Third Quarter 2008
On September 23, 2008, we held our annual shareholder information meeting in Chicago. We thank those who were able to attend either in person or via our webcast. Columbia Wanger Asset Management’s chief investment officer Chuck McQuaid served as moderator for this year’s panel discussion. Following are highlights from the information provided by your portfolio managers. Fund and index data quoted in responses have been updated through September 30, 2008. Some content has been edited for regulatory reasons.
Chuck McQuaid: Columbia Wanger Asset Management, the advisor for Columbia Acorn Funds, follows an analyst-driven investment process. We are stock pickers. With 24 analysts, we believe that we have the largest team anywhere focusing on small- and mid-cap stocks. Our team continues to be stable, with turnover below 10% a year. We have hired one new analyst this year, Eric Jacobsohn. Eric is a domestic analyst following retailers and restaurants.
All of our portfolio managers, including me, follow some individual stocks and are counted as analysts. Job one for all analysts is to beat their benchmarks, job two is to advise portfolio managers on the appropriate weighting of their areas within portfolios. Analysts have large incentives; compensation is heavily driven by performance.
Having a large, motivated team is good, but what of focus, style and strategy? We focus on stocks of small- and mid-cap companies. We understand such businesses, as they typically have just one or two divisions and little bureaucracy and we usually have access to top management. Smaller caps also tend to have less coverage than larger caps and often have higher growth potential as many innovations come from smaller companies.
Our style is growth at a reasonable price. We want to own growing businesses but we don’t want to pay too much for them. We don’t fit that well into Morningstar style boxes, as we tend to be borderline between what Morningstar calls “growth” and “core.” If we believe growth stocks are expensive we lean toward core but if growth stocks seem cheap we own more of them. Likewise, we tend to be risk-averse, and we want to be paid to take risk.
We are long-term investors. Columbia Acorn Fund has turnover around 20%, suggesting five-year holding periods, on average. Other Columbia Acorn family funds often have higher turnover than Columbia Acorn Fund but, with the exception of Columbia Thermostat Fund, still fall well below the industry average, which is near 100%. Low turnover reduces transaction costs. We care about the long-term strategies and governance of the companies that we own. We seek to exploit trends that drive growth for the long term.
Our process is also important. We try to achieve investment edges vs. our competition. Our analysts pursue an information edge. We strive to learn more about a business than what management says in conference calls and publishes in financial reports. Our analysts talk to the business’ customers, suppliers and competitors.
Valuation can be a second edge. Most stocks are valued based on reported earnings per share, but sometimes that is not a precise measure of value. Our analysts examine the quality of earnings and balance sheets. We analyze free cash flows and look for hidden virtues or problems. In some cases we use a sum-of-the-pieces approach.
Our long-term time horizon can be another edge. In many cases the market seems to overreact to news, especially bad news, and if we believe long-term fundamentals are intact we may be buyers. Our challenge is to separate short-term anomalies from what may be the start of a new long-term trend.
Finally, we have a proprietary research database. We use it to keep track of all of the stocks that we follow. It contains quantitative information such as earnings estimates, valuation models and expected returns. It also contains qualitative information such as text on business fundamentals. All stocks have “Reasons to Own” which, if disproved, can result in our selling the stock.
Now that you have an overview of our approach, let’s look more closely at the Funds.
Chuck: Rob, you are the lead manager of Columbia Acorn USA and the co-manager of Columbia Acorn Fund. What is going on with domestic small- and mid-cap stocks?
Rob Mohn: The large-cap oriented S&P 500 Index and the small-cap Russell 2000 Index were both down approximately an equal amount through the end of June. Since then, small-cap stocks have had a strong rally, while large caps have just puttered along. For the full year period from September 30, 2007 through September 30, 2008, small-cap stocks outperformed large caps by more than 7.5%.
So what happened in July to cause small-cap stocks to spike higher? We believe there were three main reasons for this change. First was the bounce in the U.S. dollar. When the dollar falls vs. other currencies, as it has for most of the past six years, U.S. exporters benefit; when the dollar rises, U.S. exporters get hurt. Small-cap companies tend to export less than large-cap companies, so when the dollar rebounds (as it has of late), small-cap stocks tend to outperform. The dollar bottomed out in mid-July, almost to the day that small stocks began their rally.
The second noteworthy event in July was the peak in oil prices. The small-cap Russell 2000 Index reduced its energy stock exposure around mid-year. At the end of September, energy stocks made up 7% of the Russell 2000 Index, much less than the S&P 500’s 13% energy weighting. So, relative to the S&P 500, the Russell 2000 became an anti-oil play. Oil prices peaked at $147 a barrel in mid-July, once again almost to the day that small stocks began their rally.
