1Q11 SMID Market Commentary

***Forgot to post this at the time.

First Quarter 2011 Quarterly Commentary

The Stewardship Partners US SMID Cap BRI strategy composite (gross) returned 3.94% in the first quarter 2011.


SMID Market Review
The “QE2” rally that began in September carried over to the first quarter 2011, propelling SMID cap equities to new all-time highs. Not even rolling revolutions in the Middle East, higher oil prices, earthquake/tsunami/nuclear catastrophe in Japan, or prospective default by Ireland or Portugal could upset the SMID cap apple cart. It may be cliché, but we truly live in historic times. What remains to be seen however, is which events leave an indelible mark on history. For the quarter, mid caps outperformed small caps (9.36% vs 7.71%), and growth again beat value. The strongest performing sectors were energy, staples and healthcare, while telecom and financials were notable laggards. It should be noted that the telecom sector is a small segment of the SMID universe, and as such, underperformance by the consumer discretionary sector contributed an even greater drag on the index. The SMID cap segment of the equities market once again outperformed large caps, with much of that attributable to outsized gains in the energy sector.

The Teflon Market
The market weathered an enormous amount of bad news over the quarter, only to come through relatively unscathed. Much was thrown at it, but nothing seemed to stick. The resilience, evident in the price action, belied a growing confidence in the future. However, it doesn’t necessarily follow that the market will continue to go up at the rate it has been appreciating. The S&P 1000 is up more than 140% from its nadir in 2009, and 40% from its lows in 2010. At this point in the cycle, it is not unreasonable to assume that as the economy normalizes, the market will normalize. A more normal market might be one where the rate of appreciation is lower, and volatility is higher. The main underpinnings of the rally thus far have been relatively attractive valuations, strong earnings, an improving economic outlook, and negative real interest rates. Getting to this point however, required a lot of borrowing from the future, with the govt/Fed providing the bridge.

At some point, the economy (and the market) will have to wean itself from its dependence upon fiscal and monetary stimulus. To date, the market has shown surprisingly little interest in the matter. Perhaps it is the hyper short term nature of the market today, or an inspired insight to the future. Whatever the case, eventually the market will have to confront the exit strategy. And when it does, the focus will likely shift from the tailwinds of massive stimulus and a cyclical recovery, to secular headwinds in the form of rising interest rates, lower government spending, and higher taxes.

Underneath the current robustness is a fragility due to the inability to make hard political decisions to solve structural imbalances, and the legacy of a decrepit international monetary system. It would be a little surprising to see another crisis of the magnitude of the 2008-09 financial crisis so soon after the event. Crisis have a large psychological dimension, but they are also predicated upon an accumulation of excesses somewhere in the system, and an increasing comfort with those excesses. Those things are building, but they are probably not here yet.

That is not to say there aren’t risks. There are still significant risks that remain. However, nearer term, the main factor that could trip the market is a faltering economy. There have been a few signs of a decline in growth this quarter, but with employment on the mend and confidence improving, the market seems comfortable with the outlook. Shorter term risk emanates from the weak housing market, the sapping effect of higher oil/commodity prices on consumers, concerns surrounding Fed exit from QE2, and questions over the sustainability of corporate profit margins. Any infusion of uncertainty could bring about a reappraisal of future perspectives, but to this point the market has run roughshod over any fear or uncertainty, and picking when that attitude will change is hard to do. The real cause for concern could come when the Fed backs off from its zero interest rate policy and the government seeks to address its fiscal affairs.



Portfolio Review
The Stewardship Partners US SMID Cap BRI strategy composite (gross) returned 3.94% in the first quarter, compared to 8.86% for the S&P 1000. During the quarter, the strategy exited two positions in healthcare that were the target of takeovers: Martek Biosciences (MATK) and Genoptix, Inc. (GXDX). Proceeds from those sales were reinvested in cash. Cash holdings rose to 21% in regular SMID cap strategies, and 6% in SMID cap tactical strategies (tactical strategies have a 12% position in the ProShares Short Russell 2000 ETF (RWM) reducing equity exposure to 70% in the portfolio).

