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. During the quarter, the U.S. dollar appreciated relative to most currencies, which exacerbated the size of the negative returns. While 20 of the 25 countries in the S&P/Citigroup EMI World ex-U.S. Index were down more than 20%, the rout through international markets hit Iceland and Norway the hardest, as equity prices in those countries fell by more than 40%. New Zealand was the best performing market with a drop of 17.5%. Keep in mind this is one quarter, not a full year or two. Key drivers of absolute performance were the energy (-37.7%) and materials (-32.5%) sectors.

Fund Commentary

From a stock selection perspective, this was one of the most challenging periods we have witnessed in many years. The Fund trailed its benchmark during the quarter mainly due to a decoupling of the fundamentals involved in our selection criteria and stock returns. Our preference for companies with attractive valuations and business momentum was a perverse indicator this quarter, highlighting a disconnect between stock price behavior and a company's fundamentals, especially fundamentals related to expected earnings. Relative performance was particularly weak among holdings in Japan and Australia. Industrials in Japan were negatively affected by the lowered expectations for global economic activity. The financials and consumer discretionary sectors also detracted from relative returns. Our holdings in health care and utilities, two of the top performing sectors for the quarter, performed well as these sectors provided a temporary safe harbor.

Our two best performing stocks were subject to takeover offers from larger peers. Union Fenosa SA (0.6% of the Fund), a Spanish utility, returned 27% for the quarter. The U.K.-based employment agency, Michael Page International, which was eliminated from the Fund in August, returned 38%. Among the weakest stocks were Incitec Pivot Limited (1.7%), an Australian fertilizer company whose stock price fell by 38% during the quarter, reversing strong gains from earlier in the year, and Sherritt International Corp. (0.6%). Sherritt's stock price fell 64% in response to falling copper and metal prices.

As noted above, irrational investor behavior fueled market sentiment during the quarter. 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 was responsible for the decoupling of a company's stock price and its long-term fundamentals. Short covering on relatively weak financial stocks produced inordinately better returns than returns for other financial companies with solid strength.

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 stockholders will be rewarded more for owning companies that have improving earnings growth than for 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.