SMID Market Commentary

First Quarter 2010 Quarterly Commentary

The Stewardship Partners US SMID Cap BRI strategy composite – gross returned 4.70% in the first quarter, but underperformed the S&P 1000 benchmark by 4.24% over the period. Our defensive posture, underperformance in stock selection, and underweighting of cyclical sectors, all served as a drag on relative performance.

Market Review – Still Climbing
It remained the best of times for small-mid cap investors in the first quarter, as the market continued to climb a wall of worry. The SMID cap sector, as captured by the S&P 1000 index, rose by 8.94% during the first quarter of 2010. The S&P 400 index (mid caps) rose 9.09%, while the S&P 600 index (small caps) rose 8.61%. The market extended its gains and momentum from 2009 into the new year. However, all was not a straight line, as the market took a tumble in January, before staging a recovery to finish the quarter up more than 14% from its February low. Growing confidence in the sustainability of the recovery, surging earnings, strong momentum, and low interest rates continue to underpin market strength. Although mid caps and small caps provided a similar return over the period, they did so via different routes. The leading sectors in the mid cap space were Consumer Discretionary (13.46%), Materials (12.95%), Health Care (12.34%) and Consumer Staples (11.46%). While the leading sectors in the small cap realm were Consumer Discretionary (19.46%), Financials (8.50%) and Health Care (8.05%). Value trumped growth by handy margins in both the mid and small cap sectors (15.08% to 11.42%, and 20.7% to 8.05% respectively). Sector laggards among mid caps were Utilities (1.08%), Telecom (3.6%), and Energy (3.7%). Sector laggards among small caps were Telecom (-12.19%), Materials (0.43%), and Utilities (1.25%). Of note, the SMID cap sector continued to outperform the large cap sector, highlighting the bullish predisposition of the market.

Recovering Balance Sheets, Recovering Psyches
It is becoming clearer that we are in the midst of a cyclical recovery, and there is little in the near term outlook to derail that process. Bolstered by exceptional monetary and fiscal policy, growth is spreading, weak sectors are stabilizing, and confidence is growing. However, recovery is fragile and we are still dealing with the de-leveraging effects of a balance sheet recession. The question remains as to whether the economy is robust enough to pass the baton from the public sector to the private sector, and when it will transition from recovery to expansion. The test is likely to come in 2011. Further down the road, it will be the middle-class who get squeezed on all sides (higher taxes, rising living costs, increasing interest rates, and higher energy costs). Having risen more than 75% off its lows, the market has already signaled high hopes for the future. But market history and common sense caution that there is less margin for error after such a move, and that the trajectory will flatten. And it is worrying when everyone seems to be on the same side of the trade. For those concerned about the risks, waiting for another collapse may be a little premature. Normally the pre-conditions for collapse (or in this case re-lapse) require high valuations, increasing leverage, and a reasonable period of stable growth in order to breed the complacency necessary to ignore risks. But with everyone focused on the risks, the likelihood that they will morph into reality is reduced. That does not mean however, that we will continue on the moon shot ride. When good news translates to bad news, then that may be ‘the tell’ that the market has gotten ahead of itself. And if we grow too fast, potentially the greatest risk is an unraveling of the recovery due to the economy’s vulnerability to rising interest rates. But don’t make the mistake of thinking that equities are not the place to be. On the contrary, the equity market may provide one of the few outlets for preserving wealth. To date, cost cutting has driven corporate profits, but it will require a pick-up in underlying demand to drive profit growth in the future. Valuation seems reasonable given the profit recovery and expected profit growth (easy YoY comparisons). The key will be whether that anticipated future growth materializes. Fund flow and small investor sentiment data indicate there are still a lot of small investors sitting out the rally. With confidence in the recovery spreading, it seems likely that these hesitant investors will be reeled in from the sidelines. The market right now is a ship without an anchor probing resistance in search of a valuation level. Many an investor has been burned standing in the way of this steamroller. Potential positive catalysts going forward are coordinated moves to address global imbalances, banks increasing their lending again, and a realization that the recovery is self-sustaining. However, prudence points to caution. The Fed has the difficult task of trying to stick the monetary landing, while our elected leaders have to come up with the courage to address our structural imbalances. Looking forward, we should expect more volatility and more compressed market cycles, as the choppy waters of stimulus exit meet the rough seas of secular headwinds.

Portfolio Review
The Stewardship Partners US SMID Cap BRI strategy composite – gross returned 4.70% in the first quarter, but underperformed the S&P 1000 benchmark by 4.24% over the period. Much of the relative underperformance was due to a large underweight position in the outperforming Consumer Discretionary and Consumer Staples sectors, and an overweight position in the underperforming Technology sector. In addition to the portfolio’s skew toward growth companies, stock selection and cash served as drags on performance relative to the benchmark. At this point we continue to maintain an overweight exposure to Technology, and Healthcare, with underweight exposure to Financials, Consumer Discretionary, Consumer Staples, and Utilities. Outperforming stocks during the quarter were Health Grades (HGRD), CapitalSource (CSE), Petmed Express (PETS), SEI Investments (SEIC), ICON PLC (ICLR), and MF Global (MF). Underperforming names were Investment Technology Group (ITG), Superior Energy (SPN), FLIR Systems (FLIR), and Yamana Gold (AUY). During the quarter we increased the portfolios equity exposure adding Nutrisystem (NTRI) in the Consumer Discretionary space, Arris Group (ARRS) in the Telecom/Technology sector, and Assurant, Inc. (AIZ) in the Financial services sector. In the current environment we are privy to companies with strong, liquid balance sheets, weak relative performance, leading market franchises, solid historic operating results, and manageable valuations. We employed the inverse ETF option in Tactical accounts in the middle of January and removed them in early February, adding nearly 1% in additional performance for Tactical accounts. We recently enacted the tactical option again at the end of the quarter, reducing equity exposure from 92% to 85% in Tactical accounts.

Outlook
Much has happened since I outlined my underlying view in the inaugural commentary, but not a lot has changed. There is still much to worry about, and much to be worried about. Psychological resistance to the recovery is giving way to a growing confidence, as investors come in from the cold. Momentum from the rising market, acceptable valuations, and 0% interest rates continue to encourage risk taking. The incessant upward movement of the market creates an unhealthy expectation, setting up potential disappointment. And so, at this point we continue to be cautious, wary that the longer term outlook is still cloudy, and that the lion’s share of the ‘easy money’ has already been made. As such, I am reluctant to chase the market, given how much it has run, how I think its trajectory will flatten, and how there are questions regarding the transition to self-sustaining growth.

This commentary represents the opinions of its author as of 4/12/10, and may change based on market and other conditions. The author’s opinions are not intended to forecast future events, guarantee future results, or serve as investment advice.