3rd Quarter 2012
Equities rallied off their early June lows in anticipation of another round of quantitative easing (QE3) during the third quarter, and the market was not disappointed when the Federal Reserve announced plans in mid-September to purchase $40 billion of mortgage-backed securities per month indefinitely. This followed plans announced by the European Central Bank to begin its own purchases of sovereign debt. The last hurdles for investors now seem to be clarity on how the “fiscal cliff”—a huge package of tax increases and government spending cuts set to take effect next year—will be resolved and steps the Chinese government might take to support its flagging economy. How the fiscal cliff gets resolved will depend heavily on the outcome of the upcoming U.S. elections. As for China, investors will have to wait for the decennial government transition later this year to determine what, if any new policies emerge.
In the meantime, global economic growth has slowed. The downturn in Europe deepened during the quarter and Emerging Market growth continues to be lackluster. After increasing at an annual rate of only 1.7% during the first half of 2012, U.S. real Gross Domestic Product (GDP) may show little if any improvement during the second half of the year. It has become increasingly clear that potential GDP growth for the U.S. economy is capped at about 2% as the private sector continues to deleverage and the public sector reduces its deficits and debt. Consumer spending trends have moderated and business investment spending is showing broad-based weakness, likely due to election and fiscal cliff uncertainties. Reduced government spending continues to be a drag on growth, while exports have weakened due to the slowdown in the global economy. We think failure to properly deal with the fiscal cliff will increase the downside risk to growth and increase the chance of a downturn in economic activity during the first half of 2013.
We have maintained for some time that, as investors determine that the ongoing deceleration in corporate profits is a likely precursor to an extended period of modest growth in earnings, the Fund’s high-quality growth holdings should do relatively well as their earnings growth is more certain. We are optimistic that recent results are an indication of the early stages of just such a shift in leadership. The Fund slightly lagged its composite 60% S&P 500 Index/40% Barclays US Government Credit Index benchmark, with its equity holdings mostly in line with the broader market and a tilt toward higher quality intermediate Corporate bonds lagging lesser quality issues.
Solid stock selection in the Technology, Consumer Staples, and Energy sectors along with an underweight stake in lagging Industrials aided performance during the quarter. Qualcomm, eBay and Accenture all outperformed within Technology, offsetting an underweight position in the sector. Energy stocks rebounded, with Cameron International outpacing its peers by a wide margin.
Other notable individual contributors were General Electric, Monsanto, and Amazon.com. GE reported second quarter results showing excess cash from GE Capital directed toward share repurchases and dividend growth. We think the company’s business mix is proving resilient amid the uneven macroeconomic backdrop, including operating margin expansion among its industrial businesses. Monsanto continued its strong relative performance within the Materials sector, while we trimmed Amazon twice during the quarter as the stock appreciated above our estimated present value.
The Fund’s holdings in Consumer Discretionary and Healthcare offered mixed performance, with some stocks doing extremely well while others lagged. Although a position in Apple continued to exceed expectations, gaining nearly 15% during the quarter, it was a relative drag on performance. The stock has become more than 8% of the Russell 1000 Growth. We trimmed the portfolio’s stake again during the quarter in maintaining less than a 5% weighting in accordance with our risk control parameters. United Parcel Service also detracted from relative returns after the company reported disappointing second-quarter results and issued a cautious outlook. We trimmed the position in UPS as a result.
Philip Morris International
The Fund initiated a position in Philip Morris International during the quarter. We think the company has a superior geographic footprint and brand portfolio. Favorable pricing and reasonable excise tax environments are driving profits, while strong operating performance has boosted cash generation allowing the company to repurchase shares and increase its dividend. We built up the position several times during the period, including after a 10% dividend hike that pushed its yield close to 4%. We believe that the earnings outlook for the company will continue to improve into the fourth quarter.
Notable additions to current positions include Starbuck’s, Express Scripts, Juniper Networks, and Google. We added to Starbuck’s after the stock was weak following disappointing fiscal third-quarter results and lowered guidance. We continue to believe the company has a number of significant growth drivers that should help sustain its double-digit growth rate. We increased Express Scripts following the company’s strong second-quarter earnings report and increased 2012 earnings guidance. Client retention is high, and mail penetration and generic dispensing rates are increasing, trends which support higher earnings growth than previously expected.
We added to the Fund’s stake in Juniper following confirmation from Verizon regarding our expectation for accelerating carrier capital spending in the second half. The stock was trading at all-time low valuations, and the company has ample cash reserves—which we believe allows the stock more upside potential. We think Google remains attractively valued and see signs that the company will have accelerating earnings growth in the fourth quarter.
Visa, Costco, and Colgate-Palmolive were trimmed after either trading at all-time highs or close to our estimated present value. Visa recently reported bank credit card data that implied spending volumes were a bit more moderate during the second quarter than previously expected. Elsewhere, we trimmed Schlumberger early in the quarter given weak economic data and the likelihood that second-quarter earnings would be lackluster for oil service companies based on commentary and pre-announcements from several companies. We also reduced the portfolio’s stake in McDonald’s after the company reported disappointing second-quarter earnings caused by lower revenues and cost pressures.
Bond yields are likely to be volatile within a narrow range over the coming quarter. Weak economic growth, continued bond purchases by the Federal Reserve and a flight to quality should continue to keep yields low. Positive developments in Europe, however, could cause a spike in U.S. bond yields as investors reverse out of such safe haven assets. Uncertainty around the U.S. election may also contribute to volatility as we approach year-end, with decisions necessary with regard to the “fiscal cliff” and an extension of tax cuts and/or the imposition of sequestration. Given the uncertain outlook, we have modestly reduced the degree to which the bond portfolio is shorter in duration (a measure of interest-rate sensitivity) than the benchmark, but it is still shorter and we continue to view the risk/reward tradeoff for longer-term bonds unfavorably. We also continue to favor high-quality intermediate Corporate bonds as we think the search for incremental yield in a low interest-rate environment should allow this sector to outperform.
Although central bank actions have been supportive of equity prices and have historically helped to limit downside risk in the market, stocks may have gotten ahead of underlying company fundamentals. It would not be surprising if the period ahead were more challenging. Global economic growth has weakened; corporate profit growth has slowed; corporate profit expectations seem too high given the global growth slowdown and near-peak profit margins. It is doubtful that the weakening economic and profit growth fundamentals, along with the political uncertainties of the upcoming election and fiscal cliff, have been adequately discounted given current market levels.
That said, we believe the outlook for the higher quality growth stocks held in the Fund is very promising. We think the shares of these companies are reasonably valued given their financial strength and global diversification. In addition, many of the Fund’s holdings have above average dividend yields and dividend growth prospects. We expect both growth and yield to be scarce in the years ahead as the developed world de-leverages and the Federal Reserve strives to keep both short and long-term interest rates low.
Montag & Caldwell Investment Counsel
As of September 30, 2012, Qualcomm comprised 2.31% of the portfolio's assets, eBay – 1.47%, Accenture – 0.95%, Cameron International – 1.59%, General Electric – 2.55%, Monsanto – 2.18%, Amazon.com – 0.68%, Apple – 2.63%, United Parcel Service – 1.33%, Philip Morris International – 1.60%, Starbuck’s – 1.32%, Express Scripts – 1.77%, Juniper Networks – 0.99%, Google – 1.71%, Visa – 1.69%, Costco – 1.75%, Colgate-Palmolive – 1.75%, Schlumberger – 0.94%, and McDonald’s – 0.92%.
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.