The Gannon Report

The Quarter That Was…

Much has been written about the historic end to the third quarter of 2008, and more will be written in the days to come. The long-term effect of those transforming 10 days will be felt by investors and the economy for years to come.

The reality of September was that the markets were driven not by fundamentals but by illiquidity, game-changing new rules, and new, far-reaching Treasury policies. Amid the alternating waves of fear and euphoria, things that were once thought to be unimaginable have become reality. Yet from our perspective we feel compelled to ask, what really changed? We are struck by how little has changed over the course of the last quarter. Simply, those equities that were attractive got more attractive, and those that were unattractive are still unattractive by our standards. In a world where words such as "unintended consequences," "systemic risk," and "bailout" are becoming part of the daily investment vernacular, we remain focused on an absolute valuation standard and stand ready to respond to the underlying opportunities the market is offering.

To be sure, it was a quarter "out of joint." Given the negative headlines, we were surprised at the strength of the Russell 2000 and astonished to see that at one point during the middle of September the small-cap index was almost flat for the year-to-date period. Financials, which comprised roughly 21% of the index as of the end of September, gained more than 15% for the quarter and contributed to most of its performance. Energy and Materials, on the other hand, represented 5% of the Russell 2000 and saw substantial enough declines to be the index's main detractor from quarterly performance. We were astounded at the magnitude of the rally in Financials, especially those of lower quality, and even more dismayed at the dramatic decline in the Natural Resources sector.

Our fondness for the natural gas, precious metals and industrial products industries should not be surprising.  For some time, we have found unique opportunities in these limited resource industries, which have been under- invested for the last 20 years. Most of these companies' valuations in the first half of 2008 did not fully reflect the strength of the underlying commodities.  The skeptical nature of the equity market in the run-up and subsequent correction of commodity prices has created what we think are even greater values.

At times, it has been difficult to look out three to five years with all of the daily noise.  However, these are finite resource companies with compelling absolute valuations that do not need a rapidly growing economy to generate significant cash flow. It should be noted that we are also doing our homework on the financial sector, specifically community banks.  Surprisingly rich valuations and uncertain balance sheets are keeping us on hold for now as the credit cycle continues to play out.

In the third quarter of 2008, valuations and fundamentals mattered little.  As we look forward, the only thing we are certain of is further uncertainty, along with high volatility, and that an economic rebound remains at least a year or two away.  We expect the equity market environment will remain turbulent and challenging over the coming weeks and months. Just our kind of market!

Stay tuned…
FDG