4th Quarter 2012
Climbing a Wall of Worry
The markets faced several headwinds in 2012, including recession in Europe, slowing growth in Emerging Markets, sluggish Gross Domestic Product (GDP) growth in the U.S., deteriorating corporate profit growth, a contentious presidential election, and political gridlock over the "fiscal cliff". Even so, markets climbed the proverbial wall of worry and U.S. stock indices notched solid gains in 2012. In fact, despite all of the issues confronting investors, at no point during the year did the broad market S&P 500 Index fall into negative territory. That said, the gains were largely made during the first quarter. Although stocks advanced nicely off their early June lows, the major market indices finished the year at roughly the levels first reached in April.
Despite the worrisome headlines, there were a few positives supporting stocks in 2012. Resilient corporate profit margins (despite slowing profit growth), an easing of strains in European sovereign debt markets, and an incipient recovery in the U.S. housing market were just a few of the catalysts that drove the stock and bond markets higher. Perhaps most importantly, the Federal Reserve and other global central banks continued to provide abundant liquidity via low interest rates and asset purchases (quantitative easing). While we have been skeptical that such monetary policy would improve economic fundamentals, with economic data throughout the year seeming to support that contention, the Fed has been able to engineer higher stock and bond prices through their unwavering commitment to unconventional monetary policies. Although the risks of unwinding these measures are unknown, the market seemed content to ride the excess liquidity higher.
This liquidity-driven market environment was evident in the underlying performance dynamics of the market. The hallmark of liquidity-driven rallies has historically been the outperformance of lower-quality stocks and more-cyclical sectors, with 2012 seemingly another textbook example. According to BofA/Merrill Lynch Quantitative Strategy Research, low-quality stocks (those ranked B-minus or worse) outperformed higher quality names (B-plus or better) by roughly 3 percentage points during the year, with the Financials and Consumer Discretionary sectors, more cyclical by nature, pacing the broader market. While we expected the market to grind higher in 2012, we were surprised by these leadership characteristics. Our expectation that higher-quality, more-defensive growth stocks and sectors would provide market leadership proved off the mark despite macroeconomic fundamentals unfolding much as we anticipated.
The Fund finished the fourth quarter of 2012 in slightly positive territory, lagging its Russell Midcap Growth Index benchmark. For the year, it significantly underperformed the index. Weak stock selection was the primary driver of the underperformance for both periods.
Holdings in Financials, Energy, and Consumer Staples were the biggest drag on performance during the quarter. Financial services firm MSCI shares fell sharply after mutual fund company Vanguard announced a plan to transition their index funds away from MSCI indices. Given the implications the Vanguard announcement has for both near-term profit forecasts and longer-term growth possibilities, we sold the position from the portfolio. Specialty grocer Fresh Market within Consumer Staples fell after a disappointing earnings report in October. Our investment disciplines requires we take action following major profit disappointments, either buying if we deem the shortfall to be transitory in nature or eliminating the position if we think it undermines our original investment thesis. We added to Fresh Market as the earnings disappointment, which centered mostly on higher than expected expenses associated with new store openings, did not weaken our belief that the company has robust growth potential.
Oil and gas equipment provider Core Laboratories pre-announced weaker than expected third quarter results in the Energy space. The shortfall was attributable to a let up in Canada and in gas-directed drilling, both well-known pressures that haven’t been completely offset by strong oil-related trends. International and deep-water results continue to show steady improvement, and with the second half of 2012 looking like a potential bottom for North American activity levels, we think the set-up into 2013 looks more promising.
Stock selection in Consumer Discretionary, Technology, and Healthcare was positive, aiding relative returns. Apparel maker Warnaco was among the Fund’s top performers during the quarter, as it agreed to be acquired by another portfolio holding, PVH Corp, at a substantial premium. We sold the portfolio’s position following the announcement. Juniper Networks and Amphenol were the two standouts within Technology, while Varian Medical Systems enjoyed strong gains after reporting a strong fiscal fourth quarter that demonstrated better than expected revenues, margins, and orders.
Temporary staffing company Robert Half within Industrials was another top individual contributor. The company benefitted from ongoing positive job growth and could profit from the implementation of President Obama’s Affordable Care Act if businesses turn to temporary staffing to avert the added costs the program levies on employers.
Positioning and Outlook
In addition to the sales of MSCI and Warnaco, the Fund exited its position in Omnicom given a subdued outlook for the global advertising firm. New additions to the portfolio included San Francisco-based First Republic Bank, which provides banking and wealth management services to high net worth individuals, and discount retailer Dollar Tree.
Now nearly four years into a recovery, the current market environment is a study in contrasts. Housing appears to have bottomed as corporate profit margins appear to be peaking. Consumers have worked to restore balance to their finances, while much heavy lifting remains to repair our country’s fiscal situation. Chinese growth appears to be stabilizing while the European Union remains mired in recession. We think these offsetting factors will continue to create market volatility as we progress through 2013. More importantly, we think valuations for quality growth stocks remain attractive. In an environment in which earnings growth may be scarce and less predictable than perhaps the market is anticipating, we think the Fund is well positioned to deliver positive and more-differentiated returns relative to the benchmark in the year ahead.
M. Scott Thompson, CFA Andrew W. Jung, CFA
January 7, 2013
As of December 31, 2012, MSCI comprised 0.00% of the portfolio’s assets, The Fresh Market – 1.50%, Core Laboratories – 1.37%, Warnaco Group – 0.00%, PVH Corp – 2.20%, Juniper Networks – 2.72%, Amphenol – 2.40%, Varian Medical Systems – 2.14%, Robert Half International – 2.75%, First Republic Bank – 1.53%, and Dollar Tree – 1.44%.
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.