2nd Quarter 2013
The second quarter opened with a continuation of the strong rally that began the year, with the broad market S&P 500 Index setting a new all-time high on May 21. After Federal Reserve Chair Ben Bernanke spoke before Congress on May 22, discussing the possibility of reducing (“tapering”) the amount of bonds the Federal Reserve buys, however, volatility increased as speculation about the timing and impact of tapering roiled financial markets globally. U.S. equities finished the quarter off their highs, though still in positive territory. The broad market S&P 500 gained 2.9% and the growth-oriented Russell 1000 Growth Index increased 2.1% during the period.
The bond market experienced a difficult quarter for the first time in several years as investors began to anticipate a reduction in the Federal Reserve’s bond buying program. Interest rates on longer maturity bonds increased almost a full percentage point from their intra-quarter lows, with the 10-year Treasury ending the quarter at a yield of 2.49%. The damage was not limited to the Treasury market, however, as many investors have sought fixed-income returns in higher-risk sectors of the bond market. The use of leverage has caused disruptions to these other bond market sectors as trades were unwound in the face of higher borrowing costs and declining bond prices.
The Fund underperformed its composited 60% S&P 500 Index/40% Barclays US Government Credit Index in posting a small loss during the quarter. A slight overweight position in Corporate bonds, one of the worst performing areas of the fixed-income market, hurt returns despite being defensively positioned against a rise in interest rates. On the equity side, after contributing to positive relative results during the first quarter, the Fund’s overweight stake in the Consumer Staples sector detracted from performance. Many of the portfolio’s holdings in the sector have healthy dividend yields, and as a result had a negative short-term reaction to the recent sharp rise in interest rates. We still find the group’s combination of growth and valuation very attractive.
An underweight position in Consumer Discretionary as well as weak stock selection within Materials and Industrials also detracted from relative performance. Results within Consumer Discretionary were disappointing given that a number of holdings posted strong gains, including Starbucks and Bed Bath & Beyond. Monsanto is the Fund’s sole holding within Materials and declined during the quarter partly sparked by news surrounding the discovery of genetically modified wheat in Oregon. We think the firm’s earnings visibility is good and that the wheat scare should pass without any lasting impact on fundamentals.
General Electric and United Parcel Service slightly lagged within Industrials. GE reported results that were in line with consensus but exhibited poor quality. The company's industrial operating profit margin was disappointing, with the bulk of the downside attributable to worse than anticipated results in its Power/Water segment, where the gas turbine unit volumes were down significantly year-over-year. This created doubts among investors as to the achievability of the targeted margin improvement in the company’s industrial division for 2013. We trimmed the Fund’s position as a result.
The Fund’s underweight position in the Technology sector as well as its underweight stake in Apple relative to the benchmark favorably affected performance, as Apple continued its decline in falling more than 8% during the quarter. We eventually sold the portfolio’s position in Apple after the company reported in-line second quarter earnings but materially reduced guidance, resulting in negative estimated earnings growth and collapsing relative momentum. Lackluster sales of the iPhone 5 and a mix shift toward legacy models in both developed and emerging markets are pressuring average selling prices and gross margin for the iPhone, while the success of iPad Mini is having the same impact on the iPad category. Longer term, we are concerned that the aforementioned mix shifts will have a permanent impact on gross margins as market saturation of high-end smartphones is evident, and Apple's lack of product differentiation versus prior models will result in lackluster demand until mid-2014.
Elsewhere, the Fund benefited from good stock selection within Financials and a rebound in energy firm Occidental Petroleum. Wells Fargo and American Express enjoyed strong gains, rising more than their respective benchmark sector, leading us to eventually trim the positions. Occidental surged on reported earnings that demonstrated solid progress on its cost reduction efforts for the second consecutive quarter, and following the announcement that CEO Steve Chazen (age 66) would remain on the job, assisting the Board in succession planning, until the end of 2014.
We established two new positions in the portfolio during the quarter in Estee Lauder and State Street. We think sustained margin expansion should fuel earnings growth and help support the premium price multiple at Estee Lauder, as the beauty products company is exposed to the fastest growing segment within the household and personal care market. Recent management meetings with analysts confirmed that the company is expecting acceleration in top-line trends and that margin progress is running ahead of schedule. Custody bank State Street stands to benefit from above-average growth in securities servicing as markets converge across the world. It derives a significant percentage of revenues and profits from equity-related products, with continued strength in the equity markets accretive to earnings.
Notable additions to current positions included two tech stocks and two healthcare holdings.
