Westport Funds Quarterly Letter
Dear Fellow Shareholder:
The U.S. major market indices experienced flat to slightly negative returns in the fourth quarter as investors were distracted by the presidential election and concerns over the outcome of the "fiscal cliff" negotiations. The quarter ended with the Dow Jones Industrial Average*, the S&P 500® Index*, and the Nasdaq Composite Index* returning -1.74%, -0.37%, and -2.47% respectively. Nevertheless, for the entire calendar year 2012 the same indices experienced strong returns 10.24%, 16.00%, and 17.75%. With the arrival of 2013 investors continue to face uncertainties in the form of Congressional battles over the federal budget, Europe's debt crisis, and slowing corporate earnings. However, with the recovery in the housing and auto industries coupled with the rapidly expanding domestic energy exploration and production, the U.S. economy appears to have the potential to grow above 2.0% in 2013.
The Westport Select Cap Fund finished 2012 on a strong note, reversing in part the disappointing performance of the first three quarters. For the final three months of the year the Westport Select Cap Fund's Class R shares were ahead 4.59% compared to the 1.85% gain for the Russell 2000® Index. However, for the full year, the Class R shares were up 5.70% compared to the 16.35% increase for the Index. Since inception, 15 years ago, the Westport Select Cap Class R shares have outperformed the Index by more than 300 basis points a year, compounding at an 8.97% annual rate compared to 5.89% gain for the Russell 2000® Index. The principal reasons for the underperformance during the first nine months were a combination of sharp declines in large positions (particularly ITT Educational Services, Inc., DeVry, Inc. and Big Lots, Inc.), lack of meaningful contribution from our two largest positions - Precision Castparts Corp. and Universal Health Services, Inc., and no benefit from mergers and acquisition activity. During the fourth quarter there were some signs of reversals in a number of situations that had depressed results. Precision Castparts Corp.'s share price rose nearly 16% resulting in a full year gain of 15%. Universal Health Services, Inc., the Fund's largest position, continued its climb that began late in the third quarter, rising nearly 6% in the fourth quarter and over 24% for the year. Action was also taken to reduce ongoing risks in the portfolio. Most significantly the Fund's long-term and most troubling position, ITT Educational Services, Inc. was eliminated. DeVry, the remaining for-profit education company holding, was reduced in size and accounted for slightly over 4% of the portfolio at year-end. The stock actually rose over 4% in the fourth quarter. Finally, acquisitions affected three of our portfolio holdings. JDA Software Group, Inc. was acquired by RedPrairie Corp., a privately held software company, resulting in a 101% gain from the average purchase price. Another long-term holding, Arbitron, Inc., agreed to be acquired by Nielsen Holdings N.V. at a 26% premium to the average purchase price. Because of possible regulatory issues, the position was eliminated. In early December, Plains Exploration & Production Company, the Fund's largest energy holding, agreed to be acquired by Freeport-McMoRan Copper & Gold, Inc. in a combination cash and stock deal valued at $50 per Plains share, more than 85% above cost. This merger and acquisition activity certainly helps performance but equally important, it validates the value of the portfolio holdings. A number of other portfolio holdings made important contributions to fourth quarter performance. IPG Photonics Corp., a laser manufacturer, was up over 16% for the quarter and 97% for the year. United Rentals, Inc., the country's largest equipment rental company, gained over 39% for the quarter and 54% for the year. Other double-digit gainers in the quarter included Orient Express Hotels Ltd., an operator of luxury hotels, up over 31%, Checkpoint Systems, Inc., a supplier of theft protection systems, up 29% and Banner Corp., a Pacific Northwest bank, up 13%. On the negative side, one position, Darden Restaurants, Inc., stood out with a decline of over 19% and cost nearly 1 percentage point in performance. Pressured by intense competition and a so far unsuccessful marketing program aimed at turning around declining sales at its key Olive Garden chain, the company pre-announced disappointing earnings. This portfolio position has been reduced by over one-third and it is believed that the stock will be supported by it's over 4% yield. Mention should be made of the unusually large $5.07 per share long term capital gains distribution made to the Westport Select Cap Fund's shareholders at year-end. The fund is managed with a long-term focus while generally minimizing to the extent possible tax liability to our shareholders. This past year a combination of factors resulted in the need to sell certain securities, which resulted in the realization of longterm capital gains. By far the most significant impact came about due to efforts to maintain reasonable position sizes as sales were required to meet shareholder redemptions. In particular, this necessitated sales of Precision Cast Parts Corp. at prices exceeding $170 per share where the Fund's cost was closer to $10 and Universal Health Services, Inc., Class B shares, at prices around $40 per share where the cost was as low as $12. Reductions in these two positions by themselves accounted for nearly one-half of the realized gains. Over one-third of the gains were realized as a result of actions to reduce the risk profile of the portfolio; the elimination of the ITT Educational Services, Inc. position, and reductions in Big Lots, Inc. and Darden Restaurants, Inc. Finally, the elimination of our two take-out positions, JDA Software Group, Inc. and Arbitron, Inc., accounted for most of the balance.
