Market Sector Update

• Third quarter of 2019 saw the stock market tread water in a relatively tight range, ending very near the level where it started. The broad geopolitical rhetoric and economic news flow was in stark contrast to a relatively calm stock market. On-again, off-again tariffs talk saw further escalation with an increased percentage added to goods, only to be once again delayed. There has been some increased optimism that an agreement will be reached prior to the implementation. Regardless, it appears the broad indecision on trade has brought with it an industrial slowdown with managements pulling back on activity taking a wait-and-see approach. While the U.S. consumer has remained resilient throughout these negotiations fortified by both solid wage and job growth numbers, the Federal Reserve (Fed) began cutting interest rates in what is being described as an “insurance cut” should the economic environment weaken given these trade issues. This drove long-term interest rates to levels not seen since 2016.
• For the quarter, the Russell Midcap Index, the Fund’s benchmark, increased 0.48% following strong returns in the prior two quarters. This has resulted in a robust 22% year-to-date return.
• Long-term interest rates declined another 0.4% following a similar decline in the prior quarter, ending the quarter at 1.7% on 10-Year US Treasuries. After multiple quarters of underperformance, dividend-paying securities produced significant relative performance in the quarter. Those stocks with a dividend yield of greater than 2.9% (the top quintile of dividend yield) outperformed the benchmark by 3.6%. We had been surprised last quarter that the underperformance was persisting, so the reversal this quarter seems like a reasonable outcome given the significant yield premium available in the stock market relative to fixed-income markets.

Portfolio Strategy

• The Fund outperformed its benchmark in the quarter. Sector allocation was a modest negative to relative performance. An underweight position in real estate and utilities drove allocation underperformance but was slightly offset by an underweight position in health care. The preference for dividend-paying securities also provided a nice relative tailwind to the strategy in the quarter.
• Health care produced the best relative performance as the aforementioned underweight position was supplemented with strong stock selection from our holdings. Quest Diagnostics and Encompass Health each produced positive returns in a sector with broad contraction. Both companies reported stronger-than-expected quarters from strong volume growth. In addition, given the reimbursement for the services each of these companies provide, their business models should be more protected regardless of any political outcomes forthcoming.
• Strong stock selection in consumer discretionary produced solid outperformance within that sector. Hasbro generated robust gains as the toy manufacturer continues to heal from losing Toys R Us to liquidation in 2018. Garmin’s stock returned to appreciation shrugging off second quarter’s gross margin concerns in its fitness business. Leggatt & Platt, V.F. Corp. and Service Corp. also produced modest outperformance.
• Materials and energy were also areas of strong stock selection driven outperformance in the quarter. RPM International and Packaging Corp. of America generated double-digit returns based on solid execution by both operators despite a difficult sales environment. Within energy, Targa Resources was a positive performer as its capital expenditure plan has peaked, which should provide for a nice inflection of free cash flow going forward.
• Real estate was an area of relative weakness for the Fund during the quarter. Much of the underperformance was driven by the sector’s underweight position. We have found it difficult to ascertain competitive positioning within many of the subsectors in this area of the market. Our one holding in real estate, American Campus Communities, was unable to keep with the strong sector returns during the quarter.

Outlook

• We continue to watch several key variables to determine positioning. These variables (domestic economic growth, change in interest rates, change in commodity prices and foreign economic growth) have remained consistent and continue to be monitored.
• One word sums up domestic economic growth: Uncertainty. We believe four broad potential outcomes are well understood. A trade deal is reached that would remove some of corporate management and investor angst, helping to drive stronger growth. Tariffs could go into effect likely dampening end demand. We could continue in this trance of trade limbo. Or we could be headed toward an economic recession where investors and managements lose confidence. A reasonable trade deal still feels like the most likely outcome at this point, but it’s very difficult to have conviction and, therefore, assigning the proper probabilities to these outcomes is difficult.
• We entered 2019 concerned about increasing interest rates and the unintended consequences that could arise given how low and for how long rates had remained depressed. With two Fed rate cuts in 2019, the potential for more to come and long-term rates significantly declining, it appears our concerns were unfounded. We feel the Fund can offer a very competitive income component relative to fixed-income markets while providing the potential for income growth and better capital appreciation.
• We continue to expect product margins will be a general tailwind for companies following the commodity cost pressures experienced in 2017 and 2018. We have begun to see price offsetting costs in the most recent quarters for many industrials and materials companies. Many companies have been reworking their supply chains to lower the reliance on China. However, if tariffs were to go into effect, they are likely to produce cost pressures throughout the supply chain that will likely need to be passed on to consumers through higher prices. Our conviction around trade/tariffs remains at a low level.
• Much is still unknown across the globe. It appears China has been attempting to stimulate its economy; however, there has been little evidence of its impact as the trade tensions are acting as a counterbalance. Europe has been an area many of our management teams have identified as a weak geography that has seen further atrophy. A larger dependence on the global economy and well identified structural issues appear to be the culprits. Central bankers around the world are pushing hard to elicit growth and inflation, but evidence of success is difficult to find. Brexit is likely to reach its apex in fourth quarter given stated deadlines. We continue to expect a moderate outcome versus a more extreme exit, but it remains a risk point.

All information is based on Class I shares.

Top 10 holdings (%) as of 09/30/2019: Targa Resources Corp. 3.1, Garmin Ltd. 3.0, Polaris, Inc. 3.0, nVent Electric plc 2.9, American Campus Communities, Inc. 2.9, V.F. Corp. 2.9, Encompass Health Corp. 2.9, First American Financial Corp. 2.9, Hasbro, Inc. 2.9 and Rockwell Automation, Inc. 2.8.

The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It is not possible to invest directly in an index.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. The Fund’s emphasis on dividend-paying stocks involves the risk that such stocks may fall out of favor with investors and underperform non-dividend paying stocks and the market as a whole over any period of time. In addition, there is no guarantee that the companies in which the Fund invests will declare dividends in the future or that dividends, if declared, will remain at current levels or increase over time. The amount of any dividend the company may pay may fluctuate significantly. In addition, the value of dividend-paying common stocks can decline when interest rates rise as fixed-income investments become more attractive to investors. This risk may be greater due to the current period of historically low interest rates. The Fund typically holds a limited number of stocks (generally 35 to 50). As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Fund’s net asset value than it would if the Fund invested in a large number of securities. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.