4th Quarter 2012
Substance Over Style
Mid-cap stocks outperformed large- and small-cap stocks during the fourth quarter and full year 2012. This is not unusual, as mid-caps have demonstrated a history of outperformance that goes back at least 15 years (as measured by the performance of the Russell indices). We think mid-sized companies have certain characteristics that make them an attractive and distinct investment relative to other U.S. equities. Although mid-caps may exhibit more volatility than more-established large-cap companies they tend to have greater growth potential, whereas versus small-caps they typically have more stable business records and less volatility. Mid-sized companies are also preferred acquisition targets since they have the ability to provide a greater overall impact to an acquirer’s bottom line than smaller acquisitions.
The strength of mid-cap stocks was reflected in the absolute returns of the Fund as they exceeded that of the broad market S&P 500 Index and the small-cap oriented Russell 2000 Index for the quarter and the year. The portfolio’s performance did marginally lag that of its S&P Midcap 400 Index benchmark for both periods, however. No single stock had a dramatic effect on fourth quarter results, though an overweight stake in Technology detracted from relative performance as that sector underperformed the overall index.
Notable individual stock underperformers during the quarter were New York Times Company, Unisys, and Nuance Communications. After surging higher during the summer, New York Times pulled back on profit taking during the fourth quarter. The stock had been one of the Fund’s top performers during each of the two previous quarters. Unisys suffered from softer demand in their services and federal business following strong earnings during the first half of the year. Nuance is transitioning to an on-demand business model, which caused a revenue miss that disappointed investors.
Top performing stocks during the quarter included Cree, Southwest Airlines, and Varian Medical Systems. Cree, a leader in LED lighting products, was added to the portfolio in 2012. The company reported stronger than expected earnings, market share gains, and margin expansion. Southwest rebounded from a weak third quarter performance after announcing new revenue initiatives and significant share repurchases. Medical device manufacturer Varian made significant share repurchases and delivered strong results during the quarter, with orders, revenue, and earnings all above analysts’ expectations.
Full Year Highlights
As we noted in last quarter’s commentary, the portfolio is structured and managed to participate in the long-term growth of companies across a variety of market environments. The recent choppy market environment has provided opportunities to add to strong secular growers suffering temporary setbacks in their stocks and to trim positions that have appreciated substantially. These changes were conducted with an eye toward company fundamentals that we think are best understood in the context of longer time horizons. Thus, we note some of the highlights of the past year as examples of this investment philosophy in action.
Printing and image service company Lexmark International was the Fund’s worst performer during the year. Two thousand twelve marked a year of transition for the firm as they implemented a major restructuring plan to diversify their revenue base and offset secular printing challenges. The company exited the inkjet business in order to focus on its managed print services and software capabilities. Lexmark returned 50% of its free cash flow to shareholders through significant buybacks and dividends, and remained a bargain trading at near book value by the end of the year. We added to the Fund’s position near its third quarter lows prior to a significant rebound in the stock prior to year-end.
Two other major detractors during the year were FMC Technologies and previously mentioned Nuance Communications. FMC provides equipment for deep-sea oil production. Although the company delivered impressive year-over-year earnings growth, they uncharacteristically missed four quarters of consensus earnings estimates citing North American weakness, higher project costs, and supply chain issues—all of which helped to drive the stock down. The execution issues are in part a function of higher volumes and the challenges associated with managing growth, including adding employees. The company’s order backlog is solid and the long-term outlook for deepwater oil development and production is strong. Thus, we added to the portfolio’s position.
Nuance was the Fund’s best performing stock in 2011, but gave back some of its gains after delivering disappointing results in the first and fourth quarters. Nuance presents a strong long-term secular play on voice recognition technology, where it is the industry leader, particularly in the consumer (automobiles) and healthcare (digitization of healthcare records) markets. After having trimmed the position earlier in the year at higher levels, we maintained the position amid its fourth quarter struggles.
Media conglomerate Gannett publishes more than 80 daily U.S. newspapers with affiliated online sites, including USA Today. Strong broadcast revenues, mainly from Olympic coverage and political spending, more than offset weak print advertising in making the stock the portfolio’s top performer for the year. With an increase in digital subscribers and the successful implementation of a “pay wall” model, we think the stock is still attractively valued relative to its fundamentals, though we did trim the position given its substantial appreciation during the year.
Long-time holding Akamai was another top-performer during the year. The firm announced better than expected results in each quarter and continued its strong execution in all geographical regions despite weak macroeconomic trends. The announcement that Co-Founder and Chief Science Officer Tom Leighton would take the position as the new CEO cleared up uncertainties about the company’s strategic direction and future leadership. Although we think the company remains poised to benefit from current significant Internet traffic and security trends, we trimmed the position after its strong 2012 such that it is not a top-10 holding for the first time in several years.
Finding Value in “Value” Stocks
In a year that saw many value investors dipping into traditional growth areas of the market, we found value in “value” stocks. This is not a change in our investment philosophy as much as a reflection of current market dynamics. The difference between so-called growth and value is typically little more than the priority between bottom line growth and price. As companies’ results are negatively affected during difficult times, stock prices often fall farther than fundamentals would warrant. Such has been the case for us during the past year, as companies that we think have strong long-term growth characteristics have become cheaper amid greater short-term uncertainty. Thus, they still have the growth that we look for, but have become “value” stocks as reported by third-party quantitative ranking systems published by firms such as Morningstar and Russell.
During the last twelve months, several stocks have been added to the portfolio based on being significantly cheaper relative to their fundamentals than others reduced or eliminated as they have met the market’s growth expectations and appreciated significantly. This “re-balancing’ comes as a natural result of our investment process that seeks to fund the best blend of price and long-term fundamentals. This has positioned the portfolio closer to the so-called value end of the spectrum in recent quarters. To be clear, we do not manage the portfolio in terms of the “style box” or weight it with a specific percentage of value or growth stocks. We invest where we see the greatest opportunity to capture upside potential by investing in companies that we believe are undervalued yet still offer strong long-term growth.
We remain positive on the global economic outlook. The U.S. recovery is progressing, growth in China has improved, and Europe is stabilizing. In the U.S., employment, auto sales, and the housing market are improving and business and consumer confidence are trending upwards. Lower energy prices should also enhance economic growth, while merger and acquisition activity has picked up pace and may even get stronger during 2013.
The political situation in Washington unfortunately remains clouded. The “fiscal cliff” became a “slope” with government spending cuts not taking place, but still under consideration. Still, most U.S. companies are in good financial health while undertaking significant share-buyback programs and increasing their dividends that has aided stock prices.
We think the portfolio overall is attractively valued relative to the earnings and growth potential of its holdings as well as those in benchmark. At the same time, we believe the portfolio’s mid-cap holdings have a better balance sheet profile and the potential to be more profitable. Holdings are well-diversified geographically, have the ability to grow market share, and in many cases represent “must have” products or services able to make their clients more efficient.
Thyra E. Zerhusen, Chief Investment Officer
Marie L. Lorden, Portfolio Manager
Mary L. Pierson, Portfolio Manager
As of December 31, 2012, New York Times Company comprised 3.17% of the portfolio’s assets, Unisys – 2.12%, Nuance Communications – 2.20%, Cree – 2.21%, Southwest Airlines – 2.86%, Varian Medical Systems – 2.69%, Lexmark International – 2.53%, FMC Technologies – 2.33%, Gannett – 3.35%, and Akamai Technologies – 2.81%.
Note: 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.