U.S. large cap value stocks made solid advances in the third quarter with the NFJ Large-Cap Value Fund delivering double-digit returns yet underperforming its benchmark, the Russell Top 200 Value Index. Stock selection decisions among industrials, consumer staples and financials companies contributed most significantly to underperformance. An underweight position in the financials sector also detracted from returns versus the benchmark. Stock selections among energy and consumer discretionary companies and an underweight position in the utilities sector benefited relative performance.

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.

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 banks and national insurers, contributed to gains for the quarter but underperformed the rally in money center banks.

Signs of a nascent economic recovery and an upturn in demand served to boost share prices for companies in the industrials sector, which had been extremely hard hit by recession. The Fund’s positions in refuse hauler Waste Management and defense contractor Northrop contributed to gains for the period but underperformed some of the sector’s largest constituents. Large diversified industrials companies, with significant exposure to lending, equipment leasing and other financial services operations, rebounded along with money center banks in the period. Unprecedented federal support and liquidity erased much of the uncertainty surrounding these companies’ loan portfolios.

Among energy stocks, higher oil prices triggered share price increases for the Fund’s holdings in exploration and production companies. An underweight position in 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 positions in oil and gas producer Apache and oilfield services firm Halliburton advanced. Although gas prices have not rebounded to the extent oil has, Apache’s long-term record of boosting production through acquisitions and efficient operations is seen as an advantage in the current market.

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.