2nd Quarter 2014
While economic growth rebounded during the second quarter from weather-depressed first quarter weakness, it wasn’t strong enough to result in much growth for the first half of the year overall. Revised first quarter real Gross Domestic Product (GDP) of a negative 2.9%, combined with our estimate of 3%-plus growth in the second quarter, suggested little if any growth during the first six months of 2014.
We do believe the economy can continue advancing at a 3% annualized rate in this year’s second half as consumer and capital spending improve and the slow housing recovery continues. This pace, however, would still result in another year of less-than-expected growth in the range of 1.5% to 2.0%, similar to last year’s gain of 1.9%. Since the beginning of the economic recovery and expansion five years ago, real GDP has advanced at about a 2% annual rate, nearly one percentage point less than in past multi-year periods of recovery and expansion.
Despite the lackluster economic recovery and the weather-depressed slowdown, the stock market continued to march higher. Still, there was turmoil beneath the surface. A meaningful sell-off in price-momentum stocks that began in early March continued into the first few weeks of April and seemed to presage a leadership change in the market. In early June, however, the European Central Bank (ECB) announced additional liquidity measures. This seemed to forestall temporarily the shift in leadership as many of the speculative issues that led the market in 2013 resumed their leadership. As we outlined last quarter, we think the volatility in both Emerging Markets and price-momentum issues may prove to be the canary in the coal mine of broader market volatility as the Federal Reserve ends its quantitative easing (QE) bond purchases.
The drop in yields of intermediate and long maturity US Treasury bonds caught us off-guard during the second quarter, but we expect yields to drift higher for the remainder of 2014. While we think part of the decrease in yields was a reflection of the weaker-than-expected GDP growth, some of the decrease was attributable to investors seeking out incremental yield as yields on European sovereign debt fell following the European Central Bank’s announcement of further stimulus measures.
The Fund posted solid gains during the quarter in slightly trailing its composite 60% S&P 500 Index/40% Barclays US Government Credit Index benchmark. The stock portfolio outpaced the broad-market S&P 500 through April and May before the ECB action at the beginning of June again boosted easy-money driven stocks. An overweight position in Corporate credits helped relative performance in the bond portfolio, as that group again outperformed Treasuries.
Overweight stakes and strong stock selection in the Healthcare and Consumer Staples sectors helped performance the most. Holdings in Allergan, Gilead Sciences, and AmerisourceBergen led the way in Healthcare. Allergan was up after activist investor Pershing Square aligned with Valeant to pursue a takeover, pushing the stock above our estimate of fair value. Given the strong relative performance and the company’s exposure to discretionary spending, we reduced the portfolio’s position. Gilead and AmerisourceBergen were up on strong earnings reports.
Walgreen, Estee Lauder, and Mondelez International were the top performers within Staples. Walgreen reported improvement in top line trends and continued above-plan synergies from its Alliance Boots merger. With the second phase of the merger likely to occur early next year, Walgreen management appears increasingly amenable to a greater pace of change, possibly including further store rationalization and cost-cutting initiatives, future share buybacks, and tax initiatives, up to and including a corporate inversion, all of which have the potential to greatly increase the company's normalized earning power. Recently improved pharmacy utilization appears sustainable, and comparisons for front-end store sales will ease in the period ahead as the company laps a period of higher promotional spending. We increased the portfolio’s position in the stock during the quarter. Estee Lauder and Mondelez were up on earnings results that were ahead of expectations.
Elsewhere, Occidental Petroleum and Monsanto had strong quarters. Monsanto rose on a strong earnings release that beat consensus estimates that included an increase in the lower end of future guidance, the authorization of a two-year share repurchase program, and a target of “doubling on-going earnings per share in the next five years.” Strong oil prices and its announced spin-off of California Resource Corporation boosted Occidental.
