1st Quarter 2013
Congress finally provided some near-term clarity on the U.S. tax structure at the beginning of 2013. This visibility, combined with ongoing monetary stimulus from the U.S. Federal Reserve and a modest improvement in U.S. economic activity, fueled a significant rally within the equity market, while bonds were mostly flat.
The Fund slightly trailed its composite 60% S&P 500 Index/40% Barclays US Government Credit Index as the growth leaning equity portion of the portfolio lagged the broader market S&P 500 during the quarter. An underweight position in Industrials combined with a smattering of holdings in Technology and Energy were the primary detractors on the equity side.
Tech firms Juniper, Oracle, and EMC declined as investors became concerned about a reduction in corporate information technology spending. We trimmed the portfolio’s position in Oracle after the company reported disappointing fiscal third-quarter results. We think the combination of economic uncertainty, starting with the fiscal cliff and more recently the sequester, is causing company chief financial officers (CFOs) to tighten purse strings. At the same time, corporations are seeing a heightened level of technology disruption associated with the cloud, big data, in-memory storage, and BYOD (bring your own devices into the workplace). We added to EMC, however, as the weak year-to-date performance provided an attractive valuation for a company we expect to deliver stronger relative earnings strength in 2013.
Occidental Petroleum continued to lag the energy sector and detracted from performance. We added to the position after the company's fourth quarter results provided evidence that management is making progress towards its goal of reducing operating costs per barrel back toward 2011 levels. Production volumes, driven by oil, were ahead of expectations, and the company raised the dividend—providing valuation support for the stock.
Strong Healthcare and Staples
Positives on the equity front during the quarter included overweight positions in the surging Healthcare and Consumer Staples sectors, and an underweight Technology stake. Healthcare was the top performing sector among the large-cap indices, with a sharply rising holding in Allergan boosting the portfolio’s returns. Consumer Staples stocks weren’t far behind, with Costco contributing positively to results.
Although Technology suffered mightily on absolute terms from the continued and notable decline in Apple, the Fund benefitted on a relative basis from its underweight stake versus the benchmark. We had reduced the portfolio’s position in Apple after the company issued a range of guidance that fell below analysts' expectations. Earnings guidance appears to be coming down as the strong iPhone launch quarter tends to lead to greater seasonal slowing, while the continued enthusiasm for the iPad Mini putting downward pressure on gross margins from a shifting product mix. We further trimmed the position later in the quarter on concerns that the company is not positioned competitively in the smartphone market due to consumers’ preference for a larger screen size. The company’s production schedule may prohibit it from launching a competitive product until 2014.
Elsewhere, General Electric rebounded from a lagging fourth quarter to help performance in the solidly performing Industrials sector to offset the Fund’s underweight position. Monsanto outpaced other stocks in the lagging Materials sector in contributing to relative performance.
More Equity Buys and Sells
We established a position in diversified global healthcare company Sanofi during the quarter. The company is a leader in Emerging Markets, is well positioned in the diabetes and vaccines markets, and is benefiting from strong launches in its Consumer Health Care division and its companion animal care market. We continued to build the position as the stock price weakened on 2013 guidance that was modestly below analysts' estimates. Despite the near-term headwinds, we think the company remains on track to meet its 2012-2015 growth and dividend objectives.
We added American Express to the portfolio as the company has expense flexibility and has shown a propensity in recent quarters to return 100% of net income to shareholders in the form of dividend payments and share repurchases. The stock was trading at a rare price/earnings multiple discount to the S&P 500 and at a wide multiple discount to competitors Visa and MasterCard, despite having shown the ability to deliver solid earnings in an uncertain environment. In addition, the company has restored confidence that the credit profile of the company’s customers has improved through lower credit losses and delinquencies.
Notable additions to current positions during the quarter included Biogen IDEC, United Parcel Service, and Nike. We increased the portfolio’s position in Biogen after the stock price weakened following news that the phase 3 trial of the company's ALS (Lou Gehrig’s disease) product failed. Although the failed trial was disappointing, we believe the lower price presented an attractive opportunity to add to the stock ahead of the company's oral Multiple Sclerosis (MS) therapy launch. We added to it further after subsequent quarterly results demonstrated stable demand in the company's major franchises and after U.S. approval of the company's oral MS product.
