Meridian Funds Inc. Semi-Annual Review
Stocks were mixed in the quarter ended December 31, 2012 as declines during the fall were largely erased by a year-end rally that preserved strong gains for the markets in 2012. Ongoing US fiscal issues, highlighted by the presidential elections, weighed on the market early in the quarter. Despite little or no resolution to these structural issues, the markets staged an impressive post-election comeback helped by continued gradual improvement in economic indicators at home, ongoing commitment to low interest rates and liquidity by the Federal Reserve, signs of economic improvement in China and a lack of bad news coming out of Europe. For the quarter, the S&P 500 declined 1.0%, the NASDAQ lost 3.1% and the Russell 2000, which includes smaller companies, gained 1.4%. The quarter's best performing sectors included financials, industrials and consumer cyclicals. Technology, energy and utilities were among the worst performing groups. The yield on the ten-year Treasury bond ticked up from 1.66% to 1.78% during the quarter, reflecting modestly improving economic indicators.
GDP grew at 3.1% during the third quarter of 2012, a meaningful acceleration from 1.3% in the second quarter. The acceleration was driven primarily by upturns in private inventory investment and government spending, combined with improving fixed residential investment. A downturn in nonresidential fixed investment and exports offset this. Many signs point to continued gradual economic growth, though the risks to the economy persist. Debt and spending concerns are unlikely to fade from view as politicians continue to use stopgap measures to delay resolution to these issues. European economies continue to be vulnerable. Historically high corporate profit margins may be difficult to sustain and could act as a headwind to earnings growth. On the positive side, interest rates remain low and the growth in domestic energy supply, if harvested intelligently, should have wide-ranging short and long term benefits to the US economy. Internationally, the Chinese economy is showing early signs of rebound. Meanwhile, European government bond yields have declined meaningfully which, at least for the time being, could give those governments some breathing room. History clearly shows that long-term investment results are improved by buying good companies or mutual funds consistently over an extended period of time. We welcome those new shareholders who joined the Meridian Funds during the quarter and appreciate the continued confidence of our existing shareholders.
We wish you a happy, healthy and prosperous New Year.
Meridian Equity Income Fund ® (MEIFX)
The Meridian Equity Income Fund's net asset value per share at December 31, 2012 was $10.82. This represents an increase of 8.6% for the calendar year. The Fund's total return and average annual compound rate of return since inception January 31, 2005 were 44.2% and 4.7%, respectively. At the close of the quarter, total net assets were $25,247,856 and were invested 5.3% in cash and other assets net of liabilities and 94.7% in stocks. On December 18, 2012, the Equity Income Fund paid an income dividend of $0.28 per share. At the close of the quarter there were 446 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 47 holdings representing 42 different industry groups. At the end of the quarter ended December 31, 2012, the portfolio's average holding had a five-year average return on equity of 19.3% and an average dividend yield of 3.7%, both measures substantially higher than the average S&P 500 stock, with an average market capitalization of $37.6 billion and an average debt to capital ratio of 36.0%.
During the quarter we purchased shares of Air Products, The Cato Corporation, Dr. Pepper Snapple Group, Hawaiian Electric and Koninklijke Phillips. We sold our shares in Coca-Cola, Integrys, International Paper, Nucor, Sonoco Products, Time Warner and Wal-Mart.
RPM International (RPM) is a leading specialty chemical company that makes products such as paints, protective coatings, sealants and adhesives for both industrial and consumer markets. The company owns category leading brands such as Rust-Oleum and DAP, and sales are historically resilient as maintenance, repair and redecoration represent over 80% of sales. We believe RPM should continue to generate solid mid-single digit growth through market share gains, new product introductions, and continued expansion into emerging markets. RPM seeks to supplement its internal growth with acquisitions of leading niche or geographically focused businesses that can grow more rapidly when put through RPM's robust commercial organization. RPM maintains conservative financial leverage and generates a return on equity in the high teens. In our opinion, future dividend increases appear likely as the company's dividend payout is less than half of forward earnings and RPM has increased the dividend for 39 straight years. With a 2.9% dividend yield and solid growth prospects, we believe RPM represents an attractive investment.
Meridian Growth Fund ® (MERDX)
The Meridian Growth Fund's net asset value per share at December 31, 2012 was $39.78. This represents an increase of 12.3% for the calendar year. The Fund's total return and average annual compound rate of return since inception August 1, 1984 were 2,698.1% and 12.4%, respectively. At the close of the quarter, total net assets were $2,021,839,567 and were invested 6.0% in cash, cash equivalents and other assets net of liabilities and 94.0% in stocks. On December 18, 2012, the Growth Fund paid an income dividend of $0.15 per share and a long term capital gain distribution of $6.88 per share. At the close of the quarter there were 83,118 shareholders in the Growth Fund.
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 53 positions representing 29 industry groups along with Treasury Bills. Our heaviest areas of concentration remain the consumer and technology sectors.
During the quarter, we purchased shares of Life Technologies, Sally Beauty Holdings and Xylem. We sold our positions in Arcos Dorados, Blackbaud, CarMax, CVB Financial, Open Text Corporation and Waste Connections.
Trimble Navigation offers GPS-enabled advanced positioning technologies that help users track physical assets and industry specific software solutions that collect and analyze data to help improve worker productivity. The company's solutions are used in the construction, agriculture, and commercial fleet industries. The company is the global leader in most of the major segment it competes in. Long term industry growth is driven by the relatively low global penetration rate of positioning related solutions and the strong value proposition they provide by helping customers lower their operating costs and become more productive. Trimble has further expanded its addressable markets in recent years as it expands into adjacent software solutions that are complementary to the core positioning products. Over the next few years, revenue and earnings are expected to continue growing in double digits. In our opinion, the stock sells at a reasonable valuation 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 December 31, 2012 was $32.86. This represents an increase of 17.4% for the calendar year. The Fund's total return and average annual compound rate of return since June 30, 1995 were 828.9% and 13.6%, respectively. The comparable period returns for the S&P 500 with dividends were 260.1% and 7.6%, respectively. At the close of the quarter, total net assets were $665,457,701 and were invested 6.9% in cash, cash equivalents and other assets net of liabilities and 93.1% in stocks. On December 18, 2012, the Value Fund paid an income dividend of $0.11 per share. At the close of the quarter there were 30,810 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 56 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 Air Products, Arthur J. Gallagher, Corning, Cree, Energen, Linear Technology and Xylem. We sold our positions in Apache, Heartland Payment Systems, KBW and Wells Fargo.
Flowserve (FLS) is a leading manufacturer of pumps, valves and seals found in a variety of end- markets such as oil & gas, power generation and chemicals. The company holds leading market positions across various geographies, product segments and end-markets. It is also ahead of the competition with aftermarket service centers located throughout the world, providing it with deeper customer relationships and steadier demand for higher margin replacement and repair business. Flowserve's late cycle markets have bottomed and pricing on new projects is beginning to improve as excess capacity gets absorbed. Additionally, the company should, in our opinion, benefit from the build-out of emerging market infrastructure and domestic opportunities such as new chemical plants and pipeline expansions brought on by abundant natural gas. Flowserve maintains modest financial leverage and generates returns on equity of 20%. We believe the company is attractively valued at 12x our $13 per share estimate of potential earnings power.
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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 (US) 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 December 31, 2012 and are subject to change without notice.