U.S. equities topped an impressive third quarter by posting their strongest quarterly results in over a decade, as the Dividend Value Fund posted a solid return, though still trailing the Russell 1000 Value Index’s gains. Investors continued to flock to low credit quality as the economy showed signs of pulling out of the longest recession of the post-war period. The quarter was characterized by a return to risk, with many of the best performers being those names that faced bankruptcy risk just a few months ago.

The relative underperformance of the Dividend Value Fund for the third quarter resulted from a combination of negative stock selection and detracting sector allocation, although both issues reflected the same underlying theme, which was a flight to low quality equities. With regard to stock selection, the greatest detractor during the quarter was the Fund’s requirement that every holding pay a dividend. Within the benchmark, dividend paying equities trailed those that do not pay a dividend by six percentage points. In fact, when narrowing the Value benchmark to only those names which pay a dividend of 5% or more (the Fund’s current average yield is 4.4%), to better reflect the product’s selection universe, the benchmark return declines below the Fund’s performance.

Regarding sector allocation, relative losses again came from an underweight position in the Financials sector, which persisted in its sharp rebound as investors returned to many companies that investors had viewed likely to go the way of Washington Mutual, Countrywide or Bear Stearns. However, after the Treasury stepped in to bail out these companies, financial stocks turned out to be one of the best performers. The Fund also suffered from being overweight some of the more defensive sectors such as Consumer Staples and Health Care that lagged during the rebound despite the fact that they offer some of the strongest and most defensible dividends in the selection universe. These relative losses were partially offset by the Fund’s underweighting in Utilities, which failed to take part in the market rally.

During the quarter, stock selection primarily detracted in the Financials sector. Selection also lagged in the Consumer Discretionary sector, which while solid, failed to keep up with the gains from those in the benchmark. In these instances, “selection” refers primarily to the higher quality names within the sector, as the securities with the lowest credit quality delivered the best performance. This was partially offset by solid stock picking in the Telecomm sector, where the Fund’s holdings outpaced those in the benchmark.

Much of the poor stock selection in the underweighted Financials sector can be attributed to what the Fund did not own, such as Citigroup, Inc. (C) which rose after its emergency capital injection from the Treasury. However, the Fund was prevented from owning Citigroup by our process on the basis of the company losing money both this year and next, and having reduced the dividend to nearly nothing. Among holdings in the Financials sector, the thrifts Hudson City Bancorp, Inc. (HCBK) and New York Community Bancorp Inc. (NYB) only rose slightly. Neither bank participated much in the run-up in Financials because they had not been as beaten down, and both declined to participate in the TARP program. Hudson City continues to offer one of the highest tangible ratios in financials with the lowest charge-offs, and the conservative bank has actually bought back shares and raised its dividend this year. Selection also lagged in the Consumer Discretionary sector, in which McGraw-Hill Companies Inc. (MHP) lost during the quarter. McGraw-Hill suffered as the market priced in significant potential liabilities and regulatory risk related to ratings at its Standard & Poor’s unit. However, Moody’s Corp. (MCO) faces the same risks but trades at a premium to McGraw-Hill, which recently hiked its dividend. Other names that detracted during the quarter were more defensive players such as Waste Management Inc. (WM) and medical supply company, Becton Dickinson and Company (BDX), which were each down slightly. Waste Management had held up relatively well during the bear market due to the defensive nature of garbage delivery. Becton Dickinson is in the less cyclical businesses of providing such consumables as syringes and IVs that are somewhat insulated from the macro picture. It trades well below its historical norms and was recently added by Warren Buffett.

