U.S. small cap value stocks made solid advances in the third quarter with the NFJ Small-Cap Value Fund delivering double-digit returns yet underperforming its benchmark, the Russell 2000 Value Index. An underweight position and stock selection decisions in the consumer discretionary sector contributed most significantly to underperformance. Stock selections in the energy, materials and consumer staples sectors also detracted from returns versus the benchmark. An underweight position in the financials sector and stock selection in technology benefited relative returns.

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, the Fund’s underweight position detracted from returns as better-than-expected sales and profits boosted shares of retailers and recreational equipment manufacturers. The advance reflected inventories returning to more normal levels and early signs of a return of consumer confidence to the economy.

Among consumer staples companies, grocery chains and food and beverage suppliers saw revenues and profits trimmed as consumers’ embraced cost-cutting measures. Shoppers preferences for generic brands and lower-priced bargains dampened results for the group.

In the financials sector, the Fund benefited from holdings of health care-focused REITS and cash-advance service providers both of which have weathered the economic downturn and continue to generate steady income streams.

Several companies in the technology sector advanced due to better-than-expected earnings results and anticipation that the markets for technology products will likely begin to improve along with a strengthening economy.

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.