It has been almost two years since the cracks in the domestic and global credit markets began to roil the equity markets and eventually the global economy. In that short time, we have witnessed dramatic shifts in the economic, political, and corporate landscapes across the globe. Halfway through 2009, we are still in the midst of a synchronized global recession.

In the midst of sprouting green shoots, inflationary fears have taken center stage as efforts to re-inflate the domestic and global economies continue unabated. The Russell 2000 lost 58.9% of its value from its peak on July 13, 2007 to its most recent trough on March 9, 2009. The Index was up 2.6% year-to-date through 6/30/09 and 48.9% from the most recent March 9th low through the end of the second quarter. Yet even with the most recent rally, the Russell 2000 was still down 38.8% from its peak.

The aftermath of any financial crisis can also be difficult. History shows that rallies in equity markets are typically met with caution, while regulations to prevent the crisis from re-occurring are bandied about. From our perspective, the aftermath of this particular crisis has been, and continues to be, an opportunity, even after the most recent rally.

Non-dividend paying stocks within the Russell 2000 have dramatically outpaced dividend paying stocks in the recent rally. From the small-cap low on March 9 through June 17, 2009, non-dividend payers rallied roughly 54%, while dividend-paying stocks only rose approximately 40% for the same period.

We also think that return on invested capital (ROIC) is perhaps the best gauge of company quality. Similarly, those stocks within the lowest quintile of ROIC outperformed those within the highest quintile of ROIC for the Russell 2000 since the most recent rally began.

James Fury, of Fury Research Partners, is quick to point out that "the top ROIC quintile has experienced periods of underperformance four times in the last 10 years. The current environment is one such market. Typically, the bottom quintile, i.e., "low quality companies" will outperform on average for 11 months before resuming their normal underperformance." According to Fury, the current cycle is roughly six months old.

Given the recent outperformance of "low quality" stocks, one could argue that there is more opportunity in high quality stocks than their low quality siblings, even after the market's upswing. So while the world debates the nature of this rally, its longevity, and whether stocks are ahead of fundamentals, we continue to find opportunities within higher quality smaller companies.

The wall of worry surrounding the equity markets has not crumbled with the rally. Consumers, corporations, and investors alike are all trying to adapt to the "new normal" after two years of tight credit and sub-par economic growth. To us, having a time-tested discipline behind our philosophy is extremely beneficial, especially in these interesting times.

Stay tuned
FDG