2nd Quarter 2013
Stocks posted decent gains during the second quarter even if they didn’t match the strong performance of the first three months of the year. Volatility returned to the markets during the period, however, after Federal Reserve Chairman Ben Bernanke raised the prospect of winding down the Fed’s asset purchase program. Investors across all asset classes took notice, sending bond yields sharply higher and gold prices and stocks lower. Subsequent commentary from other Fed members attempting to assure markets that the removal of monetary policy accommodation would be measured allowed the markets to partially recover by quarter end.
There remains some debate as to the intent of Bernanke’s comments. Whether he was attempting to transparently signal the Fed’s course should economic data continue to improve, or whether he was simply attempting to jawbone the markets lower in order to remove some unwanted froth, the result was the same. Investors must now begin to ponder the Fed’s exit strategy from unprecedented monetary accommodation.
The idea of unlimited quantitative easing (QE) has encouraged investors to seek out the riskiest assets under the premise that the Fed would continue to provide ample liquidity to the markets. Since late-May/early-June, 2012, when the Fed initiated its communication campaign to signal additional forthcoming QE, lesser quality stocks (ranked B or worse by Standard & Poor’s) have outperformed higher quality stocks (B+ or better) by more than six percentage points, including an additional 124 basis points during the second quarter of 2013, according to BofA Merrill Lynch US Quantitative Strategy. This has been a significant headwind for the Fund considering that we strive to invest in what we believe to be the best managed, most financially secure, and highest-quality growth companies.
The Fund posted a modest gain but lagged its Russell Midcap Growth Index benchmark during the quarter. The underperformance was roughly two-thirds attributable to sector allocation and one-third due to individual stock selection. Encouragingly, from the time of Mr. Bernanke’s first suggestion of tapering QE on May 22 through the end of the quarter, the Fund significantly outperformed the benchmark—perhaps a favorable indicator of a rotation to higher-quality companies.
Weak performances within the Technology, Industrials, and Healthcare sectors, exacerbated by overweight stakes in Industrials and Healthcare, drove much of the underperformance. F5 Networks, Robert Half, and Edwards Lifesciences, respectively, were the biggest individual detractors from the three sectors. We added to the Fund’s F5 position on weakness following a profit shortfall, believing that better earnings prospects lie ahead from a cyclical rebound in telecomm demand, a major product refresh, and share gains resulting from Cisco’s exit from the market. Robert Half slightly missed earnings expectations due to weaker than expected European staffing demand, which more than offset strong IT staffing, U.S. permanent placement, and risk consulting results. We think the valuation on the stock is attractive and that earnings momentum remains solid.
Edwards Lifesciences declined after the company reported disappointing earnings and lowered guidance amid an overall decline in utilization that is affecting health care spending in the U.S. and Europe. The U.S. launch of the company’s Sapien transcatheter heart valve has also been slower than expected. Although large, research-driven hospitals are able to incur the expense of training staff and upgrading their operating rooms for Sapien implants, some smaller heart centers seem to be struggling with the economics of the program and consequently have done fewer Sapien procedures than management originally forecast. With absolute earnings growth still forecasted to be in the mid-teens and with the slower growth reflected in the valuation, we decided to maintain the position.
Relative returns were supported by a number of Consumer Discretionary holdings, strong performances by Core Labs and Oceaneering in the Energy sector, and an underweight stake and solid picks within Financials. Within Consumer Discretionary, auto parts supplier LKQ, apparel company PVH (which owns brands ranging from Calvin Klein and IZOD to DKNY), and Panera Bread were among the portfolio’s strongest positive contributors. We added to the position in PVH early in the quarter on weakness following lower management guidance from plans to invest significantly in the infrastructure of the recently acquired Warnaco business as well as from some inventory cleanout. We thought the strategic rationale and long-term outlook for the business remained robust, and the stock had rebounded nicely by the end of the quarter.
Buys and Sells
We sold two positions from the portfolio during the quarter—Bed Bath & Beyond and Joy Global—and established five new positions. Bed Bath was sold following strong relative stock performance that pushed the market capitalization out of our targeted mid-cap range, while Joy Global was sold due to deteriorating earnings prospects resulting from weakening commodity prices.
Consumer brands Monster Beverage and Dunkin Brands were among the new positions purchased. Monster is a leading supplier of energy drinks, which continue to grow more rapidly than other traditional beverages in the U.S. We think the company has significant growth potential internationally. Dunkin is a quick service coffee, baked goods, and ice cream restaurant chain that employs a 100% franchise ownership model and has meaningful room for further store expansion, particularly in the western U.S.
New holding Signature Bank was one of the solid performers within Financials during the quarter. It is a full-service commercial bank with a steadily growing number of private client offices throughout the New York metropolitan area. The bank has built a strong franchise within a competitive market by pursuing a unique organic growth strategy while maintaining a best-in-class balance sheet. Lastly, Trimble Navigation is a leading provider of GPS-based productivity solutions for agriculture, engineering and construction. We purchased the stock based on rising technology adoption on farm and construction sites as a driver of above-average growth.
Although stock market volatility may rise in the period ahead, we think the outlook is still favorable. As Bernanke and others have emphasized, the timing and pace of QE withdrawal will be data dependent, requiring a further improvement in economic data. We expect continued slow but steady progress. Federal fiscal headwinds consisting of tax increases and spending restraints, along with a sluggish global economy, will likely impede growth while consumer spending on housing and autos together with an improvement in business fixed investment should be a positive.
The Fed’s desire to wind down its bond buying program could limit the market’s potential as this added liquidity has significantly boosted the values of both bonds and stocks. If we are entering a new stage where central bank accommodation begins to be withdrawn, leaving the economy to fend for itself, then investors may begin to reward companies more based on their individual merits. On this basis, we feel strongly that the companies in the portfolio will shine.
M. Scott Thompson, CFA
Andrew W. Jung, CFA
July 1, 2013
As of June 30, 2013, F5 Networks comprised 1.94% of the portfolio’s assets, Robert Half – 2.58%, Edward Lifesciences – 1.39%, Core Laboratories – 1.84%, Oceaneering International – 1.99%, LKQ – 3.08%, PVH – 2.63%, Panera Bread – 1.88%, Monster Beverage – 1.42%, Dunkin’ Brands – 1.64%, Signature Bank – 0.78%, and Trimble Navigation – 0.92%.
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.