Manager Commentary-Archive-Deleted
Manager Commentary, 2nd Quarter 2010
Q: What did you learn from the recent rebalance ofthe Russell Indexes?
A: According to our analysis of the Russell rebalance, the number of investable stocks has declined by 40% since 1999. Each year at the end of June, The Frank Russell Company rebalances its indexes to account for changes in market size. In 1999 there were nearly 6000 domestic companies listed on the major U.S. stock exchanges. At the time of the Russell rebalance in late June, the number of domestic companies listed on the major stock exchanges was 3633. The reasons for the decline in the number of publicly traded companies include bankruptcies, acquisitions, companies going private, and the decline in the number of IPO’s. We feel that the significance of this development can be understood as a simple study of Economics: a shrinking supply of companies to invest in could have a strong impact on rising stock prices in the future.
Q: Where have you found opportunity as a result of Russell rebalance?
A: We increased our position in two stocks that wereremoved from the Russell Indexes as a result of the rebalance, PC Mall (MALL) and NovaMed (NOVA). In each instance, we felt that institutional selling due to the rebalance caused the stock price to fall to a level that was well-below our valuation of the business.
PC Mall is a distributor of electronic components. One of the company’s larger clients is Apple, Inc. – Apple products such as the iPod and iPhone are distributed through PC Mall’s pipeline. Following the Russell rebalance, PC Mall had a market capitalization of $40 million, a level nearly half of its tangible book value of $70 million. The company, which trades at approximately $3.50, earns $1.1 billion in revenue and has a current P/E ratio of less than 6. We believe that future earnings power translates to a P/E ratio of below 3, which to our minds represents opportunity for significant upside on a long term basis.
Performance as of 6/30/10*
NovaMed owns and manages offices for surgeons and other health care providers, an attractive option for doctors who prefer to focus on medicine as opposed to business. Similar to PC Mall, Nova Med’s share price declined following the Russell rebalance to a level that we believe is out of touch with fundamentals. Nova Med trades at approximately $8.00 which corresponds to a market capitalization of $60 million. The company earns $160 million in revenue but, more significantly, generates an enormous amount of cash flow. The company generates $45 million annually in cash, which makes today’s price equivalent to less than 2 times cash flow and is reason for us to believe that the investment has significant upside.
Q: Second Quarter Attribution Analysis – What Happened?
A: Although the quarter was a down period for our Funds, our attribution analysis shows that stock selection added the largest positive impact in both Funds.
The Emerging Opportunities Fund attribution analysis shows that stock selection impact was driven by several stocks that increased dramatically based on positive news events. One example was Hauppauge (HAUP), a stock that rose more than three-fold over several days after management announced the release of a new application (app) for the Apple iPod. We felt the stock price appreciated to a level that was unsustainable and as a result, we sold our entire position from The Fund. Over the period, HAUP contributed 1.00% to the Fund’s overall performance. Among portfolio detractors, no single investment reduced the Fund’s overall performance by more than 0.40%. We believe this is a testament to the Fund’s efforts to reduce stock specific risk by maintaining broad diversification. The Fund holds 100-150 names and initial positions are generally limited to 0.5%-1.5% of the portfolio. The MicroCap Opportunities Fund attribution analysis shows that the stock selection impact was a result of returns related to four companies that were bought-out of the portfolio during the second quarter, each of which was acquired at a nearly 100% premium. Over the period, these investments added more than 2.0% to the Fund’s overall performance. We believe that the environment remains favorable for acquisition activity in the microcap universe, due to number of larger companies searching for a better use of their cash considering the record-low yield it is earning today.
Acquisition Activity, January 1 – June 30, 2010*