4th Quarter 2012
The Year of the American Consumer
Stocks delivered above average, double-digit returns for U.S. equities in 2012, with large-cap stocks (represented by the Russell 1000 Index) beating out small-cap stocks (Russell 2000 Index) by a nose. Value stocks outdistanced growth by more than two percentage points in both areas, with most of the outperformance for value coming during the fourth quarter. The main reason behind these results seems to be increasing investor appreciation for improved fundamentals within the Financials sector, which was the top-performing large-cap sector and among the top-three areas in the small cap universe. Along with improved fundamentals, financial services companies seem to be successfully adapting to their new regulatory environment. If the much-improved trend for the group were to continue, it would be a significant positive for the market and the economy.
The slow but steady expansion of the economy that we anticipated did occur in 2012, marked by dramatic improvement in the housing market and grudging improvement on the jobs front. Those two factors helped to push consumer confidence to a four and a half year high. As confidence has improved and the consumer de-levered, Americans have gone back to doing what we do best—shop. Given that approximately two-thirds of U.S. Gross Domestic Product (GDP) is comprised of consumer spending, the confidence and expenditures of consumers is the key to growth going forward. Interestingly, in the nearly four-year period since the recession trough in 2009, the Consumer Discretionary sector has been the best-performing large-cap sector and among the top-three for small-caps. We think further appreciation in home prices, improved access to credit, and steady, if unspectacular, job growth should help to accelerate this trend as we move through 2013.
Late Year Rally
Stocks moved higher in November and December, helping the Fund’s Russell 1000 Index benchmark to recoup its October losses in barely edging into positive territory for the quarter. The Fund, however, did not finish in positive territory, as relatively weak stock selection caused it to underperform the index. Stock selection in the Technology, Healthcare, and Financials sectors was the biggest detractor on an absolute basis, with Healthcare also underperforming the benchmark the most.
Athenahealth and Express Scripts were among the laggards in Healthcare. Online recordkeeping and health-services company Athenahealth dropped sharply after reporting quarterly revenue and bookings that were lower than expectations. The stock rebounded somewhat during the December rally, but not enough to prevent it from being one of the Fund’s five worst performers for the quarter. Pharmacy benefit manager Express Scripts reported strong quarterly results, but indicated that 2013 earnings estimates may be too aggressive. This raised visibility concerns regarding participant enrollment for its health plan customers.
The two biggest individual detractors from performance were Apple and Royal Gold. Apple sold off after the launch of its latest version of the iPhone on fears of softer demand. We still think Apple is an industry innovator that has built a powerful digital media ecosystem that commands premium pricing for its devices. Significant app and digital media sales have generated record levels of cash for the company, which we think it will now begin to return to shareholders in the form of stock buybacks and dividends. Royal Gold was hit by the falling price of gold plus the issuance of stock to fund the purchase of additional royalties. We believe the company’s unique business model enables investors to capture value in the precious metals sector without incurring many of the operating risks associated with owning and managing physical assets. Led by an experienced management team, Royal Gold has used its ample capital position to invest in attractive assets during periods of industry weakness, leaving it positioned to produce significant earnings growth going forward.
On the positive side, holdings in Industrials, Energy, and Telecommunications aided both absolute and relative returns. Top-10 holding Colfax was a top stock for the second quarter in a row as management provided details on its growth strategy during the firm’s first ever analyst day meeting. The firm is a key supplier of piping systems to a variety of industries building out global energy infrastructure. Chicago Bridge & Iron was another Industrials stock that performed well, as it completed a major acquisition that fueled improving contract performance. Management also delivered positive guidance and outlook for 2013.
The portfolio’s biggest winner was CarMax—the leader in the used-car superstore niche. The stock rose on strong quarterly results driven by improved sales conversions in response to attractive offers through the company’s financing segment. The firm appears to be successfully emerging from the economic turmoil and securitization market freezes that pummeled results in 2008-2009, with resumed plans for modest growth. Although shifts in consumer behavior and the financial markets can affect short-term results, the company seems to have built a better mousetrap that is hard for others to replicate.
As always, the portfolio’s positioning and sector allocations come from opportunities that we have identified through our bottom-up company fundamental analysis and valuation work. Only subtle changes were made during the fourth quarter, with Consumer Discretionary changing places with Financials as the top-weighted sector in the portfolio, followed by Healthcare. Year over year, the portfolio saw a significant decrease in exposure to Technology (the largest sector weight at the end of 2011), Industrials, and Energy, with those assets redirected toward opportunities in Consumer Discretionary and Consumer Staples. The changes from a year ago reflected a shift towards a strengthening domestic economy and the consumer, which altered the bottom-up dynamics. Financials was the lone survivor among the top-three sector weights from the previous year.
