons for optimism. Corporate balance sheets are strong and unemployment levels continue to gradually decrease. Many small and mid-sized growth stocks sell at reasonable valuations. We continue to follow the investment strategy that has served the Fund well for the past 28 years. Our portfolio remains diversified in mid-sized growth companies which in our opinion are predominantly market leaders, having strong returns on capital, solid growth prospects and that sell at reasonable valuations. The Fund is invested in 56 positions along with Treasury Bills. Our heaviest areas of concentration remain the consumer and technology sectors.
During the quarter we purchased shares of ANSYS, AutoZone, Dollar Tree, DSW, Perrigo, Stericycle and Woodward. We sold our positions in Advance Auto Parts, Advent Software, International Game Technology, Nuance Communications and VeriFone Systems.
Brown & Brown (NYSE:BRO), one of our largest holdings, is a large US insurance broker that focuses on property and casualty insurance for the small-and-middle markets. The company generates about 30% of revenue from Florida, its largest market. The middle-market brokerage segment is highly fragmented with smaller local competitors and has historically been more profitable than the large global insurance brokers. Brown has one of the strongest management teams in this segment, and consistently generates above industry margins driven by its strategies of strict cost control and disciplined acquisitions. Industry premiums for property and casualty insurance have increased each month since the beginning of 2012, after declining for seven consecutive years. We believe that Brown will benefit from this continued recovery in the insurance market over the next few years and that Brown is well positioned to grow faster than the industry over the long term as it continues to consolidate middle-market brokerages. The shares sell at a reasonable valuation, in our opinion, given the company's balance sheet, financial returns and long-term growth prospects.
Meridian Value Fund® (MVALX)
The Meridian Value Fund's net asset value per share at September 30, 2012 was $31.96. This represents an increase of 13.8% year-to-date. The Fund's total return and average annual compound rate of return since June 30, 1995 were 800.4% and 13.6%, respectively. The comparable period returns for the S&P 500 with dividends were 261.7% and 7.7%, respectively. At the close of the quarter, total net assets were $684,426,573 and were invested 7.5% in cash, cash equivalents and other assets net of liabilities and 92.5% in stocks. At the close of the quarter there were 31,711 shareholders in the Value Fund.
We continue to seek out-of-favor companies, typically having experienced an extended period of declining earnings. In recent years, most earnings problems have been related to poor economic conditions. With some stability in the economy, albeit tenuous, we now see more companies that meet our strategy for company-specific reasons. These investments are the traditional strength and point of differentiation of the Meridian Value Fund. We are gradually shifting the portfolio to more of these investments and believe that this should bode well for a return to the Fund's historically strong performance levels. The Fund is invested in 53 positions, representing 34 industry groups along with Treasury Bills. We continue to invest in companies of all market capitalizations and our largest areas of concentration are technology, retail and transportation.
During the quarter we purchased shares of Aeropostale, Flowers Foods, Gildan Activewear, Koninklijke Phillips, and Verint Systems. We sold our positions in Cummins, CVB Financial Group, Host Hotels & Resorts, Lincoln Electric and TD Ameritrade. One of our newest holdings, Matson, is the result of a spin-off from our holding of Alexander & Baldwin, Inc.
GATX Corporation (NYSE:GMT) is one of our largest holdings. The company specializes in owning and leasing long lived, widely used transportation assets that have a valuable service component. The majority of GATX's business is in the railcar leasing market, particularly tank cars used to transport chemicals, petroleum or food and agriculture products. The company suffered declining earnings due to the weak macroeconomic environment as long term leases signed during better times expired and were renewed at lower rates during the recent downturn and early stages of the current recovery. Earnings growth turned positive as under-production of tank cars during the economic downturn, coupled with improved demand for railcars as the economy stabilized, resulted in favorable supply and demand conditions. Demand is now augmented by secular growth in domestic production of oil and chemicals, with the latter driven by expectations for increased domestic production of low priced natural gas. GATX is well managed, in our opinion, and trades at a reasonable valuation based on normalized earnings per share, which we believe could exceed $3.50 per share if current trends persist. In addition the shares have an attractive 2.8% dividend yield.
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The Meridian Funds are no-load and there are no transaction fees or commissions charged when you purchase shares directly through our transfer agent, BNY Mellon Investment Servicing (U.S.), Inc. This is a very cost-effective way to purchase shares of the Meridian Funds if you do not need the services of a broker-dealer or if you make multiple purchases.
The information provided in this report should not be considered investment advice or a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in a particular Fund's portfolio at the time you receive this report or that securities sold have not been repurchased. Securities discussed are presented as illustrations of companies that fit a particular Fund's investment strategy and do not represent a Fund's entire portfolio and in the aggregate may represent only a small percentage of a Fund's portfolio holdings. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that investment decisions Fund management makes in the future will be profitable or will equal the investment performance of the securities discussed herein. Management's views presented herein and any discussion of a particular Fund's portfolio holdings or performance are as of September 30, 2012 and are subject to change without notice.