Small Cap Recovery Growth Commentary

June 30, 2010

Market News

The start of the quarter brought a host of positive macroeconomic data that portrayed a stronger than expected global economic recovery. For example, many leading economic indicators were making new near-term highs and U.S. corporate earnings were generally coming in better than expected.  In early May, however market sentiment turned more negative, in part, due to the British Petroleum Macondo oil well spill, China’s fiscal tightening (leading to slower economic growth), and escalating sovereign debt concerns in the Eurozone.  Lower Chinese and European growth, the latter of which was hampered further by the institution of austerity measures, along with a rapidly appreciating U.S. Dollar, gave investors pause with regard to global growth and U.S. exporters’ competitiveness. Thereafter, certain economic data signaled that the U.S. economy was heading into a soft patch.  Negative reports included those on private employment, retail sales and U.S. housing, and concerns related to the end of the homebuyers tax credit, the fading of the American Recovery and Reinvestment Act (ARRA) fiscal stimulus package, the failure to extend the federal emergency program for unemployment benefits, ongoing state and local government fiscal tightening, and the potential for federal tax hikes next year within the U.S. took center stage.  The market sold off significantly through the end of the quarter, as investors focused less on the positive aspects of the economic and corporate profit recovery, and more on macroeconomic uncertainty.

Key Contributors & Detractors

The Driehaus Small Cap Recovery Growth Composite (the “Strategy”) underperformed its benchmark, the Russell 2000 Growth Index (the “Index”), by 472 basis points during the second quarter. 

Key detractors from performance for the quarter included stock selection in the Industrials and Consumer Discretionary sectors versus the Index. Some consumer-levered names were adversely impacted and this led to some detraction in performance since the Strategy holds an overweight exposure to the Consumer Discretionary sector. Performance of the Strategy primarily benefited from holdings in the Materials sector. By the end of the second quarter, the Strategy maintained an overweighting to the Consumer Discretionary sector and underweight exposure to the Information Technology sector relative to the Index.

Changes in sector weightings over the quarter were driven by both company-specific and industry-wide factors.  By quarter-end, the Health Care sector represented the largest weighting in the Strategy. The Strategy increased its exposure to the Materials and Health Care sectors over the quarter and reduced exposure to the Consumer Discretionary and Industrials sectors.  The reduction in exposure to these sectors resulted from a combination of industry-specific weaknesses and company-specific fundamental earnings disappointments.

Portfolio Positioning and Outlook

Our focus continues to be on finding companies that are attractive on a bottom-up basis.  Given the uncertain economic environment, we have become incrementally more cautious with regards to holding cyclical companies. Specifically, we are in the process of cutting our overweight position in the Consumer Discretionary sector further and raising our underweight position in the traditionally defensive Health Care sector.

Despite the economic backdrop, we have identified several interesting themes, including companies tied to the aerospace industry, discount retailers, and certain sub-segments within the technology space. Many aerospace companies are operating within a supportive business climate due to Airbus and Boeing’s planned production increases on existing aircraft and upcoming introduction of higher content next-generation aircraft. The visibility in business investment within the aerospace industry is supported by aging fleets in developed economies (that will eventually need to be replaced) and increased passenger traffic and cargo trends in many emerging economies.  Within the U.S. retail sector, we believe that discounters (e.g., dollar stores) are poised to continue to benefit from the consumer trade down to lower priced merchandise; new product-lines such as perishable items, could provide additional business activity within this space. Finally, within technology, we believe that there are opportunities in companies exposed to the continued growth in internet traffic including networking, wireless and e-commerce companies. We believe many technology companies are in strong financial shape, holding large and growing cash balances with little to no debt.  Additionally, the restrained enterprise technology spending of many companies through the credit crisis in 2007-2009 also provides a supportive backdrop, as pent up corporate technology spending will eventually be deployed in the market place. 

NOTES

Sources: Driehaus Capital Management LLC, FactSet, Morgan Stanley Capital International and Standard & Poor’s Global Industry Classification Standard, Russell Investments

The performance numbers represent a composite of small cap recovery growth accounts managed by Driehaus Capital Management LLC.  These numbers are estimated for the period as all underlying accounts have not yet been reconciled. All rates of return include reinvested dividends and other earnings and are net of fees and brokerage commissions. The performance data shown above represents past performance and does not guarantee future results. Current performance may be lower or higher than the performance data quoted.

The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The performance data includes reinvested dividends. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index.