Manager Commentary-Archive-Deleted
Manager Commentary, 1st Quarter 2011
Q: Despite a lack of coverage in mainstream media, the Russell 2000 recently hit a new all time high. What is your outlook?
A: The Russell 2000 hit a new all time high on April 27, 2011, closing at 858.31, above the mark of 855.77 set on July 13, 2007. Both the S&P 500 Index and the Dow Jones Industrial Average still have yet to fully recover from the bear market of 2008-09. The Russell 2000 Index’s continued climb relative to the broader markets has prompted us to take a closer look at what has been driving the Index’s recent performance, and to understand what this might mean for investors.
Despite the recent leadership by the Russell 2000 Index, a closer look at market internals leads us to believe that we are actually in the middle of a small-cap correction.
The Russell 2000 Index’s return has been driven by a small number of larger market-cap names. For the period of 12/21/10-4/12/11, the median return for companies with a market capitalization above $2 billion was 8.1%, as compared to just 1.1% for companies in the $150 million to $500 million market-cap range. Because the Russell 2000 Index is market-cap weighted, the stronger performance among larger names had an even greater effect on the Index’s overall return. Investors should be aware that the Russell 2000 Index will be rebalanced on June 24, 2011, as is performed annually. At that time, many of the larger stocks that have been driving the Index’s performance will be rotated out of the index in favor of smaller names. The correction can be observed in many of the true micro-cap names within the Russell 2000 Index that have in fact declined in price. In our opinion, much of these declines can be attributed to investors’ decisions to take profits, as many of the smallest names in the Index provided some of the strongest returns coming out of the down market.
Average Annualized Performance % as of 3/31/11*
Q: The MicroCap Opportunities Fund was up 6.27% for the quarter, yet the Fund saw its P/E ratios decline. How do you explain this apparent anomaly?
A: We believe that our ability to lower the P/E ratios in the portfolios during a strong period of positive returns demonstrates that we are still able to find value within our universe of micro-cap names. We are able to find value because of improving business fundamentals and the relative lagging performance of smaller names within the Russell 2000 Index, as discussed previously.
The decline in P/E ratios is two-fold: we rotated out of several more expensive names into more modestly priced equities and we also saw a broad increase in company earnings
The most interesting part of the decline in P/E ratios is that on a weighted average basis this trend is amplified. As you can see in the table below, the weighted average P/E ratio of the Fund declined significantly within the last quarter. This demonstrates that we have focused portfolio assets among more value-oriented equities. For example, in the MicroCap Opportunities Fund we recently sold Vasco Data Security (VDSI), a company trading at 40x earnings, and purchased two companies, Global Cash Access (GCA) and Intersections (INTX), which are both trading close to 10x earnings.
Russell 2000 Index Performance by Market Capitalization 12/31/10-4/12/11*
Q: What trends are you discovering regarding dividends within the small company universe?
A: Smaller companies are certainly not known to pay out a significant amount of dividends. However, lately more small companies are both initiating dividends as well as increasing dividends. In The Microcap Opportunities Fund there are 28 companies that pay out dividends. Eight of these have actually increased their dividends over the quarter. In The Emerging Opportunities Fund 16 companies pay out dividends. Five of these sixteen have recently increased dividends. Companies are also taking other actions in deploying their cash such as buying other businesses or buying back their own stock. Each of these trends has been significant in our portfolio and in the small-cap market as a whole. In our opinion, the fact that companies are finally using their cash instead of holding onto it demonstrates that they are no longer afraid of near-term problems with the overall economy. This gives us confidence that management teams should continue to take actions that will ultimately increase shareholder value.
Median and Dollar Weighted P/E ratios 12/31/10-3/31/11*