The final reason for the recent small-cap spike is a hedge fund phenomenon. The hedge fund community is under significant strain. Brokers are pulling down credit lines and investors are requesting redemptions. As hedge funds are being forced to shrink, they have had to cover existing short positions, putting upward pressure on highly-shorted stock prices. Many of the “hedgies” favorite shorts are the micro-cap, poor earning, lower quality stocks that have been particularly strong performers since the end of June.
So how have the Funds been doing? Columbia Acorn USA was doing well through the end of June (slightly outperforming its small-cap benchmark, the Russell 2000 Index), but the July spike in the Russell 2000 left us behind. Relative to the benchmark, the Fund is overweight in industrial stocks, many of which are exporters. The rebounding dollar has not boosted performance as much as it has that of the more export-light Russell 2000. Note that the dollar has recovered only a tenth of its massive six-year decline against the Euro. We believe U.S. exporters are still very competitive in global markets.
Columbia Acorn USA is also overweight in energy stocks (at 9%, vs. the Russell 2000’s 7% at end of September). Though this stance has hurt the Fund’s relative performance these last few months, we still have a positive long-term outlook on many energy names, especially the deep-water oil service companies.
Finally, Columbia Acorn USA is underweight in the micro-cap, lower-quality stocks that have benefited from hedge fund unwinding. The pop in these stocks looks like a short-term anomaly. Specifically, micro-caps as a group are experiencing declining earnings, yet they have traded at premium valuations. Paying a higher price for slower growth doesn’t make much sense to us, so we own few of these micro-cap names in the Fund.
Much of what I’ve explained also applies to Columbia Acorn Fund. Columbia Acorn Fund’s primary benchmark is the Russell 2500, which is more of a small/mid-cap index (usually referred to as smid-cap). The Russell 2500 saw the same July jump that we saw in the smaller-cap Russell 2000. Columbia Acorn Fund lagged behind its benchmark for the same reasons as Columbia Acorn USA: overweighted industrials and energy, underweighted micro-caps. Columbia Acorn’s performance since June was also hurt by its international stocks, which directly suffered from the U.S. dollar rebound, though I should note that over the past five years, the Fund’s foreign stocks have significantly boosted performance.
Chuck: Ben, you manage Columbia Acorn Select, a Fund that consists largely of domestic mid caps in a concentrated portfolio. How have you positioned the Fund?
Ben Andrews: One year ago, I was looking at a mid-cap index that had risen quite a bit over the preceding five years, outperforming the market as measured by the S&P 500 Index. We were also seeing strains on the economy. A week before we had this meeting last year, Northern Rock, a large UK bank, had a run on its deposits. Also at that time there were several hundred million dollar or more hedge funds being liquidated for bad investments in U.S. mortgages. In short, I had an expensive benchmark and an economy that wasn’t on the best footing.
Against this backdrop, my plan was to reposition some of the portfolio into cheaper companies that were realigning themselves from problems caused by events other than the economy. These companies were fixing their problems, so I believed their performance over the next year would run countercyclical to the economy and the index valuation. Unfortunately, it didn’t work. The discount on these out-of-favor stocks vs. the benchmark didn’t shrink, it widened over the next year. This happened even though the fundamentals in many of these companies improved during the period. These stocks are now trading at huge discounts to what we think their valuation would be in a private transaction. This usually leads to an upturn in stock price. So, it’s been a setback, which I’m not happy about, but I don’t believe it will cause a permanent loss in capital.
Chuck: Zach you are co-manager of Columbia Acorn International. What are you seeing in international markets and how is that impacting the Fund?
Zach Egan: The market has been tough on international stocks. The Fund’s primary benchmark, the S&P/Citigroup Global ex-US Cap Range $500M-$5B Index, was down 34.09% for the year ended September 30, 2008, and the larger cap international MSCI EAFE Index fell 30.50%.
To understand what is happening in international markets, it’s helpful to understand what has happened over the last five years. There were a lot of surprises in that period, including sky high oil prices and the credit crisis. At the same time, Europe staged a surprising economic recovery that drove buoyant stock market returns for the first three-and-a-half years of that period.
How did this happen? Well, many European companies export sophisticated capital equipment and infrastructure inputs, which represent very important components of European economies. With the geographic reorganization of global production, Western European exporters ran into extremely strong demand coming out of Asia and, to a lesser extent, Central and Eastern Europe. Production has migrated closer to newly industrializing markets, where companies also have lower labor costs. This necessitated large capital outlays for European industrial goods.
