3rd Quarter 2012
The Consumer Is King
Investors caught the summer breeze during the third quarter and pushed U.S. equities to new highs for the year. Although the economy provided some forward momentum, it was the Federal Reserve’s September announcement of open-ended quantitative easing that ensured the period would end on a positive note. With Europe seemingly on the verge of a severe recession and Asian economies decelerating, the U.S. economy continues to find its footing. Why? In America, the consumer is king, and consumer sentiment is at a post-recovery high despite persistent above-average unemployment. That may seem like a conundrum, yet housing is central to the American economy and after falling for nearly six years since its peak in 2006, an upturn in home prices is fueling the positive trend in consumer sentiment.
Not only is the U.S. consumer king, but his home is his castle—something the Fed well understands. Roughly 69% of American families own a home and the median value of that home is approximately $210,000. Another 49% of Americans own stocks directly or indirectly via mutual funds. The median value of that portfolio is approximately $49,000. In our opinion, stock prices move the needle primarily for those in the upper middle class and above. As equity prices move higher, you get a wealth effect within that demographic. For most Americans, however, equity prices do not mean much. To the broader population the one asset they own of any real monetary value is their house. Thus, housing price deflation or inflation has the more significant impact on sentiment and spending. We believe this positive trend in housing will continue and prove supportive to both equity prices and economic growth.
Strong Stock Selection
The Fund bested its Russell 1000 Index benchmark by more than two percentage points during the quarter. Sector allocation was neutral, with strong stock selection in the Technology, Energy, Industrials, Materials, Consumer Discretionary, and Consumer Staples sectors providing the outperformance relative to the index. Top individual contributors included Apple, Phillips 66, and Royal Gold. Tech company Apple benefited from anticipation surrounding the launch of its new iphone 5, while Royal Gold in Materials appreciated with the surge in the price of gold itself.
Independent refiner Philips 66, which became a full position in the Fund during the quarter, announced quarterly earnings that were better than expected and plans for accelerating growth initiatives. With an average tenure of more than 30 years, the four key executives leading the company know which assets deserve the most attention as the company seeks to achieve its stated long-term goal of 15% return on capital. Recently, management has been aggressively investing in its Midstream and Chemicals segments to spur additional growth and profitability. We expect the combination of a consolidated refining business with those two growing businesses to generate increasing earnings over the long run.
Stock selection within Healthcare was the primary detractor to relative performance. Pharmaceutical and medical device maker Allergan dropped on investor fear that economic weakness could affect sales given the discretionary spending nature of many of its products, including Botox. Other notable detractors included Boeing and Bed, Bath & Beyond. Order cancellations from a major customer and the potential negative impact from a labor contract dispute hurt the stock of Boeing.
Bed Bath & Beyond is a new holding that became a full position during the quarter. The stock sold off on concerns surrounding online competition and margin sustainability. In our view, the company is a best-in-class retailer led by well-tenured management and supported by strong free cash generation and return on invested capital. We also see the recent acquisition of Cost Plus as providing an additional growth vehicle to a concept portfolio that already holds significant optionality. We think the recent sell-off offered an opportunity to own an excellent business at an attractive valuation.
The top three sectors in the Fund at the end of the third quarter remained the same from the prior quarter—Financials, Consumer Discretionary, and Healthcare. From a bottom-up perspective, we continue to find these three sectors, and the companies we own in them, the most attractive. From a top-down perspective, all three are highly domestic-facing industries. We think the ongoing recovery in the U.S. economy, aided by the upturn in housing, should prove to be a significant tailwind for these areas going forward.
We saw opportunities to expand positions or add new holdings in Healthcare, Consumer Discretionary, Industrials, and Materials during the quarter. Six stocks became full positions through either direct purchases or market appreciation, including Express Scripts and Qualcomm. Express Scripts is one of the nation’s largest pharmacy benefits managers (PBM) to health insurers, HMOs, employers, unions and government entities. The company uses its scale and expertise to lower overall drug costs, and has solidified its position as the undisputed PBM leader with its acquisition of Medco Health Solutions. We think the resolution of an impasse with drug retailer Walgreen and the resulting contract has removed much of the uncertainty surrounding the stock.
Qualcomm is a pioneer in the cellular wireless communication market and one of the best integrators in the semiconductor industry. The company’s products help facilitate the connection and conversation between two devices or between a device and a fixed point. We used recent pressure from supply concerns and an uncertain global macroeconomic environment as an entry point in purchasing the stock.
We trimmed or sold outright positions in Financials and Technology, including full positions in Goldman Sachs Group and Morningstar. Although Goldman offered good value, the company is confronting a dramatically changed and much more onerous regulatory environment. We used the proceeds to reduce the stake in Financials and add to existing or new ideas where we had greater trend confidence. Morningstar had performed well over the long run, but we sold the stock to fund other investments that we felt were better relative opportunities.
TAMRO Capital Partners
As of September 30, 2012, Apple comprised 5.08% of the portfolio's assets, Phillips 66 – 2.03%, Royal Gold – 2.28%, Allergan – 1.92%, Boeing – 1.76%, Bed, Bath & Beyond – 1.52%, Express Scripts – 1.72%, Qualcomm – 1.95%, and Walgreen – 1.51%.
Note: Small- and mid-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.