We added to eBay as the stock lagged while earnings continued to grow, providing an attractive valuation. We think the company is capable of double-digit earnings growth through the remainder of the year. Google was increased after the stock pulled back from recent highs, presenting an opportunity to add at an attractive valuation. We expect accelerating earnings momentum for the company during the second half of the year.
Despite a strong run-up in its stock price the last few years, we increased the Fund’s position in biotech firm Biogen IDEC on recent weakness as it traded at a discount to our estimate of present value based on the U.S. approval of the company's oral multiple sclerosis (MS) product. The delayed European launch of the same product sparked the recent weakness owing to a lack of clarity on regulatory data protection from the European Medicines Agency. Although the European launch is a risk, the U.S. outlook is solid and valuation is attractive. We increased the position in pharmaceutical company Sanofi as we think the stock remained attractively valued and the company is expected to deliver accelerating earnings growth during the second half of the year, preceded by multiple Phase III drug trial readouts in the coming quarter.
We eliminated the Fund’s positions in Schlumberger and McDonald’s during the quarter. We think sluggish economic growth and range-bound commodity prices are likely to constrain valuations across the energy sector, leading to the sale of Schlumberger. McDonald’s was eliminated due to a lack of near-term catalysts for earnings growth and as a source of funds for more attractive investments.
Notable trims to existing positions included Qualcomm and Oracle in Technology, as well as Philip Morris International and Costco within Consumer Staples. Qualcomm reported a mixed quarter. Although chip and device volumes and total revenue were better than expected, chip margins were weak and earnings were only in-line with analyst expectations. The concern is that slower growth in higher end smart phones is leading to lower profit margins as the firm’s revenue mix shifts towards lower end devices. Oracle was trimmed after the company uncharacteristically missed analyst revenue expectations for the usually strong May quarter, with the blame placed mainly on economic pressures and currency headwinds.
Philip Morris was reduced after the company reported earnings that disappointed on both volume and earnings. We think the stock is likely to be range-bound in the short-term until an inflection point is reached in earnings momentum for the second half of the year. The company is facing adverse foreign currency movements without the benefit of lower commodity prices for its cost of goods. Costco traded at a rich valuation and was getting closer to our estimate of present value. In addition, the company's fiscal third quarter earnings report indicates that the incremental member fee benefit has peaked, and that the company is again being more aggressive on price investment, particularly internationally where they have more of a profit cushion.
We believe the recent increase in rates is premature as Gross Domestic Product (GDP) growth is likely to remain subdued due to continued deleveraging and federal fiscal headwinds, while inflation is low due to the sharp decline in many commodity prices. Thus, we expect the Fed will continue its bond purchases during the third quarter to support economic growth. We extended the duration (a measure of interest-rate sensitivity) of the bond portfolio to a level neutral with most bond indices as interest rates rose during the quarter. We continue to maintain an overweight position in high-quality intermediate Corporate bonds as we believe investors will resume purchases of higher yielding bonds in a low interest rate environment.
Although the stock market could be more volatile in the period ahead, we think the outlook is still favorable. The risk of recession is low, monetary policy is expansive, stock market valuations are fair but not extreme, and investors are enthusiastic though not yet euphoric. Volatility may increase as the market appears fairly valued amid an environment of consensus economic and earnings expectations that seem too high. The Federal Reserve’s desire to wind down its bond buying program (the third round of Quantitative Easing, or QE3) could limit the market’s potential as added liquidity has significantly helped boost the values of both bonds and stocks up until now.
Given the potential for heightened uncertainty and volatility, we believe high-quality growth stocks will reassert their leadership after recent relative weakness. Having pulled back from the market peak, these stocks appear reasonably valued, and in our opinion offer more assured earnings growth due to their global diversification and financial strength. In addition, many of the Fund’s holdings have above-average dividend yields and dividend growth prospects. We expect both growth and yield to 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 June 30, 2013, Starbucks comprised 1.58% of the portfolio's assets, Bed Bath & Beyond – 1.56%, Monsanto – 2.52%, General Electric – 1.71%, United Parcel Service – 2.08%, Occidental Petroleum – 1.83%, Wells Fargo – 2.09%, American Express – 1.11%, Estee Lauder – 1.53%, State Street – 1.10%, eBay – 1.68%, Google – 2.24%, Biogen IDEC – 2.45%, Sanofi – 2.44%, Qualcomm – 1.57%, Oracle – 0.63%, Philip Morris International – 1.77%, and Costco – 1.33%.
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.
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.