While Asia may increasingly be the factory of the world, if you look closely it’s Swiss, German, northern Italian and Scandinavian companies that build those factories and some of the higher-end components in the goods that those factories are turning out. As supply chains are reworked around these new production locations, there’s been a demand for large investments in infrastructure (rail links, port cranes, power generation). European companies make a lot of these things.
The timing of growth in demand for European capital equipment and infrastructure inputs was very lucky, because it soaked up excess capacity in Europe just as many of these producers emerged from difficult restructuring periods at the outset of the decade. With much leaner cost structures, and an ability to raise prices in a tight supply environment, their profitability went through the roof in many cases.
There is reason to believe that, even if demand were to slow, a substantial part of the margin improvement could be sustained. The reorganization of production geographically has been accompanied by changes in the division of labor. European companies increasingly provide only higher value, higher margin products, leaving commodity industrials to Asian competitors.
But many international investors believe the party is over, that the emerging market demand for capital equipment that jump-started many European economies five or six years ago is gone and that earnings estimates will have to be revised sharply downward as profitability falls. In the short-term, given what’s going on in banking and the effects that reduced access to credit could have on the business cycle, one has to worry about how a cyclical slowdown could weigh on earnings. In Columbia Acorn International, we’re monitoring order book development and pricing in industrials very closely, and selling or trimming positions in companies that we think are likely to disappoint.
Though stocks are down a lot, I don’t think a global recession is already priced into international small caps. While valuations might look cheap on the basis of earnings multiples, profitability levels remain higher than average. Valuations look considerably less cheap if earnings are adjusted downward to the average levels of profitability over the last 10 to 15 years. The big question from our standpoint is whether the relocation of production that has kept industrial order books full for the last five years will prove to be an ongoing project. I don’t believe this global transformation is over. It may occur in fits and starts, but it will likely prove to be a multi-decade project and one from which European and other capital equipment companies stand to make a lot of money.
Chuck: Louis, you co-manage Columbia Acorn International. Please discuss what is happening with emerging markets?
Louis Mendes: While not everyone agrees on which countries should be considered “emerging markets,” our emerging market universe is made up of countries with over 65% of the world’s population. We include all of the major developing countries, such as China, India, Brazil and Indonesia, as well as other smaller markets. As a group, these countries have sold off more than the global averages over the past year as investors have fled what they perceive to be higher risk.
The Fund’s emerging markets exposure is about 22%. This weighting hasn’t changed very much over the last couple years, ranging from the high teens to low twenties. Three countries—China, India and Brazil—represent over 50% of the Fund’s emerging market exposure. Over the last 10 years these countries have taken some of the most significant steps in protecting investors and corporations alike, giving them a greater ability to develop their own markets. This is one of the main reasons that we focus on these three countries.
So the big question: Are these countries still exciting and dynamic given the current global uncertainty? My answer is yes. Despite concerns of recession in Japan, the United States and Europe, both China and India are expected to grow roughly 9% and 7% next year, respectively. Last year we talked about investing in markets and companies with tailwinds. We think this economic growth is still significant enough to be quite a large tailwind to companies that have strong franchises.
The current U.S.-centered credit crisis is going to result in deleveraging an over-indebted society. As investors, we want to be invested in those markets that aren’t suffering from this deleveraging crisis. You may recall the Asian financial crisis 10 years ago. At that time, this highly-leveraged region came crashing down. If you look at Asia now, however, most of the impacted countries are operating with very low debt levels and boast a 30% to 40% savings rate. This is true not only for China but for many other markets in Southeast Asia. So there’s capital available and there’s also a strong work ethic that has rewarded workers over the last decade with a rapidly rising standard of living. It can be argued that these markets are actually better positioned right now than most to withstand any oncoming external shock to global demand.
Chuck: Chris, you manage Columbia Acorn International Select. The Fund has enjoyed fine relative performance for several years. How have you done it?
Chris Olson: There are a number of things that have impacted Fund performance over the past few years, but probably the most important one relates to the Fund’s financial exposure.
For several years leading up to 2007, the Fund had a large overweight in financials, which helped drive some very good performance particularly in banks in the United Kingdom and Ireland, an area I cover as part of my analyst responsibilities. I was fortunate to have a very close view of what was going on in the banks and to be able to develop some opinions about management’s thinking. I became increasingly concerned about two factors in the banks: funding costs and bad debt. Both had gone to extremely low levels, perhaps to levels that hadn’t been seen before. Everyone from top bank management to investors to people in the industry seemed to think that this was normal and that it would continue. Nobody was really considering what would happen if this situation changed. There was really no consideration of reversal in these areas so the stocks were pretty much priced for perfection.
