International markets have been unsettled all year but the third quarter hit record negative territory across all sectors. The confluence of hedge fund activity, the deleveraging of commodity speculators and a dislocation in the credit markets created the perfect storm in global equity markets. The U.S. dollar appreciated relative to other currencies, which exacerbated the size of the negative returns. While 15 of the 21 EAFE countries were down more than 20%, the rout through international markets hit Ireland, Austria and Norway hardest as equity prices in these countries fell more than 40.0%. Switzerland was one of the best performing markets with a drop of -13.3%. Keep in mind this is one quarter, not a full year or two. Key drivers of absolute performance were the energy (-30.4%) and materials (-39.3%) sectors in Europe and the U.K., which were pounded by selling that may have been accentuated by deleveraging speculative market participants. The financials, consumer staples and health care sectors were the safest harbors. While they outperformed other sectors during the quarter, their returns ranged from -8.0% to -17.0%.

Fund Commentary

This was one of the most challenging periods we have witnessed from a stock selection perspective in many years. The Fund trailed the Index during the quarter, mainly due to a decoupling of fundamentals between our selection criteria and stock returns. There are always a few tough picks each quarter. The third quarter market activity, however, was such that opposites would have been the best theme next to owning gold. Irrational behavior fueled market sentiment and we have seen anecdotal evidence that withdrawals from long/short equity managers and the unwinding of the long energy and materials sectors/short financial sector positions caused stocks to perform in a perverse manner by decoupling from their long-term fundamentals. Short covering on financial stocks produced inordinately better returns than we saw for other companies with solid strength.

Fund returns relative to the Index were negatively impacted because long-term proven fundamentals, such as positive business momentum (earnings growth and positive revisions) as well as valuation (Price/Earnings or P/E ratio) were discarded and stock prices and returns were driven by fear and emotion. In this environment, throughout sectors and countries, lower-ranked companies outperformed higher-ranked companies with proven earnings potential. The best performing stocks had a combination of the highest valuations as measured by P/E and Enterprise Value/EBITDA (earnings before interest, taxes and depreciation) and the most earnings downgrades over the past four months. These are exactly the companies we avoid. The least expensive companies with the largest number of earnings upgrades performed the worst. Clearly this is not an environment in which the Fund's strategy will outperform.

The Fund's relative performance was especially poor in the industrials and consumer discretionary sectors. Japanese hand tool manufacturer Makita Corp. (0.7% of the Fund) fell over 50% on concerns over slowing European economic growth and currency weakness. U.K. domiciled global mining firm Xstrata fell 45% as commodity prices plummeted and the market reacted with some skepticism to their offer to buy platinum miner Lonmin PLC (not held in the Fund) for $9.8 Billion. Shortly after quarter end, Xstrata PLC (1.4%) walked away from its bid.

Outlook

These are times that test anyone's conviction to a set discipline. We continue to be vigilant in our research to make sure we have done everything we can to construct a portfolio of stocks that will outperform. What we believe is that certain fundamentals of valuation have worked in the past and will work in the future with regard to establishing equity prices. We believe that stock holders will be rewarded more for owning companies that have improving earnings growth than owning those that do not. That has been our focus in the past and that is our focus today and, regardless of the market's volatility, that is our focus going forward.