2nd Quarter 2013
The Goldilocks Factor
The fundamental economic news during the second quarter corroborated our belief of a continued, albeit slow, expansion in the U.S. economy. There is evidence of a number of positive trends for U.S. equities. The ongoing mending of the housing market has been providing a significant boost to consumer sentiment and bank balance sheets. Consumers have de-levered, and the amount of household income going to debt service is at a decades low. Recent headlines notwithstanding, monetary policy remains highly accommodative in the U.S. and around the globe. U.S. corporations are flush with cash and companies are increasingly returning excess cash to shareholders via dividends and stock buybacks. The deficit profile of the U.S. has improved dramatically, at least in the near term. Finally, the recent transformation of the U.S. into an energy superpower is a development that should support U.S. manufacturing and lower domestic energy costs over the long term.
But what’s going on with interest rates? The major news during the quarter was the sharp rise in interest rates on a percent change basis. The move, combined with comments from the Federal Reserve that the central bank could taper its bond buying program, led to an acceleration in market volatility. Strictly based on fundamentals, the higher rates seemed excessive. Yet, it also revealed investors’ reliance on Fed-induced low rates. From our perspective, market forces have been less at work than those of Washington. Are rates too high or too low? At what level is the Goldilocks factor?
We think the environment is still attractive for stocks. The consumer continues to lead the way and the level of interest rates should reach a balance between Washington and our Goldilocks factor, market forces. Hang in there investors. Despite the volatility, it was a decent quarter for stocks and the domestic economy continues to expand.
The Fund was essentially flat for the quarter in underperforming its Russell 2000 Index benchmark by a sizeable margin. Poor stock selection in the Technology, Healthcare, and Financials sectors was the primary driver of underperformance. Corporate spending on technology has decelerated and competition has increased. Growth in consumer demand for smart phones seems to have plateaued and may be decelerating amid a period of few innovative product upgrades. This trend had a negative impact on holdings Aruba Networks, Cirrus Logic, and Ixia. Indeed, Aruba was one of the Fund’s primary individual detractors after management lowered revenue guidance amid slowing growth due to competitive pressures and a weak tech spending environment.
The rise in interest rates lowered sentiment towards companies in the Financials sector that had been executing well for the portfolio, namely real estate investment trusts (REITs) Redwood Trust and Colony Financial. REITs are often hard hit in a rising interest rate environment on fears it will translate into higher capitalization rates and lower net asset values for real estate portfolios. We believe the fundamentals of most of these companies remain intact and we have added to a number of holdings within Financials on weakness. Lastly, a keener competitive landscape and a deceleration in earnings growth affected Healthcare holdings such as Athenahealth, HMS Holdings, and Analogic.
Stock selection within the Energy and Consumer Discretionary aided relative performance, boosted by an overweight stake in the latter sector as well as an underweight allocation to struggling Materials. Grand Canyon Education and Monro Muffler Brake were two of the standouts in the Discretionary sector. Online education firm Grand Canyon delivered better-than-expected quarterly results and increased its earnings guidance. Monro’s sales trends turned positive during the period and it provided guidance ahead of expectations.
Given recent trends, we continue to orient the Fund toward better capitalized, better run companies able to participate in more domestic-facing industries such as Consumer Discretionary and Financial Services. As the U.S. consumer, the U.S. housing market, and the U.S. economy continue to come back, we think these companies should be well positioned.
We remain vigilant to fundamental changes and valuations at the company level, with sector allocations resulting from stock specific opportunities we identify. There were numerous changes at the stock level in the second quarter where we either took profits in names based on valuation or sold companies where there had been a deterioration in fundamentals. We then redeployed the proceeds to stocks where we thought the valuation had become out of line with fundamentals—in other words, the stock price became more attractive. The net result, after adjusting for returns, was an increase in the sector weight of Financials and a decrease to Healthcare.
Seven positions in the portfolio became what we consider full positions during the period. Some were purchased prior to the second quarter, but we only completed filling them out or market appreciation brought them to full positions in the last three months. Previously mentioned Colony Financial is one such example. We added to the small-cap REIT on weakness given its diversified model of buying distressed commercial mortgages, originating commercial mortgages, and purchasing and renting out single family homes. The company is led by an experienced group of real estate professionals, backed by privately held and global real estate firm Colony Capital, and offers an attractive dividend yield.
Regional bank FirstMerit also became a full position during the quarter. The Ohio-based bank that provides a wide range of banking services to corporate, institutional and individual customers throughout the upper Midwest. The company combines a focus on providing the high level of service typically associated with a small town bank with a breadth of products and services typically associated with a super-regional or national bank.
Five full positions were sold from the portfolio during the second quarter, including Lufkin Industries, Cirrus Logic, and Titan International. Lufkin exited the portfolio because the company was acquired by General Electric for $88.50 per share. Sales of both Cirrus and Titan were due to company-specific issues. Integrated circuit maker Cirrus lowered its guidance during the period, which we feared would lead to a downward revaluation of the stock price. Industrial tire maker Titan faces growing headwinds from too much tire supply within their mining channel and our expectation was that this would weigh on sales and earnings going forward.
Given these changes and the correction relative to the Russell 2000 during the quarter, we think the valuation of the overall portfolio has improved, leaving the Fund well positioned as we move into the second half of the year.
TAMRO Capital Partners
As of June 30, 2013, Aruba Networks comprised 1.60% of the portfolio's assets, Cirrus Logic – 0.00%, Ixia – 1.39%, Redwood Trust – 1.95%, Colony Financial – 1.83%, Athenahealth – 1.60%, HMS Holdings – 1.40%, Analogic – 1.80%, Grand Canyon Education – 2.30%, Munro Muffler Brake – 2.40%, and FirstMerit – 1.96%.
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.