International trade volumes, particularly out of Asia, are improving at UPS as its domestic ground business remains solid due to e-commerce. Recent cost actions to boost profit margins should also lead to stronger earnings momentum as we move through 2013, and we expect the company to further support the share price with a sizable share repurchase and another dividend increase.
Nike continued to deliver better-than-expected gross margins and enjoy robust sales in North America. The company has also taken decisive action to position itself for sustainable growth in China by focusing on building brand connections with consumers, improving productivity and profitability, and adapting apparel products to align with the needs of Chinese consumers. The company has a consistent record of delivering growth in revenue, earnings, and cash returns to shareholders, and proven its ability to sustain long-term growth opportunities. Nike has a diverse business mix and we think has the necessary financial discipline and balance sheet strength to effectively manage risk in a volatile environment.
Two positions were sold from the Fund during the quarter. Express Scripts was eliminated as benefits from the company's merger with Medco are waning and we think earnings growth will decelerate sharply. This reflects the roll-off of additional United Health claims and the fully consolidated post-merger comparisons of the last nine months of 2012. We also sold the small remaining position in Las Vegas Sands after the stock price moved up nicely on signs that the Chinese economy has turned the corner, resulting in a stock price that was close to our estimate of fair value.
Elsewhere, Abbott Labs spun off its pharmaceutical division at the beginning of the year. Although the Fund kept the “new” Abbott, as the company's diverse mix of businesses provides ample opportunity for margin expansion and earnings upside relative to analysts' muted expectations, we sold the spun-off AbbVie pharmaceutical division. AbbVie relies heavily on the Humira drug, and we do not have confidence that the company will be able to achieve the 10% earnings growth that we require over the long term.
Treasury yields rose slightly during the first quarter as the economy improved. Despite the improvement, we continue to expect a range-bound environment for Treasury yields. Federal fiscal headwinds are likely to cause Gross Domestic Product (GDP) growth to downshift, and we expect the Federal Reserve to continue its bond buying program, limiting further increases in yields such as normally occur in an economic expansion.
Investors are likely to continue to seek incremental yield in the low interest-rate environment, and this demand should lead to continued outperformance of Corporate bonds. While we continue to favor high-quality, intermediate Corporates, we have modestly reduced the degree to which the portfolio is overweight the sector on the fixed-income side. This is because the yield differential, or spread, between Corporate and Treasury bonds has narrowed to its long-term average, implying that the performance advantage to Treasuries is now more limited. We remain defensively positioned in terms of duration, or interest-rate risk, reflecting the poor risk/reward opportunity in the low-yield environment.
The stock market could be in what strategists describe as a sweet spot of moderate economic growth, low inflation, and accommodative Federal Reserve monetary policy. Nevertheless, we think it is extended after recent gains, and a pullback in share prices would not be surprising as economic growth most likely slows in the period ahead. We believe any stock market setback to be limited, however. Recession risk is low, monetary policy expansive, stock market valuations fair to full, though not extreme, and investors are enthusiastic, but not yet euphoric.
Although the Fund has fully participated in the market’s advance, we believe its high quality holdings remain reasonably valued with the opportunity for greater earnings growth due to their financial strength and global diversification. In addition, many of the Fund’s holdings have above-average dividend yields and dividend growth prospects. We think both growth and yield will be scarce in the years ahead as the developed world deleverages and the Federal Reserve strives to keep both short and long-term interest rates low.
Montag & Caldwell Investment Counsel
As of March 31, 2013, Juniper Networks comprised 1.23% of the portfolio's assets, Oracle – 1.18%, EMC – 0.97%, Occidental Petroleum – 1.34%, Allergan – 2.02%, Costco – 1.46%, Apple – 0.57%, General Electric – 2.25%, Monsanto – 2.43%, Sanofi – 1.96%, American Express – 1.00%, Visa – 1.77%, Biogen IDEC – 1.51%, United Parcel Service – 2.02%, Nike – 1.50%, and Abbott Laboratories – 2.10%.
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.