I didn’t think, necessarily, that the whole financial system would collapse. I don’t think many people did. All I thought was that it would return to a more normal environment. In a more normal environment, when your funding costs aren’t super cheap they are going to go up and your interest margin will get hit, your bad debts will rise and you are going to have to take some write-offs. Bank earnings would take a tumble as a result. So, I decided it was best to avoid all that.
Beginning in spring of 2007, we started taking the Fund’s financial weighting down and sold out of all the bank stocks in the Fund, ending up with a significant underweight. We were, therefore, able to sidestep the crisis in financials when it initially hit.
Chuck: Chris, please explain the difference between Columbia Acorn International Select and Columbia Acorn International?
These Funds have a lot of things in common. It’s the same firm. It’s the same culture, the same philosophy and the same investment process. But what makes the Funds different? Columbia Acorn International Select is more of a mid-cap fund. We can access stocks up to $25 billion whereas Columbia Acorn International focuses more on the smaller cap end. We have about triple the weighted average market cap in Columbia Acorn International Select, which is also a more concentrated fund. Because of the liquidity in this space now we are able to take larger positions in the names that we think are best ideas. Finally, Columbia Acorn International Select is a much smaller fund. It hasn’t been around as long as Columbia Acorn International, which has garnered most of the inflows over the years.
Chuck: I’d like to also add a few words on Columbia Thermostat Fund. Columbia Thermostat Fund is a fund of funds and owns Columbia Acorn Fund, Columbia Acorn Select, Columbia Acorn International, plus some large-cap Columbia stock funds and some Columbia bond funds. It automatically adjusts between stock and bond funds based on the level of the S&P 500 Index, with the goal to “buy low, sell high.” When the market was low in 2002, the Fund had 70% to 80% of its assets in stock funds. When the S&P 500 was near its peak in 2006, the Fund’s stock fund percentage dropped to 25% to 35%. Recently, with the market down so much, the Fund returned to 70% to 80% in stocks and, as of the end of September, topped that range to reach 85% in stock funds. Given stock valuations and weighing risk vs. return, we think Columbia Thermostat Fund’s current stock weight is appropriate. Fund shareholders will benefit if the market returns to average valuations.
Over the short term, Columbia Thermostat Fund is likely to have returns between those of stocks and bonds. If the market is within a trading range over the longer term, the Fund can do well. Over its lifetime, Columbia Thermostat Fund has had returns near, or a percentage or two below, the S&P 500 and has accomplished this with far less risk than the index because it generally holds a mix of stock and bond funds.
Update Warranted by Current Market Conditions
Fund shareholders assume risks of stock ownership, expecting that over the long term, they will be rewarded with commensurate returns. Due to the credit crisis, we’ve been receiving questions from Columbia Acorn shareholders about additional potential risks. We asked Columbia Acorn Trust treasurer Bruce Lauer to address the following questions:
Where are the Funds’ cash, cash equivalents and securities kept?
State Street Bank and Trust Company is the Funds’ custodian and holds the Funds’ assets, including cash, cash equivalents and securities in segregated accounts for the benefit of each Fund. Segregated accounts cannot be accessed by State Street or anyone else, and therefore their soundness does not rely on the creditworthiness of that firm.
How are cash balances invested for the Funds?
The Funds have policies with respect to short-term investments designed to limit risk, control concentration and insure high credit quality. The policy prohibits investments in so-called structured investment vehicles and similar products that have been problematic recently. Under the policy, cash is either held in a segregated account at State Street, invested in overnight repurchase agreements, or invested in commercial paper of issuers approved by Columbia Wanger Asset Management. Overnight repurchase agreements are secured by U.S. treasury securities. No single commercial paper investment exceeds 0.5% of any Fund’s assets at the time of investment. The issuers approved by Columbia Wanger Asset Management are large, well-capitalized companies. Commercial paper issued by Lehman Brothers, AIG, Wachovia, Washington Mutual, Fannie Mae or Freddie Mac is not on our approved list, and we continue to closely monitor our counterparty risk, as described below. All of our cash investments to date have paid in full at maturity. Columbia Acorn shareholder reports list overnight repurchase agreements and commercial paper as Short-Term Obligations in the Statement of Investments for each Fund.
What is securities lending?
