3rd Quarter 2013
Where are the Three Bears?
Last quarter we wrote about the Goldilocks factor, meaning market forces that seemed just right. After a fantastic third quarter and year-to-date thus far U.S. equities, should we worry about the three bears coming home to discover Goldilocks sleeping in their beds and eating their porridge? We think no, since we see a continued attractive environment for stocks. We do not believe the conditions exist to usher in a bear market for either U.S. equities or the U.S. economy. It appears that there is a balance of opposing forces—monetary policy and fiscal policy—that should keep prospects in the U.S. on an even keel. The major factors keeping that balance are:
1. An accommodative Federal Reserve policy—the most liquid on record. Interest rates are likely to remain low, with only brief periods of volatility.
2. Low to no inflation. Looking at the Commodity Research Bureau Index, it has risen less than 2% the past 5 years since hitting a recession trough.
3. Slow to moderate growth in the U.S. economy. It has been one of the slowest recoveries in a generation, averaging 2% to 2.5% annual growth since the recession bottomed in the spring of 2009.
4. Onerous fiscal policy. Higher taxes, more regulations, and now the implementation of the Affordable Care Act should act as a damper on growth.
In the near term, we do not see any signs of these trends changing. Although the government shutdown and debt limit discussions could cause a rise in volatility, we would view that as an opportunity to add to existing positions or initiate new investments.
The Fund outperformed its Russell 1000 Index benchmark during the quarter. Outperformance relative to the benchmark was primarily due to strong stock selection in the Consumer Staples, Financials, and Industrials sectors, with sector allocation and added benefit overall.
Safeway, Walgreen, and United Natural Foods led the way within Consumer Staples. Grocery-chain Safeway reacted favorably to news that an activist investor had accumulated a significant stake in the company. Walgreen moved higher as Wall Street firms published constructive reports on the company.
United Natural Foods is the largest distributor of natural and organic foods in the United States. The company’s profitability had been depressed due to the build-out of its distribution network and the initiation of a number of new, large relationships. We believed that the recently won business and significant infrastructure investment would lead to higher revenues and profitability going forward. That proved to be the case during the quarter as the company reported earnings results that exceeded Wall Street expectations.
Stock selection in the Energy, Technology, and Healthcare sectors were the biggest detractors from relative performance during the quarter. Tech giant Hewlett-Packard reported weaker-than-expected quarterly results, which weighed on the stock. DaVita Healthcare Partners underperformed on near-term uncertainty surrounding Medicare reimbursements. Also among the biggest individual disappointments was retailer Macy’s. Sales at the firm were weaker during the period driven in part by merchandising and weather trends.
We remain positive towards equities. This has not been an average economic recovery, where a rising tide lifts all boats. A keener focus on competitive forces is imperative, as those companies that have attained a strong lead over their peers should continue to receive the market’s favor. Conversely, deep-value companies that have not executed up to their potential could attract activist investors to unlock value. Although we normally would expect to see rising consolidation in various industries, it seems the sluggishness of the economy has kept the growth of mergers and acquisitions subdued.
In this environment, valuations for companies that are executing may go higher than in recent years. We understand the need to differentiate between speculative stocks and those that are truly executing better, for which valuations can go higher.
From a sector perspective, we identified new opportunities in Technology, some of which we are continuing to build, resulting in a net three-percentage point increase in exposure from the prior quarter. Although the portfolio’s weighting in Financials fell only slightly, we sold four long-term positions and redeployed a portion of the proceeds to two companies that we believe will benefit from a pick-up in overseas economies. The largest three sectors remained the same from the last quarter, namely Consumer Discretionary, Financials, and Industrials. The over- and underweights relative to the benchmark are modest as we focus more on stock selection.
Six stocks reached full-position status during the quarter through purchase, appreciation, or both. Facebook became a top-10 holding in the portfolio as we believe the company has a competitive advantage based on scale, an enormous collection of data that should help advertisers, and a strong and loyal culture. We see the continued shift towards online targeted advertising as the catalyst for the stock.
Within Financials, Citigroup and regional bank FirstMerit also became full positions. Citi suffered mightily during the Great Recession, requiring $45 billion in government financial assistance and significant asset sales and capital raises to avoid bankruptcy. Today, led by a new Chief Executive Officer and new Chairman of the Board, the company finds itself on much firmer financial and operational footing. The U.S. government has been paid back in full, the firm passed the most recent Federal Reserve “stress test”, and profitability has been increasing. We expect the company will continue to benefit as new management executes around their cost cutting and growth initiatives and the global economy continues to improve. Ohio-based FirstMerit’s focus is on providing customers with a high level of service typically associated with a small town bank, combined with a breadth of products and services typically associated with a super-regional or national bank. The current CEO has been in the top job since 2006 and he successfully de-risked the loan book prior to the credit crisis and saw the company through the Great Recession.
Valuation was the primary reason for the sale of four Financials holdings—Franklin Resources, JPMorgan Chase, T. Rowe Price Group, and Raymond James Financial—mentioned earlier. Within Consumer Staples, we exited both Kraft Foods Group and McCormick to add to more attractively valued companies in the sector. Microchip Technology was sold to fund stocks that in our view were better relative opportunities, while a difficult interest rate environment that could lead to higher operating costs was the reason for the sale of homebuilder Toll Brothers.
TAMRO Capital Partners
As of September 30, 2013, Safeway comprised 2.14% of the portfolio's assets, Walgreen – 2.16%, United Natural Foods – 2.43%, Hewlett-Packard – 0.99%, DaVita Healthcare Partners – 2.04%, Macy’s – 1.40%, Facebook – 2.52%, Citigroup – 2.58%, and FirstMerit – 2.02%.
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.