Weak Tech and Consumer Discretionary
Stock selection in Consumer Discretionary and Technology hurt relative returns, despite underweight positions in both sectors. Ralph Lauren and TJX Companies were the primary detractors in Discretionary. Ralph Lauren issued guidance below consensus estimates during the quarter. Investments into the launch of Polo stores, Polo Women's wholesale, and e-commerce marketing efforts are diminishing near-term earnings growth, warranting a smaller position size within the portfolio. TJX’s fiscal first quarter results missed expectations on slower same-store sales and currency headwinds. While we continue to like the fundamentals at the company, we trimmed the position as its price/earnings ratio remains somewhat above historical levels and the stock may need to mark time for a while as it 'catches up' to the valuation re-rating it has already achieved.
Within Technology, Visa fell during the period and was well below its peak in late January. We see no change in fundamentals and with the stock trading at 18-20 times earnings versus a peak of 24 times we took the opportunity to add to the Fund’s holding based on an attractive valuation. Juniper Networks also detracted from relative performance as the company missed on margin expectations. We viewed the margin miss was transitory (higher legal expenses), but the stock traded lower despite the company being on course for improved profitability. The data breach/password change announcement at eBay appeared to be the driver of its slide. Although the downside risk to earnings seems manageable and limited, the prospect of downward revisions probably limits upside in the stock over the intermediate term, prompting us to reduce the position.
Stock selection in Financials and Energy sector detracted from relative performance as well. State Street was the largest detractor from performance, and given our expectation for more muted earnings growth this year, we reduced the position. Finally, Procter & Gamble was a laggard owing to skepticism regarding the potential for revenue acceleration, prompting us to trim it as well.
We established three new positions in the Fund during the quarter—Schlumberger, Thermo Fisher Scientific, and W.W. Grainger. Oilfield services company Schlumberger has embraced the shift to more moderate industry capital spending growth, allowing the company to focus on improving margins and returning capital to shareholders. We built the position on better-than-expected U.S. oil activity levels, increasing the chances for upward revisions on top of already solid earnings momentum. Management’s three-year guidance was well ahead of expectations, which prompted an increase in our estimate of fair value.
Thermo Fisher Scientific is a manufacturer of scientific instruments, consumables, and chemicals. The company has a strong merger and acquisition record, and we think the February 2014 acquisition of Life Technologies should enhance the company's depth and scale in genetic sciences and biosciences, and providing a leadership position in proteomics, genomics and cell biology. Earnings are set to accelerate due to the full inclusion of Life’s results and a buildup of operating synergies. We increased the position when the company disappointed on organic revenue growth given our belief that significant synergies from the Life acquisition will increase going into 2015.
We think positive average daily sales along with peaking internal spending on growth initiatives and higher incremental margins should drive acceleration in revenue and earnings growth for W.W. Grainger, a distributor of maintenance, repair, and operating supplies used by businesses and institutions in the U.S. and Canada. We continued to build this position at a more attractive price following a reported May sales number that missed analysts' expectations.
Notable additions to current positions included PepsiCo, Yum! Brands, and Union Pacific. We expect earnings growth at Pepsi to be better than anticipated due to pressure from activist investor Trian. Increased scrutiny on the company is likely to prompt management to make significant changes to improve earnings, including perhaps splitting up the company to unlock shareholder value. Channel checks in China suggesting a boost in sales comparisons for Yum! Brands could be a catalyst for the stock as investors gain confidence in potential earnings growth. Other catalysts include a new menu launch and marketing campaign in China, as well as the national rollout of breakfast at Taco Bell in the United States. Railroad operator Union Pacific reported first quarter earnings that were better than expected despite weather disruptions. We expect further strong volume growth driven by strength in coal transport due to low utility stockpiles and high natural gas prices.
Out With Coke
We eliminated the portfolio’s positions in Coca-Cola, Franklin Resources, and Johnson Controls during the quarter. We sold Coke given a lack of catalysts for earnings growth. Carbonated soft drink volumes continued to decline despite the company being more aggressive on pricing, and new studies have highlighted the cardiovascular risks associated with diet soft drinks. In addition, adverse currency movements have already reduced earnings growth.
