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Large Cap Value  Download PDF
March 31, 2008
We are pleased to share with you our review and outlook for the U.S. large cap value market as of March 31, 2008. In the first quarter, the Russell 1000 Value Index had a total return of –8.7%, compared with –9.5% for the S&P 500 Index.
Investment Review
The first quarter was decidedly negative for U.S. equities, which had their poorest quarterly performance since 2002 as measured by the S&P 500 Index. The bulk of the decline occurred in January, as concerns over the credit crisis and its potential to harm the broad economy intensified. Investors sold stocks amid a fresh wave of large write-downs from major banks and a slowing economy; fourth-quarter GDP growth came in at only 0.6%, down from a 3% to 4% pace in the previous two quarters. Market conditions were more stable late in the period, reflecting Federal Reserve actions that, while far from resolving credit worries, provided some relief.
Lender of last resort
The Fed lowered short-term interest rates from 4.25% at the start of the quarter to 2.25% by mid-March in an aggressive response to weak economic data and instability in global financial markets. The Fed also announced new lending programs aimed at easing the credit crunch. Late in the period the Fed’s role in the proposed acquisition of Bear Stearns by JPMorgan Chase eased financial market concerns somewhat. Also of note, federal regulators lowered capital reserve requirements for Fannie Mae and Freddie Mac, increasing those companies’ ability to purchase troubled mortgages.
Most sectors within the Russell index declined in the quarter. Financial services stocks (which had a total return of –12.6% in the period) underperformed, with wide performance swings in response to news both good and bad. Technology and telecommunications stocks underperformed (down 14.6% and 14.2%, respectively) as investors avoided companies associated with longer-term growth but shorter-term risk. Utilities (–9.7%), which had strong returns in 2007, underperformed. The top-performing sectors were materials (–2.4%), supported by favorable pricing, and industrials (–2.5%), reflecting good performance from some globally oriented companies.
Outperformance was due to stock selection
While our portfolios declined in this environment, they outperformed both the value benchmark and the broader market. We attribute this to our emphasis on higher-quality companies as measured by such factors as strong market position, healthy balance sheets and the ability to increase dividends over time. Amid heightened uncertainty, these stocks outperformed lower-quality stocks in the quarter, as they have over the past year.
From a sector standpoint, stock selection was favorable in the financial services sector, where we held a diverse mix of banks, insurance companies, asset managers and REITs. Stock selection within health care helped performance, as we did not own managed care companies, which are less attractive from a dividend-growth perspective. The portfolios’ consumer discretionary, technology, utilities and telecommunications holdings outperformed as well, while our industrial stocks underperformed—most specifically, aerospace holdings.
Investment Outlook
While it is uncertain if the worst of the credit crisis is behind us, recent news regarding bank write-downs and capital raisings—an indication that they are addressing their problems—is encouraging. We believe that housing-related earnings downgrades will be largely limited to 2008, and that investors should start to look beyond the crisis in the third quarter.
It is our view that tight liquidity conditions in the bond market will gradually ease, and when that happens, economic growth will gain momentum. This could be delayed by the weak dollar; a modestly stronger dollar would attract foreign capital and ease liquidity concerns in the overall economy.
Although the U.S. economy has slowed, we believe conditions for equities are relatively favorable compared with previous downturns. Employment levels are still high by historical standards, corporate balance sheets are strong and U.S. companies have been investing productively in overseas markets. Earnings growth, while slowing from 2007 rates, is likely to remain in the single digits (high single digits when excluding financial companies). We also expect overall dividend growth to increase at single-digit rates, and low double-digit growth rates for the companies in our portfolios. Regarding valuations, we believe stocks are reasonably priced, with S&P 500 companies trading at 14 times consensus estimated earnings, and about 17 times earnings by our estimates.
The views and opinions in the preceding commentary are as of the date of publication and are subject to change. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice and is not intended to predict or depict performance of any investment.
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