Securities lending is the temporary lending of a Fund’s portfolio securities to broker/dealers and other institutional investors. The Fund retains the benefits of owning the securities, including receipt of dividends or interest generated by the security. The Fund also receives a fee for the loan. The Fund may recall the loans at any time and may do so in order to vote proxies or to sell the loaned securities. Furthermore, borrowers provide the Funds with collateral that exceeds the value of the securities on loan. For more information on securities lending, see the Funds’ Statement of Additional Information.
Have the Funds loaned securities?
After intensive reviews by the Columbia Acorn Trust Board and Columbia Wanger Asset Management, the Funds began lending securities in the third quarter of 2008. Due to the turmoil in the financial markets, we suspended securities lending activities on September 17, 2008. No new loans were made after that date and notice was given to the Funds’ lending agent to recall the securities on loan. The securities lending agent is Goldman Sachs Agency Lending and the collateral for the program was invested in the Dreyfus Government Cash Management Fund. All securities have been returned and there were no losses of invested collateral. Securities lending was profitable for shareholders and resumption of securities lending will be reconsidered as market conditions change.
How do the Funds address “counterparty risk” relating to portfolio security trading?
Funds buy and sell securities, and “counterparty risk” relating to portfolio security trading is the possibility that the broker/dealer that the Funds transact with does not deliver the security being purchased or the cash for securities being sold. Transactions made on the trade date are routed through central depositories and clearing houses so that the terms of the settlement of the transactions can be confirmed with the broker/dealer prior to the settlement date, allowing for timely settlement of the transaction. Use of depositories and clearing houses virtually eliminates the chance that the Funds will buy securities and not receive them, or sell securities and not receive payment for them. However, since securities prices move between the time of transactions and settlements, we do want all trades to settle properly. Consequently, we continually monitor the list of brokers/dealers that we utilize and suspend trading with firms when we think it prudent. We also transact with a large number of brokers/dealers. To date, the Funds have not incurred a loss due to a failed settlement.
Past performance is no guarantee of future performance.
Current and future holdings are subject to risk, including, but not limited to, market and credit risk.
S&P (Standard & Poor’s) 500 Index tracks the performance of 500 widely held, large-capitalization U.S. stocks.
Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 7% of the total market capitalization of the Russell 3000 Index.
Russell 2500TM Index measures the performance of the 2,500 smallest companies in the Russell 3000 Index, which represents approximately 17% of the total market capitalization of the Russell 3000 Index.
S&P MidCap 400 Index is a market value-weighted index that tracks the performance of 400 mid-cap U.S. companies.
S&P/Citigroup Global ex-US Cap Range $500M-$5B Index is a subset of the broad market selected by the index sponsor representing the mid- and small-cap developed and emerging markets, excluding the United States.
Morgan Stanley Capital International Europe, Australia, Far East (MSCI EAFE) Index is a capitalization-weighted index that tracks the total return of common stocks in 21 developed-market countries within Europe, Australia and the Far East.
Unlike mutual funds, indexes are not managed and do not incur fees or expenses. It is not possible to invest directly in an index.
The information and data provided in this analysis are derived from sources that we deem to be reliable and accurate. These views are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict so actual outcomes and results may differ significantly from the views expressed. The views/opinions are those of the authors and not of the Columbia Acorn Trust Board, are subject to change at any time based upon economic, market or other conditions, may differ from views expressed by other Columbia Management associates or other divisions of Bank of America and the respective parties disclaim any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Columbia Acorn Fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any particular Columbia Acorn Fund. References to specific company securities should not be construed as a recommendation or investment advice and there can be no assurance that as of the date of publication of this report, the securities mentioned in each Fund’s portfolio are still held or that the securities sold have not been repurchased.
Stocks of small- and mid-cap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. A fund that maintains a relatively concentrated portfolio may be subject to greater risk than a fund that is more fully diversified.
Please read and consider the investment objectives, risks, charges and expenses for any fund carefully before investing. For a prospectus which contains this and other important information about the fund, contact your Columbia Management representative or financial advisor or go to www.columbiamanagement.com.
Columbia Management Group, LLC (“Columbia Management”) is the investment management division of Bank of America Corporation. Columbia Management entities furnish investment management services and products for institutional and individual investors. Columbia funds are distributed byColumbia Management Distributors, Inc., member of FINRA, SIPC. Columbia Management Distributors, Inc. is part of Columbia Management and an affiliate of Bank of America Corporation.
Columbia Wanger Asset Management, L.P. (“CWAM”) is an SEC-registered investment adviser and indirect, wholly owned subsidiary of Bank of America Corporation. CWAM is part of Columbia Management. |