U.S. value stocks achieved solid, double-digit advances in the third quarter with the NFJ All-Cap Value Fund outperforming its benchmark, the Russell 3000 Value Index. Stock selection decisions among consumer discretionary companies contributed most significantly to outperformance and overall gains as consumer spending and inventories began to rebound along with the economy. Stock selections in the energy and industrials sectors also contributed positively to relative returns. Security selection in the technology sector, an overweight position in consumer staples companies and an underweighting of the financials sector detracted from performance versus the benchmark.

Capital Markets

U.S. equity markets advanced solidly in the third quarter, adding to gains for the year and recovering more of the value lost in the 16-month bear market that ended in March. Although economic growth remained subdued, investors showed newfound enthusiasm for riskier assets, bidding up stock prices especially in the beaten-down financials and materials sectors. During the quarter, value and growth indexes spanning all capitalization segments recorded double-digit returns with value stocks somewhat more in favor. Among value indexes, all sectors registered positive returns with stocks in the financials and industrials sectors contributing most significantly to gains. Utilities and telecommunications stocks posted positive returns but underperformed value indexes.

In the consumer discretionary sector, better-than-expected sales and profits for select companies reflected both a surge in inventories and improving consumer confidence, albeit from historical low levels. Shares of CBS, the nation’s most-watched television network, rose on increases in auto advertising spending, which is the network’s top source of revenue. Although Harley-Davidson continued to cut production, its announcement of plans to enter the India market, was well received by analysts and investors leading to the stock’s outperformance in the period. In India, two-wheeled transportation far outnumbers cars. Limited Brands shares advanced as the company’s strategy of reducing prices on some of its Victoria’s Secret line paid off with enhanced second quarter sales.

Among energy stocks, higher oil prices triggered share price increases for the Fund’s holdings in exploration and production companies. An underweight position in the large, integrated oil companies also contributed to returns relative to the benchmark as those companies tend to underperform production companies in periods of rising oil prices and heightened demand for discovery and development. In this environment, the Fund’s position in Cimarex advanced on quarterly financial results ahead of forecast and an improving outlook for earnings growth. Oil and gas producer Apache saw its share price rise on multiple analyst upgrades. Although gas prices have not rebounded like oil has, Apache’s long-term record of boosting production through acquisitions and efficient operations is seen as an advantage in the current market.

An overweight position in the industrials sector benefited relative performance in the quarter as the sector rebounded with improving sentiment for an economic recovery. Companies that have experienced weak sales in prior quarters, including printer RR Donnelly and employment services firm Manpower, rose on the prospects of growing demand for their services.

In the technology sector, computer chip and component manufacturers tended to outperform software companies. The Fund’s position in Microsoft underperformed the sector on the company’s prediction that information technology spending would remain soft.

Among financials companies, share prices for large national banks led the equity market recovery as additional indications of government support rallied investors to some of the companies that had borne the brunt of the market downturn. The Fund does not hold positions in these companies because they do not meet the strategy’s strict investment criteria, which demand healthy balance sheets, capable managements and potential for free cash flow growth. The Fund’s holdings in an array of financial services companies, including regional and national insurers, contributed to gains for the quarter.

We expect equity returns to moderate in coming quarters as the effects of cost-cutting initiatives by U.S. corporations run their course and the challenges presented by subdued economic growth and growing unemployment limit further improvements in company fundamentals. We believe that this emerging environment of flat-to-modest market returns will favor managers with demonstrable stock selection skills and companies with durable franchises, solid balance sheets and a commitment to paying dividends. We continue to fully invest our Funds in stocks exhibiting these characteristics along with the potential for stable future cash flows.