4th Quarter 2011 Commentary - ASTON/TAMRO Small Cap Fund
4th Quarter 2011
Year in Review
Uncertainty about growth in the global economy made 2011 a year of volatility in the stock market. All year, headlines questioned whether there would be a double-dip recession in the U.S. The fourth quarter saw the upside to that query as markets rallied globally. Small-cap stocks in the Fund’s Russell 2000 Index benchmark led during that period, though large-caps (Russell 1000 Index) led for the year. The year-end strength came mostly during October, reflecting encouraging news on corporate earnings. This belied arguments for a double-dip. In addition, a pick-up in Gross Domestic Product growth and less hostile employment results corroborated views on a more constructive market outcome.
Last year we postulated that large-caps could be big in 2011 and that U.S. domestic stocks would be recognized and preferred by investors because of sentiment, valuation, and improving fundamentals. Well, the U.S. stock market (as defined by the large-cap oriented S&P 500 Index) was the best performing equity market for the year, and one of only two markets across the globe to post positive gains. This was the second year in a row where U.S. stocks in general provided superior returns on the global equity stage.
Small-caps in the benchmark finished the year down about 4%. The Fund was basically flat versus the benchmark for the year. Positive stock selection within Industrials, Healthcare, and Financials was offset by a lack of exposure to Utilities and an overweight position in the struggling Energy sector.
We believe that in a slow growing global economy consolidation is likely to take place, as leading companies grow market share and improve efficiencies by acquiring away competition. Small-caps have historically been the innovators in the domestic economy and we have seen many acquisitions in this universe, particularly in Technology, this past year.
Fourth Quarter Rally
Although markets rebounded during the fourth quarter and absolute returns were strong, the Fund trailed its benchmark for the period. The underperformance came primarily from negative stock selection within the Energy, Healthcare, and Consumer Discretionary sectors. In addition, the Fund’s overweight stake in Energy had a negative impact here as well.
Healthcare IT companies Quality Systems and Athenahealth were among the biggest individual detractors from performance. Concerns that the market for ambulatory electronic health records is more saturated than originally believed weighed on the stock of Quality Systems, while Athena’s management issued 2012 guidance below expectations driven by reinvestment in the business. Telecomm-related firms Acme Packet and Meru Networks were also notable detractors. Delayed orders caused Acme to reduce its quarterly guidance, and Meru missed its earnings target, despite record revenues, owing to expense pressures from sales and marketing.
On the positive side, Financials, Technology, and Industrials were the best performing sectors on both an absolute and relative basis. An overweight in Industrials benefited the portfolio overall, with holdings in Colfax and Westinghouse Airbrake Technologies (Wabtec) as the standouts. Colfax delivered better than expected sales and earnings growth, and further acceleration is expected as a result of a recent acquisition. Solid execution at Wabtec resulted in better than expected earnings and raised guidance.
The Fund benefited from three take-out offers for holdings in Technology: RightNow Technologies, DemandTech, and recently purchased SuccessFactors. All three companies are innovators in cloud computing, which as we have stated over the past several years is one of the strongest trends to hit technology in more than thirty years. Within Financials, top-10 holding Bank of the Ozarks reported better than expected quarterly results.
The portfolio remains broadly diversified, with sector allocations resulting from opportunities we identify at the stock level through our bottom-up fundamental analysis and valuation work. The most notable shifts during the quarter were a decline in the Healthcare sector weighting due to sales/profit-taking based on valuation and an increase in Technology as a result of appreciation from the buy-out offers mentioned above.
Industrials, Financials, and Technology were the three largest sectors in the portfolio at quarter end. The opportunities we see in Industrials are related to infrastructure build-outs in Emerging Markets for water and energy as those economies continue to grow. Although the Financials sector within the Russell 2000 Index slightly outperformed the full index in 2011, we have identified what we think are high-quality companies within the sector that offer attractive valuations, particularly in the banking industry. We believe the U.S. is still “overbanked” and that consolidation within the industry is likely to continue.
During the quarter, seven stocks reached full-position status either through purchase, appreciation, or a combination of the two. Coinstar is an innovative leader in its eponymous automated coin counting service and the DVD kiosk business through its Redbox subsidiary. Despite impressive growth and market share gains through Redbox, the stock has been weak given a recent executive resignation as well as investor skepticism over management’s outlook and ability to execute a digital strategy. We believe Coinstar’s services offer value and convenience, and think the company is in an excellent position to enhance its competitive position given the demise of traditional brick and mortar video stores. Coinstar generates strong free cash flow and returns on capital.
Two other notable new full positions are in Amerigroup and Red Robin Gourmet Burgers. Amerigroup is the largest pure play Medicaid managed care organization (MCO) serving approximately two million members in 11 states. Although profit margins are being squeezed, we believe this risk is more than fully reflected in the valuation following the stock’s recent correction. In our view, Amerigroup is the best positioned MCO for Medicaid expansion as well as health reform and has competitive advantages relative to its peers given its cost leadership, focused business model, attractive geographic footprint, and strong management. Red Robin has suffered a series of management missteps, including overly aggressive new unit expansion through the economic downturn and poor overall execution. A new CEO and independent board members have recently joined the company to direct an ongoing restructuring effort in response to activist shareholder groups. We believe Red Robin is in the early stages of a turnaround, and are encouraged by the initial success from management’s new focused strategy.
Six full positions were sold from the portfolio during the fourth quarter. Blue Coat Systems, ESCO Technologies, Texas Industries, and Winnebago Industries were sold to fund purchases in other companies that we view as better relative investment opportunities. Cbeyond was sold in light of a shift in the company’s strategy that we believe entails execution risk. Quality Systems was sold due to valuation and better relative opportunities in the sector. Despite the weakness this quarter, the stock had delivered strong gains since its initial 2008 purchase.
We believe that U.S. stocks can potentially provide investors good-to-average returns for the upcoming year. We think that large-caps should have an edge over small- and mid-cap stocks due to superior valuation and improving fundamentals, though as noted previously small-caps can continue to benefit from industry consolidation. The domestic economy will likely register continued subpar economic growth, and global markets will likely remain subdued due to credit issues in Europe and softness in export markets—a key driver for emerging economies. As this is an election year, we believe there will continue to be volatility in the U.S. market. We hope to take advantage of any near term downward volatility to add to best-in-class companies at more compelling prices.
TAMRO Capital Partners
As of December 31, 2011, Quality Systems comprised 0.00% of the portfolio's assets, Athenahealth – 2.23%, Acme Packet – 2.09%, Meru Networks – 0.29%, Colfax – 2.85%, Westinghouse Airbrake Technologies (Wabtec) – 2.10%, RightNow Technologies – 0.67%, DemandTEch – 1.16%, SuccessFactors – 2.98%, Bank of the Ozarks – 2.80%, Coinstar – 2.21%, Amerigroup – 1.75%, and Red Robin Gourmet Burgers – 1.47%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.