Offsetting these losses were several solid performing securities in the Industrials sector. R.R. Donnelley and Sons Co. (RRD) was the Fund’s best-performing stock, rising to get back above where it traded a year ago as printer sales appear to have bottomed. The company produces a 20% free cash flow yield and is taking advantage of weaker competitors having to close. Other top performers in the Industrials sector include Boeing Co. (BA) and 3M Co. (MMM). Boeing’s price was lifted by news that the new Dreamliner 787 is expected to make its first flight by year-end. Although there have been delays for the plane, it still has 850 firm orders, making it the most successful aircraft of all time. 3M’s second quarter results beat forecasts and the stock price is now flat from where we bought it a year-and-a-half ago, while the S&P 500 Index is down over over the same time horizon. In the Financials sector, PNC Financial Services Group Inc. (PNC) and Annaly Capital Management Inc. (NLY) were up. PNC rebounded as the pace of bad loans slowed and management indicated that it intended to repay TARP funding in a shareholder-friendly manner. Annaly hiked its dividend, bringing its yield to a product-best. Harris Corp. (HRS) and VF Corp. (VFC) were other top performers for the quarter, as both solidly beat estimates and provided optimistic outlooks for the rest of the year.

In July, we sold JPMorgan Chase & Co. (JPM) after it had doubled from its March lows, and was nearing where it finished 2007. Though it traded at a reasonable multiple of normalized earnings, it requires investors to pay a steep premium for management’s reputation for managing risk and capital. We swapped into Hudson City Bancorp Inc. (HCBK), one of the largest thrifts in the U.S. Hudson City offered an even higher tangible ratio than JPMorgan Chase and some of the lowest levels of non-performing assets among its peers. While competitors issued dilutive shares and accepted bailouts, it had refused government assistance and had actually raised the dividend this spring and continued to buy back stock. We also sold Halliburton Co. (HAL), which had been one of the best performing stocks over the past couple of quarters, to acquire Diamond Offshore Drilling Inc. (DO), which offered a much higher dividend yield and a lower forward earnings multiple than that of Halliburton. Diamond Offshore has no net debt and has the majority of 2010 revenues locked in at attractive day rates.

In August, we sold Cardinal Health, Inc. (CAH), as the earnings multiple had risen from the time of purchase to due to lowered earnings estimates, resulting in the stock also falling into the bottom decile on our earnings revision model. The Fund acquired McGraw-Hill Companies, Inc. (MHP). Standard & Poor’s comprises most of its earnings, and the closest comparable, Moody’s Corp. (MCO), still faces the same litigation and regulatory concerns.

The best way to address the Fund’s year-to-date relative performance is in light of our investment process. When considering that the style attributes upon which we focus have been out of favor in the market, trailing the benchmark over the past few months is disappointing, but not altogether surprising. For one, the requirement that each holding pay a dividend has been a major cause of near-term underperformance, even though that constraint is a primary factor in the product’s long-term success. Year-to-date, dividend paying stocks in the Russell 1000 Value benchmark have trailed those that don’t pay a dividend. Likewise, among domestic equities, the highest P/E equities in the market have been the best performing by a wide margin. As such, if we had loaded up on speculative companies back in March after they had cut their dividends and were losing money, we might be writing about stronger relative performance in the near term, but we would have had to violate our process to do so.

Another challenge in the recent months has been our use of price momentum. This has historically differentiated us from traditional value investors by allowing us to pick up low P/E stocks while avoiding certain types of value traps and stocks that go to $0 (like Enron and Bear Stearns). Because price momentum tends to work most of the time, with the exception of during sharp market reversals, this attribute also failed to add value during the flight to low-quality companies. This spring we saw the U.S. government step in and bail out some of the most speculative companies. If not for this intervention, some stocks that we avoided would have likely failed. However, in this case they have been top performers only because they were bailed out. The last time we saw price momentum models reverse in such a manner was during the “dash to trash” period of 2003, after which it reverted to form and generated even more alpha during the subsequent three years than normal.

As such, what we have seen during 2009 so far has been a period in which high-P/E, low dividend paying stocks are a place to be (similar to 1999 and 2003). Reversion to the mean would suggest that if investors do not believe that it is different this time, it is probably a good time to focus on investment rules that have worked over the past several decades, not the past several months.