1st Quarter 2013
Climbing the proverbial “wall of fear” equities in general—and the small-cap market in particular—shrugged off January concerns about the “fiscal cliff” and sequestration of government spending on the way to posting double-digit gains for the quarter. In addition, the market overcame varying bouts of investor anxiety regarding the effects of higher payroll taxes on consumer spending, the potential effects of Cyprus bank failures on the European continent, and the flare-up of tensions on the Korean Peninsula.
U.S. economic data came in generally better than expected and U.S. housing continued its recovery, buoying personal consumption through the so-called wealth effect. Thus far, consumer outlays have been strong enough to mitigate the dwindling growth in state and municipal spending. Company management teams at several of the Fund’s holdings have indicated that their U.S. businesses are in decent shape and that there seems to be a trend toward shorter supply lines and a bolstering of U.S., Mexican, and Canadian manufacturing at the expense of Western Europe and the Far East. All of which bodes well for the economy and the U.S. stock market.
Quality trends within the Fund’s Russell 2000 Value Index benchmark were mixed for the quarter, with larger market-capitalization companies outperforming smaller ones. Companies whose share price was more than $20 outperformed those under $5, and companies with earnings outperformed non-earners. The exception was companies with high debt levels, which also outperformed. Overall, we would suggest that the portfolio experienced a modest tailwind towards our higher-quality approach to picking stocks.
Stock Picking Boost
The Fund outperformed its benchmark during the quarter, boosted primarily by strong stock selection within Consumer Discretionary and an overweight stake in Industrials. AFC Enterprises (owner and operator of the Popeyes fast-food restaurant chain) was the portfolio’s best performing individual stock. The company continued to execute extremely well. We trimmed the position during the period, however, as the shares appear fairly valued. Although an overweight to the Materials sector, one of the worst performing areas of the benchmark, hurt relative returns, stock selection within the sector was strong. Specialty paper manufacturer Glatfelter led the way after rallying on news of its announcement of a potentially accretive acquisition.
Sector allocation was a modest negative during the quarter, as an underweight position in Financials and the aforementioned overweight to Materials weighed on returns. The poor relative performance of the portfolio’s real estate investment trust (REIT) holdings added to the woes within Financials.
Lackluster Healthcare holdings were the primary detractor from relative returns, however, with Invacare the single-worst performing stock. A cessation of production at a wheelchair plant as part of a consent decree with the Food & Drug Administration (FDA) hampered the company. Invacare has spent considerable funds and management time addressing the issues raised by the FDA, and think they have made considerable progress in remediation. We have struggled with the stock given the earnings potential and likely appreciation should they receive a clean re-inspection by the FDA and make progress on longer-term margin goals. We decided we did not have enough conviction to add to the Fund’s small holding given the uncertainty, and began selling the position late in the quarter.
We initiated five new positions in the Fund during the quarter, including PacWest Bancorp, M/A–COM Technology Solutions (MTSI), and Mentor Graphics. PacWest is the 12th-largest bank based in California and offered a solid management team, reasonable valuation, franchise value, above-average dividend yield, and potential to exceed consensus earnings targets following its consummation of the pending acquisition of First California. We think the bank represents a nice geographic diversification from the portfolio’s existing exposure to regional banks.
MTSI is one of the market leaders in the high performance radio frequency and microwave semiconductor markets. Our feeling is that the company was orphaned after being purchased by AMP in the late ‘90s and subsequently becoming part of Tyco. Under relatively new leadership we think the company has a chance to improve results, moving margins closer to its well-regarded competitor Hittite Microwave.
Mentor Graphics is the smallest of the “Big 3” in EDA (Electronic Design Automation) software, behind Synopsys and Cadence Design Systems. We think the industry can continue to post solid revenue growth in a reasonable environment for semiconductor research and development spending. Under pressure from activist shareholder Carl Icahn, Mentor has improved margins but still has some room to catch the industry leaders. We think the large discount to its peers and historical valuation are excessive and with continued good execution expect the stock to gap to close.
We sold three stocks from the portfolio during the quarter, one after the company (Duff & Phelps) received a proposed takeout offer. We reluctantly threw in the towel on ScanSource, an interesting and valuable niche tech company. The shares have been mired around the $30 level for 10 years, with periodic rallies to the high $30s followed by downdrafts to the high $20s. We are tired of the treadmill and think our energy can be put to better use elsewhere as we find we lack sufficient enthusiasm to take a more meaningful position.
Recent results at aerospace firm Cubic were below expectations due to a generally weak environment on the defense side of the business, and start-up costs on some transportation contracts. With the passing of the CEO, we expect some type of stock sale by the family. Although possible that the entire company might be sold, we prefer not to anchor our investment thesis on a sale. The shares appear undervalued, but the next few quarters might be difficult in the current environment and we have less confidence in estimating “normalized” earnings.
From a thematic perspective, we continue to favor the economically sensitive areas of the market, since the macroeconomic environment in the U.S. continues to improve at a measured pace. After nearly seven years of acting as a drag on Gross Domestic Product (GDP), housing’s self-sustaining recovery troops along, underpinned by still tight supply-demand conditions, historically high affordability, and rising prices. The wealth effect on individuals should reinforce confidence along with modest improvements in job growth.
We continue to believe the portfolio is attractively valued. Corporate balance sheets are in excellent shape, and most companies continue to generate healthy amounts of free cash flow. We finally saw one of the Fund’s companies become a takeout target at the end of 2012, and remain convinced that there is significant pent up demand for more deals. Talk of a potential U.S. “manufacturing renaissance” might make the greater U.S. exposure of small-cap stocks more attractive to foreign corporate buyers as well as to U.S. equity investors.
Silvercrest Asset Management Group
New York, NY
As of March 31, 2013, AFC Enterprises comprised 1.77% of the portfolio's assets, Glatfelter – 2.75%, Invacare – 0.64%, PacWest Bancorp – 1.53%, M/A-COM Technology Solutions – 1.27%, and Mentor Graphics – 1.23%.
Note: Small-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.