Eight stocks became full-positions through purchase, appreciation or a combination of the two during the fourth quarter, including American International Group (AIG), Kinder Morgan, and Mondelez International. The U.S. government effectively nationalized global insurance company AIG following the 2008 financial crisis. 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. We think the company is now well positioned to both grow market share and improve profitability.
Pipeline owner Kinder Morgan connects every link of the energy supply chain from producers to processors to refiners and consumers. The company charges customers a fee to use its infrastructure, much like a toll-taker charges a toll for the use of a highway or bridge, except it also requires a long-term contract. This business model has historically meant that the firm’s financial performance has been much less volatile than the prices of the commodities that rely on its infrastructure. With its economies of scale and scope, we believe the company is likely to be a major beneficiary of the coming energy infrastructure reconfiguration.
Mondelez International is the recently spun off global snacks segment of Kraft Foods that includes such worldwide favorite brands as Oreo, Cadbury and Trident. The company’s focus is on growing sales and earnings in underpenetrated Emerging Markets. It should also benefit from economies of scale and cross-selling opportunities afforded by its 2010 acquisition of Cadbury. With 15 “Power Brands” generating more than $500 million each in annual sales, we believe the company has ample assets to increase shareholder value over time.
Six full positions were sold during the quarter. Company-specific reasons led to the sale of AGCO and BMC Software, as AGCO reported quarterly results that were shy of expectations and lowered guidance for the year while BMC essentially put itself up for sale, thus limiting the long-term opportunity. The Fund pocketed profits from EOG Resources, F5 Networks, and Mosaic and used the proceeds to fund what we believe to be better relative opportunities. Finally, depressed shares in Iberiabank were replaced with another depressed name where we have more confidence in management’s ability to execute.
Full Year Recap and Outlook
Unconventional and accommodative monetary policy ultimately trumped investor concerns over fiscal policy, the Presidential election, and weakness overseas in making 2012 an above-average year for stock returns across the domestic market-cap spectrum. The Federal Reserve entered uncharted waters when it announced open-ended quantitative easing through the ongoing purchasing of government securities. Other central banks waded in by mimicking the Fed in word if not deed, further contributing to the global liquidity cycle. The domestic economy continued to expand while the housing and job markets recovered to boost consumer sentiment.
The Fund underperformed its benchmark for the full year owing to slightly negative stock selection, notably in sectors where the portfolio was actually positively weighted. Holdings in the Consumer Discretionary, Financials, and Technology sectors were the biggest detractors to relative performance, with names such as Tempur-Pedic International, Bed Bath & Beyond, and Goldman Sachs among the major disappointments. Energy, Consumer Staples, and Materials were the sectors that added the most to relative returns, with Athenahealth, Home Depot, and Phillips 66 among the top individual performers.
With the Federal Reserve indicating it will continue its easy-money policies until unemployment hits 6.5%, subject to inflation limitations, the markets entered 2013 with a significant tailwind and we anticipate ample investment opportunities in the new year. Although higher individual tax rates in the U.S. could weigh on sentiment and growth, the offset could be ongoing economic improvement in key Emerging Markets and perhaps even a stabilization of conditions in Europe. Here at home, we expect consumers to further find their footing and the overall economy to benefit from improving credit and lending conditions. On balance, we think the U.S. economy should continue to enjoy a slow and steady expansion, much like that which we have experienced recently. Interestingly, despite stocks significantly outperforming bonds during the past four years there have been large net outflows from equity funds into fixed-income securities. Maybe this year we could see investors begin to re-allocate assets back towards equities.
TAMRO Capital Partners
As of December 31, 2012, Athenahealth comprised 1.64% of the portfolio's assets, Express Scripts – 1.96%, Apple – 5.35%, Royal Gold – 2.09%, Colfax – 2.19%, Chicago Bridge & Iron – 1.75%, CarMax – 2.33%, American International Group – 1.51%, Kinder Morgan – 1.52%, Mondelez International – 1.39%, Tempur-Pedic International – 0.72%, Bed, Bath & Beyond – 1.87%, Goldman Sachs – 0.00%, Home Depot – 1.98%, and Phillips 66 – 2.07%.
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.