After four consecutive quarters of positive returns, equity markets reversed course in the second quarter.  With negative returns being registered across the market capitalization spectrum, performance quickly became a relative issue.  The wall of worry simply became too high for the market to climb in 2Q; while many of the domestic concerns are not new (continued high unemployment, the federal deficit, housing) the prospect of a sovereign crisis within the Eurozone and the potential for a hard landing in China galvanized investors to head for the exits.

 

With all due respect to the above-mentioned headwinds in the markets, the shift in investor sentiment from euphoria to panic over such a short timeframe is nothing short of amazing.  Given the pattern of lower lows and lower highs, the biggest debate is whether the recent sell-off is a healthy correction of a market that has gotten ahead of itself, or the beginning of a double-dip recession.  Cambiar is of the opinion that it is the former, but we are certainly on the lookout for signs of the latter.

 

While stock prices certainly imply a double-dip is in the offing, there should be confirming signals from other segments of the market as well.  For example, the fixed income market is often a good early-warning signal for an ominous event in the equity markets; however, credit spreads remain relatively tame.  And while commodity prices have retreated, they remain well above their 2008 lows, and meaningfully above their marginal cost of production.  At the industry level, business conditions for most sectors we follow continue to improve.  Metrics such as truck tonnage, railcar loadings, credit card delinquency rates and temporary staffing activity all point to an economy that continues to heal, not make a return to the intensive care unit. 

 

A final non-trivial point as it relates to the potential for a double-dip recession – such a scenario has not occurred on its own since the Great Depression.  The lone exception was in the 1981-82 timeframe, and this was an intentional move as part of the Fed’s efforts to control inflation.  Obviously one could take an ‘it’s different this time’ stance; however, the fact that this is quite a rare event is worth considering when contemplating the future direction of the markets. 

 

While it is impossible to exclude the macro from our investment thinking, the Cambiar investment team remains focused on closely watching our current holdings, while always seeking new opportunities.  Given the recent sell-off, we are finding no shortage of attractive investment candidates. 

 

The Cambiar Opportunity Fund returned -14.0% in the second quarter of 2010, vs. a return of -11.1% for the Russell 1000 Value and -11.4 for the S&P 500 Index.  While disappointed in our inability to do a better job protecting capital in the quarter, the time horizon we use for making buy/sell decisions is significantly longer than 90 days.  Many of the Fund’s holdings are now trading at or near all-time trough valuations; this low multiple (i.e. P/E, P/B) on low expectations scenario sets the stage for a material revaluation should these companies deliver on the earnings front and sentiment towards equities improves.

 

The second quarter provided a good illustration that you can analyze a company from every possible angle, but there is a serendipitous component to investing that cannot be predicted.  The Deepwater Horizon Rig is one such example.  The Fund owned British Petroleum and Anadarko, two companies that are involved in the ongoing oil spill in the Gulf of Mexico.  While Cambiar’s quick response to liquidate both positions protected the Fund from material capital losses, both of these names were negative contributors to performance.  The oil spill, in tandem with fears of a global economic slowdown, put the entire energy complex on the defensive for the quarter.  Looking ahead, one anticipated fallout from this crisis is that the subsequent marginal supply of oil production will be more expensive and difficult to produce, thus putting a floor under oil prices.  While Cambiar’s energy weighting is now lower vs. the past couple years, we continue to believe that there is a secular investment opportunity in the sector.  

 

Cambiar’s technology positions comprised another drag on performance in the quarter. While virtually nothing in technology worked during the quarter, an overweight allocation and lackluster stock performance did not help matters.  Similar to other cyclical sectors, technology is correlated to the direction of the economy.  Not surprisingly, these stocks lag when sentiment turns negative toward the outlook for the economic recovery.  While we would agree that the trajectory of the recovery is slowing, the valuations of our tech companies imply zero or negative growth in many cases.  We simply do not concur and are staying the course with many of our positions.

 

After lagging their peers during the market rally, the more-defensive utilities, telecom and consumer staples sectors proved their mettle by holding up better in the quarter.  Cambiar’s absence in utilities and telecom were subsequent performance detractors for the quarter.  And despite a material overweight in consumer staples, Cambiar’s holdings could not keep pace with the benchmarks.

 

In a quarter that was short on bright spots, Cambiar did benefit from positive stock selection in the basic materials and industrial sectors.  As business conditions continue to improve, our holdings in these sectors should be direct beneficiaries.  And in a reversal from the first quarter, the Fund outperformed within the consumer discretionary and financials sectors.

 

 

After moving sharply higher over the past year, the markets have been in a state of decline since late April.  The catalyst has been a topping in various leading economic indicators, as well as a ratcheting downwards of economic expectations.  The market sell-off has caused treasury yields to plummet in the U.S., with similar appreciation in other risk haven asset classes.  The divergent moves in stocks versus bonds has caused the equity risk premium (ERP) to rise from a seemingly normal level in the early spring back to a level consistent with historically high risk aversion and market stress.  Cambiar calculates the current ERP to be at 4.7%; to put that in perspective, there are few breaches above the 3.5% level over the past 50 years. 

 

Yet while the last move notable rise in the ERP was due to the credit crisis, the financial markets today appear to be relatively stable.  It is Cambiar’s opinion that the bigger cause for the today’s elevated ERP is an acute lack of investor confidence. 

 

The paradox for value investors like Cambiar is that such sell-offs present very attractive entry points for longer-term investors.  As such, we remain cautious on the market path from here, but are being opportunistic in those situations when the risk/reward profile is particularly compelling.

 

As always, we appreciate your continued confidence in Cambiar Investors.