3rd Quarter 2013
The old market axiom “sell in May and go away” failed to materialize this year, with stocks shaking off the brief bout of volatility in June (the “taper tantrum”) and posting solid gains during the third quarter. Although economic growth has been modest and corporate profit growth has continued its descent to single digit territory, the US Federal Reserve’s commitment to easy money policies has allowed significant market gains in 2013. The ongoing promise of low rates for an extended period of time and continued, even if reduced, levels of bond buying (quantitative easing) has driven some pockets of speculation in mid-caps, in our opinion, with some of the best performing stocks in the universe being those most excessively overvalued. This has been a significant headwind for the portfolio considering we strive to invest in what we believe to be the best managed, most financially secure, and highest quality growth companies at more reasonable valuations.
Given that backdrop, the Fund not surprisingly lagged its Russell Midcap Growth Index benchmark during the quarter. The relative performance was fully attributable to stock selection as sector allocation contributed positively to returns, albeit modestly. Notable individual performers like LKQ Corp., First Republic Bank, and F5 Networks were offset by weak performances among the portfolio’s Consumer Staples holdings, including Monster Beverage, Mead Johnson Nutrition, and Church & Dwight. Wealth manager Raymond James Financial was another negative contributor, as was oil service equipment company Cameron International.
The five laggards listed accounted for about 80% of the negative attribution that resulted from stock selection. Although the short-term underperformance of these names is frustrating, we continued to hold the positions based on our expectation of good future earnings growth prospects. Beyond what the Fund owns, the lack of exposure to several highly valued, rapidly growing names enjoying strong price momentum in the Consumer Discretionary sector and biotechnology industry weighed on relative performance.
We added four new holdings to the portfolio this quarter and exited five. Two of the new names, Harman International and Marriott International, have been held in the Fund before. Harman is a provider of high quality audio, electronic and infotainment systems for the auto industry. We expect the company to benefit from the ongoing recovery in auto sales as well as restructuring efforts implemented by a new management team in 2008. The Fund last owned hotel operator/franchisor Marriott in 2010, which we sold when the stock achieved our fair value target. The stock has lagged the market since then, yet intrinsic value has increased as earnings power has grown. Other new positions were accessory/apparel manufacturer Michael Kors, which is enjoying rapid growth as a result of significant market share gains, and fuel fleet card and electronic payment provider Wex, which is benefitting from growing penetration of fleet cards to commercial and government vehicles.
In terms of our total sales, Fiserv and Fastenal were each selling at or above our estimate of intrinsic value. The medium-term earnings prospects for Edwards Lifesciences have become more uncertain than we previously believed, while the stock became fully priced relative to its medical technology peers. Although still undervalued in our estimation, Dentsply has failed to achieve a sufficient level of earnings momentum to look attractive relative to other holdings in the portfolio. Finally, we sold Ecolab, which had been a cornerstone of the portfolio for many years, as its market-capitalization exceeded the high end of the benchmark. To keep the portfolio true to its mid-cap orientation, as a general rule we sell positions once they exceed the capitalization of the largest stock in the benchmark.
The outlook for the stock market continues to be favorable. The risk of a recession is low, monetary policy is very expansive, market valuations are fair to full though not extreme, and investors are optimistic but not euphoric. The market may be more volatile in the near term, however, as consensus economic and earnings expectations remain too high. While the Federal Reserve’s bond buying program should continue to support the stock market, this added liquidity has both reduced investors’ sensitivity to risk and significantly helped boost bond and stock prices. Consequently, the Fed’s stated intention of eventually winding down that program coupled with the uncertainty as to how and when it will do so could also contribute to increased market volatility.
Although pleased with the portfolio’s strong absolute returns for the year-to-date through September, we are well aware of the lagging relative performance. Amid easy money policies, the higher quality, consistent growth companies we favor have failed to keep pace with broader market averages. Even so, we remain resolute in our belief that our process, with its emphasis on quality, valuation, and earnings growth, will serve shareholders well over the course of a full market cycle.
M. Scott Thompson, CFA
Andrew W. Jung, CFA
As of September 30, 2013, LKQ Corp. comprised 3.79% of the portfolio’s assets, First Republic Bank – 3.05%, %, F5 Networks – 2.41%, Monster Beverage – 1.22%, Mead Johnson Nutrition – 1.08%, Church & Dwight – 2.45%, Raymond James Financial – 2.17%, Cameron International – 1.60%, Harman International – 1.74%, Marriot International – 1.07%, Michael Kors – 1.68%, and Wex – 1.77%.
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.