During 2012 the Westport Fund Class R shares returned 12.26% versus 17.28% for the Russell Midcap® Index. Ninety-four percent of the 502 basis point return differential is attributable to three industry sectors: 208 basis points for Consumer Discretionary and Services, 127 basis points for Financial Services and 137 basis points for REITs. As 2012 began, the continuation of the 17 member Eurozone monetary union was in doubt and the financial ramifications of its dismemberment were greatly feared. Add in an expected slowing of growth in China and investors unsurprisingly shifted their focus to companies with predominantly U.S. end markets and operations. Consumer Discretionary companies were a natural choice for investors concerned about weak economic growth or financial dislocations outside the U.S. The profits of these firms also benefitted from the effects of substantial U.S. monetary and fiscal stimulus with this segment providing a 21% return in 2012. Neither sector weighting, other than the avoidance of excessive concentration, nor sector rotation as the economic cycle plays out, is a parameter in portfolio construction. The portfolio holdings in the Westport Fund's Consumer Discretionary and Services sector returned over 23% for 2012 outperforming that sector of the benchmark Russell Midcap® Index. The sector weighting of 17% in the Index, more than three times that of the weighting in the Westport Fund, extracted a performance penalty. Many banks had outstanding returns for the year as investors responded to the effect of the Federal Reserve's quantitative easing program on housing, benefitting the Financial Services Sector. The 127 basis point performance differential for this sector can be separated into two components: approximately 43% from under weighting and 57% from stock selection with too few credit quality challenged banks. With new regulations and the likelihood of profit center divestitures, future profitability for the banking industry appears likely to be less than that delivered prior to the recent recession, not supportive of gains beyond those from the resolution of credit problems. Finally REITs were a logical beneficiary of the Fed's quantitative easing as investors sought better yields than those available in many fixed income investments. However, REITs generally lack competitive insulation, which is a key parameter in the Fund's investment strategy. On the positive side, the return for the Fund's technology sector holdings surpassed that of the benchmark Russell Midcap® Index by 136 basis points and Materials and Processing sector holdings were 83 basis points better than that for the corresponding sector in the benchmark Index. Performance of the Westport Fund's individual holdings was quite good during the year with 42 gainers out of 51 stocks in the portfolio. The nine companies in the portfolio with losses for the year had a total negative return of 170 basis points. The weakest industry group was Energy where four of the six holdings reported losses for the year. Forest Oil Corporation and its spinoff, Lone Pine Resources, Inc., which combined cost 68 basis points, saw their market value erode 61% during the year from a lethal combination of significantly lower natural gas prices and a level of leverage that proved excessive. Despite this disappointment, the energy sector provided a positive return for the year, due to excellent drilling results in onshore shale basins by EOG Resources, Inc. and an agreement for the acquisition of Plains Exploration and Production Company by Freeport-McMoRan Copper & Gold, Inc. for $50 a share in cash and stock. Turning to positive individual holdings, eight reported a total return for the year exceeding 30%, led by Lender Processing Services, Inc. which provides mortgage processing and default management services to mortgage lenders with a 63% gain. Other portfolio holdings returning more than 30% for the year include: Amphenol Corp. (connectors), FEI Company (electron microscopes), American Eagle Outfitters, Inc. (teenage apparel), Charles River Laboratories International, Inc. (research models), FMC Corp. (chemical compounds), and Master Card, Inc., Class A Shares (payment solutions).
The Westport Fund's fourth quarter results had a foundation similar to that for the full year 2012. Underweighting of the Westport Fund's Consumer Discretionary and Services segment relative to the benchmark Russell Midcap® Index was primarily responsible for the underperformance of 108 basis points. The lack of REIT's played virtually no role in the results for the fourth quarter. During the fourth quarter, positions were increased for Air Products and Chemicals, Charles River Laboratories International, Inc. and Nordson Corporation. The position in Nordson Corporation was initiated in the third quarter and was expanded during the fourth quarter. The company, a leader in the design of systems for applying adhesives and sealants in a wide range of industrial and consumer applications has exhibited success in integrating a number of smaller niche acquisitions. There was a small addition to the Abbott Laboratories holding in anticipation of the spinoff of the company's pharmaceutical business at the end of 2012. Finally, a new position was established in Core Laboratories N.V., a unique oil service company that provides reservoir management services and production enhancement when it experienced an earnings shortfall relative to expectations for third quarter results. The company's capabilities in reserve modeling are highly valued in the shale areas of the U.S.
Last year marked the fifteenth anniversary of the Westport Fund's inception and the long term performance for the Class R shares is an average annual return of 10.20% for the 15 years. This compares favorably to the 7.75% for the Russell Midcap® Index and the 4.79% 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
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 R 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.