2nd Quarter 2013 Commentary - ASTON/TAMRO Diversified Equity Fund
2nd Quarter 2013
The Goldilocks Factor
The fundamental economic news during the second quarter corroborated our belief of a continued, albeit slow, expansion in the U.S. economy. There is evidence of a number of positive trends for U.S. equities. The ongoing mending of the housing market has been providing a significant boost to consumer sentiment and bank balance sheets. Consumers have de-levered, and the amount of household income going to debt service is at a decades low. Recent headlines notwithstanding, monetary policy remains highly accommodative in the U.S. and around the globe. U.S. corporations are flush with cash and companies are increasingly returning excess cash to shareholders via dividends and stock buybacks. The deficit profile of the U.S. has improved dramatically, at least in the near term. Finally, the recent transformation of the U.S. into an energy superpower is a development that should support U.S. manufacturing and lower domestic energy costs over the long term.
But what’s going on with interest rates? The major news during the quarter was the sharp rise in interest rates on a percent change basis. The move, combined with comments from the Federal Reserve that the central bank could taper its bond buying program, led to an acceleration in market volatility. Strictly based on fundamentals, the higher rates seemed excessive. Yet, it also revealed investors’ reliance on Fed-induced low rates. From our perspective, market forces have been less at work than those of Washington. Are rates too high or too low? At what level is the Goldilocks factor?
We think the environment is still attractive for stocks. The consumer continues to lead the way and the level of interest rates should reach a balance between Washington and our Goldilocks factor, market forces. Hang in there investors. Despite the volatility, it was a decent quarter for stocks and the domestic economy continues to expand.
The Fund posted a slight absolute loss for the quarter, but underperformed its Russell 1000 Index benchmark by a sizeable margin. Poor stock selection in the Healthcare, and Financials sectors was the primary driver of underperformance. Decelerating growth or specific near-term miscues affected several companies within Healthcare. Allergan announced that their Phase II drug trial for macular degeneration would experience a one- to two-year delay due to the need for additional studies. The stock of Athenahealth corrected on lower-than-expected revenue growth and lighter bookings for the Internet-based physician services company. Healthcare payment services firm HMS Holdings reduced guidance significantly after announcing quarterly results that were below expectations, leading us to eliminate the position from the portfolio.
The rise in interest rates affected several positions in the portfolio within Financials, namely Redwood Trust, Franklin Resources, and Raymond James Financial. Fundamentally we remain constructive on most of these companies and used the recent weakness to add to several of them. Despite underweight stakes in the struggling Energy and Materials sectors, stock selection also detracted from performance in those areas.
Sector allocation had a net positive effect overall, though, driven by an overweight stake in Consumer Discretionary sector and no exposure to Utilities. Top-holding American International Group (AIG) and Industrials stocks Boeing and Colfax were among the top individual contributors to performance during the quarter. Global insurer AIG announced strong quarterly results and additional plans to sell off non-core assets. The company has undergone a remarkable turnaround as new management has invested in IT systems and underwriting resources, sold off non-core businesses and successfully paid back all borrowed funds to the U.S. Treasury.
Colfax is a key supplier to companies building the global energy infrastructure, providing pumps, systems and controls to pipelines, oil and gas producers, refiners, petrochemical companies, ship builders, etc. It has already completed one major acquisition to open a second platform (welding and cutting tools) and is likely to spur additional growth with future platform acquisitions. The firm recently reported better-than-expected order growth in its Power Generation segment. Boeing saw increased order activity from the Paris Airshow.
Given recent trends, we continue to orient the Fund toward better capitalized, better run companies able to participate in more domestic-facing industries such as Consumer Discretionary and Financial Services. As the U.S. consumer, the U.S. housing market, and the U.S. economy continue to come back, we think these companies should be well positioned.
We remain vigilant to fundamental changes and valuations at the company level, with sector allocations resulting from stock specific opportunities we identify. There were numerous changes at the stock level in the second quarter where we either took profits in names based on valuation or sold companies where there had been a deterioration in fundamentals. We then redeployed the proceeds to stocks where we thought the valuation had become out of line with fundamentals—in other words, the stock price became more attractive. The net result, after adjusting for returns, was an increase in the sector weight of Energy, a decrease to Financials and Healthcare (due to sales based on dissipating growth trends).
Ten positions, across a variety of sectors, became what we consider full positions in the portfolio during the quarter through purchases or appreciation. Exploration and production company Ultra Petroleum was part of the boost in the weighting in the Energy sector. The company has a history of success having grown reserves and production exponentially the past decade while earning a strong return on capital employed. As commodity prices improve, we think Ultra should see better-than-average margin expansion thanks to both higher realized prices and lower depreciation expenses stemming from 2012 write-downs.
Other new positions in the portfolio included Best Buy, Seagate Technology, and Edwards Lifesciences. Following years of organic sales pressure and margin deterioration from prior mismanagement combined with structural headwinds from online competition, a new management team with restructuring and retail expertise was appointed to turnaround company operations at Best Buy. We think there is significant room for operating margin expansion at given cost reduction opportunities, system improvements, inventory optimization, and more directed marketing efforts. Storage-drive maker Seagate Technology has gone through a massive consolidation leading to a duopoly between it and Western Digital, with Toshiba on the outside looking in. We see an opportunity for the company to help improve the pricing/inventory dynamics of the industry given its market share, with an attractive product portfolio for upcoming changes in the market.
Medical technology company Edwards Lifesciences has significantly underperformed the broader market recently due to the slower-than-anticipated launch of its minimally invasive transcatheter heart valve in the U.S. Although we believe that regulatory and reimbursement challenges have negatively affected the broader expansion of this procedure, we believe Edwards has a clear competitive advantage given its focused business mix and first-mover advantage in this market.
Seven full positions were sold from the portfolio during the second quarter in addition to the previously mentioned HMS Holdings. The Fund took profits in Advisory Board and Yahoo! as valuations became rich relative to their fundamentals. FactSet Research Systems and MetLife were sold due to the identification of other companies that we believe to be better relative opportunities.
Apple, Carnival, and Fluor were all eliminated from the portfolio for company-specific reasons. For Apple, that meant poor visibility that made it difficult to evaluate. We didn’t think that the management at Carnival had addressed its maintenance and control problems. We thought that trends in the operations at Fluor could likely decelerate given the downturn in the commodities sector.
Given these changes and the correction relative to the Russell 1000 during the quarter, we think the valuation of the overall portfolio has improved, leaving the Fund well positioned as we move into the second half of the year.
TAMRO Capital Partners
As of June 30, 2013, Allergan comprised 1.82% of the portfolio's assets, Athenahealth – 1.43%, HMS Holdings – 0.00%, Redwood Trust – 1.38%, Franklin Resources – 1.51%, Raymond James Financial – 2.05%, American International Group – 3.11%, Boeing – 1.66%, Colfax – 2.58%, Ultra Petroleum – 1.37%, Best Buy – 2.17%, Seagate Technology – 2.09%, and Edwards Lifesciences – 2.05%.
Note: Small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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