3rd Quarter 2013
It was strong quarter for international equity markets as the Fund’s MSCI EAFE Index benchmark gained more than 11%. All sectors and all regions delivered positive absolute returns. Continental Europe was particularly robust, leading all other regions in anticipation of a European economic recovery. The performance was driven entirely by higher valuations as analysts downgraded overall company earnings. Merger and acquisition activity also added to the positive investor sentiment. Microsoft's purchase of Nokia, Applied Materials' purchase of Tokyo Electron and Vodafone's sale of its stake in Verizon Wireless to Verizon Communications all happened during the period.
The Japanese market also performed well in absolute terms but lagged the benchmark. Economically sensitive sectors such as Materials, Industrials, Financials, and Consumer Discretionary tended to perform the best, while less cyclical sectors such as Healthcare, Consumer Staples, and Utilities lagged the overall market, though Telecommunications was an exception.
Lagging European Picks
The Fund posted solid gains, but lagged the performance of the benchmark during the quarter. By region and by sector, asset allocation was a minor detractor from returns. An allocation to struggling Emerging Markets, an overweight position in Japan, and an underweight to Europe weighed slightly on the regional allocation, while an overweight to Healthcare hurt on a sector basis.
Stock selection was the primary source of underperformance owing mainly to weak stock selection in Europe. Although few of the portfolio’s European stocks stood out as being poor performers, it did not hold enough stocks geared to a potential European economic recovery or any of the takeover targets mentioned above. Zurich Insurance was the weakest European stock after it sank following news of the death of the company's Chief Financial Officer.
Several individual stocks in other regions also detracted moderately from performance. Mostly, however, it was the lack of big winners that hurt relative returns. Fears of weaker potash pricing affected Materials stock Israel Chemicals, while Taiwan Semiconductor lagged its benchmark sector on no particular company news. Golden Agri-Resources was another laggard after reporting weak first half earnings results.
We had an active quarter making changes to the portfolio. We made new purchases in European holdings AXA and Bayerische Motoren Werke (BMW). We believe that both companies can be beneficiaries of a potential European recovery, and that insurance company AXA has an attractive cost reduction story able to drive earnings growth. Following the announcement of a capital raising as part of a restructuring program, we purchased a position in Barclays. We also added a new position in Hong Kong listed insurer AIA Group. We funded the purchases in part by selling UK-based Imperial Tobacco and Singapore bank DBS Group.
Other new holdings included Japanese construction machinery company Komatsu, miner BHP Billiton, and Swiss pharmaceutical company Roche. We like the recurring maintenance revenue at Komatsu, and think it stands to benefit from a potential construction recovery in Japan, while we purchased BHP following an upgrade of the Materials sector by our Strategic Policy Group (SPG).
It is typical for performance such as was seen during the third quarter of 2013 to be accompanied by a backdrop of improving economic data and improving company data. Despite a number of areas of improvement, however, overall economic and company data remained mixed throughout the summer months. Of all the regions, the U.S. remained the most consistent economic growth story. U.S. gross domestic product (GDP) growth has been a bit lackluster, but the important Institute of Supply Managers (ISM) survey has continued to point to stronger economic growth ahead. It remains to be seen what impact rising interest rates will have on the U.S. housing recovery, which has been at the center of the US recovery story. Unemployment remains too high and real wage growth is muted, but this area too is gradually improving. We continue to watch the U.S. closely, as it remains an end market to which we seek exposure from the portfolio’s international holdings.
New government leadership in China continued to show signs of being committed to reforming the economy. One sign is an ongoing effort to crackdown on corruption. This is not affecting equities meaningfully except maybe on high-end luxury sales. The other sign is an apparent effort to shift the economy away from fixed asset investment-led growth and more toward domestic consumption-led growth. The main tool the government has used is to curtail lending outside of the normal banking channel. The so-called “shadow banking” sector has been a significant source of funding that, until now, the Chinese authorities have not managed to regulate effectively.
It is certain the high investment share of Chinese GDP is not sustainable and a rebalancing at some point is inevitable. The challenge for the Chinese authorities is to manage that shift as smoothly as possible. Because the consumption share of the Chinese economy starts from a much smaller base than the investment side of the economy, it seems unlikely that this shift can happen without a slowdown in economic growth, possibly why Chinese GDP growth has generally been getting softer in recent years. This shift will have investment implications. To us, opportunities in China are likely to continue to come more from companies selling finished goods and services to the Chinese than from those selling them raw materials.
In Japan, our view is that Prime Minister Abe’s program for economic recovery remains on track. The upper house elections in July saw a win by Abe’s LDP party as expected, meaning that his economic program can continue to find political support. We think it likely, however, for there to be a pause in the equity market until Abe’s government moves on to announcing the fiscal and reform aspects of his program. Thus, our SPG downgraded Japan and we took some profits and reduced some of the Fund’s Japanese holdings during the quarter. If Japan’s continued program for economic recovery creates additional investment opportunities, we will look to add again to the portfolio’s Japanese weight.
To be clear, Japan’s recovery is not a sure thing and risks remain. Its current asset purchase program is of a scale never attempted before. The government is highly indebted with a gross debt-to-GDP of 200%. Whatever fiscal program they announce, it is unlikely that the government will be able to fund it by itself. Japanese households are cash rich, however, and a public, private partnership (PPP) may be a way for Japanese banks to utilize their under-used balance sheets and effectively intermediate government spending with household savings.
Economically, Europe continues to be a mixed picture. Unemployment remains at a very high level, particularly in peripheral Europe. Bank lending continues to contract as banks attempt to reduce leverage. Greece will very likely need a third bailout and Portuguese 10-year bond rates are again touching 7%, which is not sustainable. On the positive side, the European manufacturing purchasing manager’s index (PMI) has been a bright spot, showing an improving trend over the past year with exports starting to grow in some of the peripheral countries.
Overall, we expect a fairly muted GDP recovery in Europe, but considerably better than what we have seen recently. Our SPG had upgraded the region to neutral and we have been reducing the portfolio’s underweight position. With company earnings revisions remaining negative while the market has gone up, we recognize that earnings will have to grow to justify current share prices. We have focused on finding self-help stories or companies where we anticipate earnings surprises as the economy grows.
Central bank and government intervention in the economy in recent years has had a large impact on asset prices. The degree of the intervention may or may not continue at current levels—witness the US Federal Reserve’s plan to taper its quantitative easing bond-buying program. In this type of uncertain world, we are looking to find investment opportunities across all regions where growth prospects are less driven by external factors, than by controllable internal factors that will allow a company to deliver solid growth.
Baring Asset Management
As of September 30, 2013, Zurich Insurance comprised 1.66% of the portfolio's assets, Israel Chemicals – 0.67%, Taiwan Semiconductor – 1.14%, Golden Agri-Resources – 0.73%, AXA – 1.27%, Bayerische Motoren Werke – 1.38%, Barclays – 1.57%, AIA Group – 0.95%, Komatsu – 1.32%, BHP Billiton – 1.21%, and Roche – 1.77%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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.