4th Quarter 2012 Commentary - ASTON/TAMRO Small Cap Fund
4th Quarter 2012
The Year of the American Consumer
The recently concluded calendar year 2012 delivered above-average, double-digit returns for US equities, with large-cap stocks (represented by the Russell 1000 Index) beating out small-cap stocks (Russell 2000 Index) by a nose. Value stocks outdistanced growth by more than two percentage points in both areas, with most of the outperformance for value coming during the fourth quarter. The main reason behind these results seems to be increasing investor appreciation for improved fundamentals within the Financials sector, which was the top-performing large-cap sector and among the top-three areas in the small cap universe. Along with improved fundamentals, financial services companies seem to be successfully adapting to their new regulatory environment. If the much-improved trend for the group were to continue, it would be a significant positive for the market and the economy.
The slow but steady expansion of the economy that we anticipated did occur in 2012, marked by dramatic improvement in the housing market and grudging improvement on the jobs front. Those two factors helped to push consumer confidence to a four and a half year high. As confidence has improved and the consumer de-levered, Americans have gone back to doing what we do best—shop. Given that approximately two-thirds of U.S. Gross Domestic Product (GDP) is comprised of consumer spending, the confidence and expenditures of consumers is the key to growth going forward. Interestingly, in the nearly four-year period since the recession trough in 2009, the Consumer Discretionary sector has been the best-performing large-cap sector and among the top-three for small-caps. We think further appreciation in home prices, improved access to credit, and steady, if unspectacular, job growth should help to accelerate this trend as we move through 2013.
A December rally helped markets to recoup losses from earlier in the quarter, with the Fund’s Russell 2000 Index benchmark finishing in positive territory for the period. The Fund, however, did not finish in positive territory, as relatively poor stock selection caused it to underperform the benchmark. Overweight stakes in the Consumer Staples and Healthcare sectors also detracted from performance, but it was the impact of stock selection within the Industrials, Consumer Discretionary, Energy, and Consumer Staples sectors had the biggest negative impact.
Comstock Resources, The Fresh Market, and BJ’s Restaurants were among the notable laggards during the quarter. Comstock, an oil and gas exploration and development company, was hurt by a significant decline in natural gas prices during the quarter. Specialty grocer Fresh Market announced future comparable store sales guidance that was below expectations, while BJ’s reported weaker-than-expected revenues and earnings amid concerns over heightened competition in the casual dining industry. The biggest individual detractor from performance, however, was online real estate service Zillow on worries about slowing growth in its advertising business.
On the positive side, holdings in Technology aided both absolute and relative returns during the quarter led by Acme Packet and CommVault Systems. Telecom equipment provider Acme maintained guidance despite the tepid economy. With telecom capital expenditures expected to increase in 2013, we think this innovator’s ability to smooth the transfer of data will be in demand amid the still rapidly growing wireless space. Data management software company CommVault (a 1996 spinoff from Lucent Technologies) continued to execute well, and reported better-than-expected quarterly results during the period.
Other top individual performers included top-10 holdings Colfax and Redwood Trust. Colfax was a top stock for the second quarter in a row as management provided details on its growth strategy during the firm’s first ever analyst day meeting. The firm is a key supplier of piping systems to a variety of industries building out global energy infrastructure. Redwood is a real estate investment trust (REIT) that invests in residential mortgage loans and commercial real estate financing that beat earnings estimates and raised its annual dividend.
As always, the portfolio’s positioning and sector allocations are based on opportunities that we have identified through our bottom-up company fundamental analysis and valuation work. Only subtle changes were made during the fourth quarter, with the three largest sector weightings in Financials, Consumer Discretionary, and Healthcare remaining the same from the previous quarter. Year over year, the portfolio saw a significant decrease in exposure to Industrials (the largest sector weight at the end of 2011) Energy, and Technology. The changes from a year ago reflected a shift towards a strengthening domestic economy and the consumer, which altered the bottom-up dynamics. Financials was the lone survivor among the top-three sector weights.
