Westport Funds' 2012 Annual Report
A recent column in the Financial Times summarized the effects of central banks' expansionary monetary policy in 2012, which underpinned domestic financial markets. "The search for yield turned 2012 into a veritable dash for trash. The lower the credit quality, the better the performance was the guiding principle, with poor quality credit outperforming investment-grade credit. At the same time, credit securities more generally tended to outperform government bonds and equities. With the notable exception of Japan, it was a triumphant year for the central banks, whose unconventional measures to secure ever looser monetary conditions worked a remarkable spell on global markets."i
The Federal Reserve ("Fed") purchased long term Treasury bonds with proceeds from the sale of short term Treasury obligations (Operation Twist) starting in September 2011 and concluding at year-end 2012. At the September 2012 Federal Open Market Committee ("FOMC") meeting, the Fed announced the third round of Quantitative Easing (a/k/a "QE3") committing to purchase $40 billion per month of mortgage backed bonds with the duration of the program unspecified. At the December 2012 FOMC meeting, the Fed announced its intention to also purchase $45 billion per month of Treasury bonds to replace Operation Twist. The Fed's monetary policy has been the primary driver of higher prices in domestic financial markets. The bond market's response to the Fed's unconventional monetary easing has been mostly declining yields suggesting stability in inflation expectations. These lower interest rates enhance the attractiveness of risky assets including equities whose prices have generally risen.
The Fed's actions since 2008 directly supported the stabilization and recovery of housing with lower mortgage interest rates. Higher home prices reduce write-downs and foreclosures improving the credit quality of bank assets and the value of bank shares. Looking beyond improved credit quality, banks look less attractive with new regulations and profit center divestitures likely to reduce future profitability below that recorded by the industry prior to the 2008 recession. Lower interest rates also supported higher share prices for real estate investment trusts ("REITs") as high yielding alternatives to fixed income investments. REITs generally lack competitive insulation and for that reason are absent from both Westport Funds. The results for the Westport Select Cap Fund and the Westport Fund in 2012 can best be assessed against their investment strategy. The focus of that strategy is to invest in companies that have a "good business" – one with a measure of competitive insulation and that is undervalued based on our estimates. Further, neither sector weighting, other than the avoidance of excessive concentration, nor sector rotation with the economic cycle, is a parameter of our portfolio construction.
Westport Select Cap Fund
The Westport Select Cap Fund finished 2012 on a strong note, reversing 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 had a 5.70% average annual return compared to the 16.35% average annual return for the Index. Since inception, 15 years ago, the Westport Select Cap Class R shares have outperformed the Index by more than 300 basis pointsii a year, compounding at an 8.97% average annual rate compared to 5.89% average annual rate for the Russell 2000® Index. The Westport Select Cap Fund was fairly concentrated during the year with 29 portfolio holdings at the start of 2012. Sharp declines in five positions (ITT Educational Services, Inc., DeVry, Inc., Big Lots, Inc. and Forest Oil Corp. and its spin-off, Lone Pine Resources Inc.) subtracted 581 basis points from the Fund's 2012 return, accounting for nearly 55% of the underperformance. The Fund's Financial Services sector holdings and the absence of REITs in the portfolio decreased performance relative to the Russell 2000® Index by 266 basis points and 205 basis points, respectively, accounting for 44% of the underperformance.
Positive actions were taken to reduce ongoing risks in the portfolio. Most significantly the most troubling position, ITT Educational Services, Inc., was eliminated as was Lone Pine Resources, Inc. DeVry, Inc., the remaining for-profit education company holding, was reduced in size and accounted for 4.4% of the portfolio at year-end. The two largest Fund holdings, Precisions Castparts Corp. and Universal Health Services, Inc., Class B shares, had satisfactory full year results with returns of 15% and 24%, respectively.
The fourth quarter saw active interest in mergers and acquisitions including three of the Fund's portfolio companies. JDA Software Group, Inc., a supplier of supply chain management software, was acquired by RedPrairie Corp., a privately held software company, resulting in a 101% gain from our average purchase price. Another long-term holding, Arbitron, Inc., agreed to be acquired by Nielsen Holdings N.V. at a 25.5% premium to our average purchase price. Because of possible regulatory issues, the holding was sold. 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 the Fund's average cost. The increase of mergers and acquisitions is very encouraging. It not only helps performance but equally important, it validates the value of the Fund's portfolio holdings. This is particularly true when companies are acquired by knowledgeable peers who understand the real operational value of a business.
A number of other portfolio holdings made important contributions to the Fund's performance. IPG Photonics Corp. (a laser manufacturer) was up nearly 97% for the year and United Rentals, Inc. (the country's largest equipment rental company) gained 54% for the year. Other significant gainers for the year included Orient Express Hotels Ltd. (an operator of luxury hotels) up over 56%, with a portion of the gain reflecting an acquisition proposal from Indian Hotels Company, Ltd. (a subsidiary of The Tata Group) that was declined; Rogers, Inc.(a supplier of specialty materials) up 34% and Carter's Inc. (retailer of children's apparel) up 40%.