The persistence of the trend in the market and the amount of inertia in the system has been somewhat surprising. As fundamental-based, bottom-up investors it is incumbent upon us to keep our eye on the goal. And the goal is to find and invest in quality companies that can produce above average returns for shareholders over the long term. Easier said than done. In adopting a more conservative position in deference to macro risks, we have missed opportunities with individual companies. Consequently, the situation is all the more difficult today, because the market has risen 40% in the last six months. Stock returns are a function of earnings growth, dividend yield, and the multiple the market is willing to pay for those earnings. A rising market is factoring in higher future cash flows and/or a higher multiple attached to those earnings. In so doing, expectations rise implying, ceteris paribas, lower future expected returns (because a greater portion of future profits have been incorporated into today’s prices). In addition, the odds of a correction increase as a market moves higher, for the simple reason that there is less room for disappointment. As a market participant, it is hard to like artificial imposts upon the market such as QE2, because they create distortions that lead to misallocated resources. We subscribe to the adage that there is no such thing as a free lunch. There is a cost to any artificial impost. However, by focusing on the risks associated with pump priming, we have misjudged the strength, carefree nature, and resilience of the market. Many a bomb has gone off only to be repelled by surging momentum and a buy the dip mantra. The market has been climbing the proverbial wall of worry, and instead of a possible black swan derailing things, it could just as easily be a piece of seemingly innocuous news that becomes the straw that breaks the camel’s back. That having been said, SMID cap valuations are not overly excessive relative to their long term averages, and have been supported by strong earnings growth (although questions surround the sustainability of future profit margins). There is nothing one can do about missed opportunities, and even though the market may be indicating that it is safe to get back in the water, most of the big gains have already been had. In that circumstance, jumping on the bandwagon may be deleterious to your wealth and your psychological well-being. It continues to be our contention that SMID caps are overvalued relative to large caps, and that a reversal of that relationship will occur at some point in the future. We are defensively positioned in our SMID cap strategies relative to our benchmark, and continue to believe that caution is the more prudent way to approach things at this point, given the cloudiness of the future and the size of the risk factors in play.


Outlook
It is remarkable how much has happened, but how little things have changed. The market seems to be caught in a kind of Groundhog Day loop where the outlook every quarter appears the same - cloudy with a chance of rain, but the market rallies anyway. The price action implies that valuations (both absolute and relative to bonds) are reasonable, and this reasonability provides reinforcing. The lion’s share of the gains have already been had, however waiting for the market to start worrying about the stimulus exit feels like waiting for Godot. The complexion of a market can change in the blink of an eye. Discerning what the cause is, or will be, can be like chasing after the wind. In the present environment stresses and fear are much reduced. Earnings are strong. Interest rates are low. Growth is positive. The general skew is positive and could quite possibly remain that way for some time - at least until the bill comes due. IPO and M&A activity is expected to pick-up providing additional support for investor confidence. Equities are under-owned and, in conjunction with low interest rates, are pulling investors back in. The economy continues to recover pointing to a real possibility that it may move from recovery to expansion this year. However, a rising market embeds rising expectations, leaving less room for positive surprises. Countering the positive notions are structural imbalances that continue to overhang the economy and the market, and no real solution at this point. Caution, in our opinion, continues to be the better part of valor, with the preservation of capital more important than eeking out a few extra returns. It has been a trying time over the past two to three years, and at times has felt like the slough of despond, but those who have stayed the course have been rewarded with the return of capital. It is our hope that good fortune is also just around the corner with continuing positive returns for the SMID cap strategy. Thank you for the opportunity and the privilege to manage your funds, and it is our hope that over time we can reward that trust and confidence.

This commentary represents the opinions of its author as of 4/15/11, 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.

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.