Franklin Resources approached our fair value shortly after we initiated a position last summer. With market volatility expected to pick up and having just an initial position, we sold the shares. Johnson Controls traded close to our estimate of fair value and we felt most of the benefits from its restructuring program implemented 18 months ago had run their course.
Elsewhere, we trimmed the portfolio’s stakes in Abbott Laboratories, Stryker, and Nike. We cut Abbott on inflated earnings estimates in the face of worsening foreign currency trends and potential weather related disruptions in the medical device business. Stryker was reduced after an earnings disappointment that renewed our near-term concerns about its MAKO acquisition despite believing it to be a positive longer-term catalyst for the stock. Reductions to fiscal year 2015 earnings estimates resulted in Nike trading at a 13-year high based on its price/earnings ratio. Given Nike's peak multiple and difficult earnings comparisons for the next two fiscal quarters, the opportunity for near-term upside seemed fairly limited.
A moderate but synchronized global economic recovery and accommodative central bank policies throughout the developed world continued to support higher stock prices. Although the Federal Reserve has reduced its bond-buying program, it still has been providing sufficient financial liquidity to support higher prices and low levels of volatility in the stock market. The long-term outlook remains favorable with recession risk low and corporate profits likely to hold up, but the intermediate-term outlook is more uncertain. Valuation and sentiment appear stretched enough now to suggest that investors are taking too much short-term risk for too little reward.
As central banks continue to provide ample liquidity to financial markets, some of these funds are finding their way to US Treasury bonds. As domestic economic growth rebounds from weather-induced weakness in the first quarter, we believe interest rates will resume their upward climb. While we expect higher yields from current levels, the increase will be tempered by continued modest gains in GDP growth and subdued inflation. We expect the spread on Corporate bonds to narrow modestly as investors seek out incremental yield in a low interest rate environment. Accordingly, we are maintaining a duration (a measure of sensitivity to moves in interest rates) in the portfolio that is shorter than the benchmark and overweighting high quality intermediate corporate bonds.
Although the Federal Reserve’s QE program could inflate asset prices further before it ends this fall, we think any further increase in prices will only increase stock market risk, as investors are likely to be left with inflated asset prices and unattainable fundamentals. We expect stock market volatility to pick up as QE ends and market forces, rather than central bank manipulation, become a greater influence on asset prices. While an increase in market volatility could be disruptive to investors, an end to artificially high liquidity would be healthier over the long term as free markets are preferable to distorted markets and mispriced assets.
We believe that because high-quality growth stocks are more reasonably valued and have sound earnings prospects, they are likely to do relatively well in a more volatile environment. Should a market correction take place, which is overdue in our view, these positive fundamentals should aid the Fund on a relative basis as well. Longer term, we think the Fund is well positioned to benefit from the ongoing synchronized global recovery as many holdings have strong global franchises and derive a large part of their earnings from international markets. The portfolio also has a moderate amount of buying reserves that will enable us to take advantage of better opportunities that appear as share prices adjust to free market forces.
Montag & Caldwell Investment Counsel
As of June 30, 2014, Allergan comprised 2.26% of the portfolio's assets, Gilead Sciences – 2.72%, Amerisource Bergen – 1.36%, Walgreen – 2.40%, Estee Lauder – 1.90%, Mondelez International – 2.59%, Monsanto – 2.24%, Occidental Petroleum – 1.93%, Ralph Lauren – 0.61%, TJX Companies – 0.78%, Visa – 1.67%, Juniper Networks – 1.68%, eBay – 1.06%, State Street – 0.53%, Procter & Gamble – 1.63%, Schlumberger – 1.55%, Thermo Fisher Scientific – 1.55%, W.W. Grainger – 0.58%, PepsiCo – 2.28%, Yum Brands – 1.10%, Union Pacific – 1.18%, Abbott Laboratories – 2.01%, Stryker – 0.68%, and Nike – 0.74%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its dividends.
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.