Both Westport Funds are managed with a long-term focus, which generally minimizes capital gains tax liability to our shareholders. This past year a combination of factors resulted in the need to sell certain securities with large embedded gains, which resulted in the realization of an unusually large $5.0 8 per share long term capital gains distribution for the Westport Select Cap Fund. By far the most significant impact came from security sales required to meet shareholder redemptions while maintaining reasonable position sizes.
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 - 127 basis points from the Financial Services sector, 137 basis points from the absence of REITs in the Fund's portfolio and 208 basis points from the Consumer Discretionary and Services sector. Many banks had outstanding returns for the year on improved credit quality benefitting the Financial Services sector as investors responded to the effect of the Fed's continuing quantitative easing program. The 127 basis point performance differential can be apportioned as - approximately 43% from sector underweighting and 57% from stock selection – mainly too few credit quality challenged banks in the portfolio. The Consumer Discretionary and Services sector's results for 2012 reflect investor perception of it as a beneficiary of monetary and fiscal stimulus for consumers and as a relative safe haven from weak economic growth or financial dislocations outside the U.S., since the continuation of the 17 member Eurozone monetary union was questioned as 2012 began. The Fund's portfolio holdings in the Consumer Discretionary and Services sector returned over 23% for 2012 compared to 21% for that sector of the Russell Midcap® Index. The performance differential arose from the sector weighting of 17.3% in the Index, more than three times the weighting for the Westport Fund. On the positive side, the return for the Fund's Technology sector holdings surpassed that of the 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 Index.
The Westport Fund's individual holdings performed well 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 negative impact of 170 basis points. The weakest industry sector 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 oil 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 at 63%. Other portfolio holdings returning more than 30% for the year include: Amphenol Corp. (connectors), FEI Company (electron microscopes), American Eagle Outfitters, Inc. (teen 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 long term performance for the Class R shares is an average annual return of 10.20% for the 15 years since its inception. This compares favorably to the 7.75% average annual return for the Russell Midcap® Index and the 4.79% average annual return 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.
When 2012 began, the market faced a multitude of uncertainties and headwinds and one positive driver – the Fed's commitment to maintain unusually low interest rates at least through mid-2013 and Operation Twist through yearend 2012. The Fed not only stuck to its commitment but even expanded it by announcing QE3, an enlarged bond buying program and an extension of the period of low rates through 2015. In fact, the Fed went one step further by quantifying its threshold for raising rates - not until unemployment falls below 6.5% or inflation expectations rise above 2.5%. Given that operating earnings are expected to rise 6% in 2012 and the S&P 500 gained 13.4%, excluding dividends, nearly half the market's price performance last year came from an expansion in valuations. It is also apparent that unusually low interest rates drove the expansion in P/E ratios.iii
As 2013 begins, the market, as usual, faces many uncertainties. However, it seems that the same key driver to 2012's good market performance, the Fed's easy monetary policy, could once again support higher equity prices. Perhaps equally important, the Fed is being joined by central banks around the world. Ever since the European Central Bank's (ECB) Mario Draghi made the statement "the ECB will do whatever it takes to preserve the Euro," pressures on Eurozone markets have eased and long term interest rates in key countries – Spain and Italy - have declined. In Japan, where easing has been in place for years, the new government has announced even more aggressive actions to stimulate that country's economy; raise the inflation target to 2% from 1%, deploy more quantitative easing to reach the target and spend an added $116 billion or approximately 2% of Gross Domestic Product (GDP) for fiscal stimulus. China has moved to more expansionary actions and recent data indicates that these are working. Taken together these global efforts should, for the shortterm, reduce the likelihood of a significant macro dislocation.
The Fed's monthly purchases of $85 billion or $1 trillion on an annual basis are enough to cover the current estimated U.S. budget deficit for fiscal 2013. The Fed's actions will supplant foreign buyers for the debt securities issued to fund the deficit, keeping interest rates low and supporting economic activity through lower capital costs and enabling additional fiscal stimulus. Helped by the monetization of the forecast $1 trillion fiscal 2013 deficit, which represents about 6% of GDP, the U.S. economy should continue to grow at a solid rate somewhat above 2% and under these circumstances has the potential for some upside, particularly in the second half of the year. Housing should continue to recover, domestic energy exploration and production is booming, deferred capital spending could pick up and state and local government budgets appear to be under less pressure.
Of course, what this might mean longer-term is higher inflation and currency debasing but these issues are unlikely to impact 2013. All of this points us to the potential for reasonable but not spectacular gains in the equity markets.
We appreciate the continued confidence of our shareholders.
Edmund H. Nicklin, Jr.
Andrew J. Knuth
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.
References to specific securities, sectors and industries discussed herein are not recommendations to buy or sell the securities or investments, and the Funds may not necessarily hold these securities or investments today.
There are special risks associated with small and mid-capitalization issues such as market illiquidity and greater market volatility than larger capitalization issues.