Four stocks reached full-position status through purchase, appreciation or a combination of the two during the fourth quarter, including Titan International and Cloud Peak Energy. Titan is the leading manufacturer of off-highway tires and wheels used for heavy machinery in construction, agriculture, and mining. The company is still run by its founder, who led a management buy-out of the company in 1990. Financial performance has been mixed due largely to the end-markets that it serves, but industry consolidation (now a 3-company market) and tenacious negotiations for new capacity have yielded scale and pricing advantages to the only company focused entirely on this segment. Indeed, the stock was among the Fund’s best performers during the fourth quarter after the company beat expectations and provided better-than-expected long-term guidance.
Cloud Peak is a leading producer of Powder River Basin coal, the single largest coal producing area in the U.S. As with any producer of commodities, Cloud Peak is a price taker and must focus on low costs as a competitive advantage. It boasts a non-unionized labor force, safe and efficient surface mining, a proven mine acquisition strategy, and low-cost transport as the keys to profitability. Low natural gas prices and increased regulatory risks have caused coal to fall out of favor with electricity producers, but there are initial indications that natural gas prices could rise again, allowing coal to become more competitive. In addition, the firm is using the current low price environment to accelerate its push into Asian and European coal markets.
Seven positions were sold during the quarter, and can be broadly classified into two categories—management issues and relative opportunities. In the case of the former, management execution fell short of our expectations with AeroVironment and Websense, while Contango Oil & Gas faced potential disruption from an anticipated change in senior management.
Better relative opportunities became available as a stretched valuation led us to take profits in East West Bancorp. UMB Financial had executed well, but profitability was under pressure. The failure to win FDA approval for its next generation drug left United Therapeutics with a barren product pipeline and severely diminished growth prospects. Finally, we sold Forward Air, a depressed stock, to buy another equally depressed name in which we had more confidence of a turnaround.
Full Year Recap and Outlook
Unconventional and accommodative monetary policy ultimately trumped investor concerns over fiscal policy, the Presidential election, and weakness overseas in making 2012 an above-average year for stock returns across the domestic market-cap spectrum. The Federal Reserve entered uncharted waters when it announced open-ended quantitative easing through the ongoing purchasing of government securities. Other central banks waded in by mimicking the Fed in word if not deed, further contributing to the global liquidity cycle. The domestic economy continued to expand while the housing and job markets recovered to boost consumer sentiment.
The Fund outperformed its benchmark for the full year, driven by strong stock selection. Holdings in the Healthcare, Materials, and Technology sectors were the biggest contributors to relative performance, led by names such as Athenahealth, Westlake Chemical, and Ixia. Picks within Industrials, Energy, and Consumer Staples hurt returns, with AeroVironment, Contango Oil & Gas, and Treehouse Foods among the major disappointments. Underweight stakes in Materials and Financials, plus an overweight to Energy, also detracted from performance.
With the Federal Reserve indicating it will continue its easy-money policies until unemployment hits 6.5%, subject to inflation limitations, the markets entered 2013 with a significant tailwind and we anticipate ample investment opportunities in the new year. Although higher individual tax rates in the U.S. could weigh on sentiment and growth, the offset could be ongoing economic improvement in key Emerging Markets and perhaps even a stabilization of conditions in Europe. Here at home, we expect the consumer to further find their footing and the overall economy to benefit from improving credit and lending conditions. On balance, we think the U.S. economy should continue to enjoy a slow and steady expansion, much like that which we have experienced recently. Interestingly, despite stocks significantly outperforming bonds during the past four years there have been large net outflows from equity funds into fixed-income securities. Maybe this year we could see investors begin to re-allocate assets back towards equities.
TAMRO Capital Partners
As of December 31, 2012, Comstock Resources comprised 1.81% of the portfolio's assets, The Fresh Market – 1.98%, BJ’s Restaurants – 1.40%, Zillow – 1.45%, Acme Packet – 2.33%, CommVault Systems – 2.16%, Colfax – 2.69%, Redwood Trust – 2.31%, Titan International – 1.53%, Cloud Peak Energy – 1.77%, Athenahealth – 1.95%, Westlake Chemical – 0.00%, Ixia – 2.26%, AeroVironment – 0.00%, Contango Oil & Gas – 0.00%, and Treehouse Foods – 1.09%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.