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Jan 17 2014

4th Quarter 2013 Commentary - ASTON/TAMRO Small Cap Fund

4th Quarter 2013

A Look Back and Ahead 

The Favorable
The past year was a very successful period for investors in small-cap stocks, with the broad-based Russell 2000 Index gaining nearly 39%. In fact, it was the strongest total return for the Fund’s benchmark in 10 years. We were correct in anticipating a favorable environment for equities in 2013, yet we failed to anticipate how significant an impact the Federal Reserve’s policy of quantitative easing would have on stock prices and, in particular, to what parts of the market the liquidity it unleashed would flow. Although the long-term impact of the Federal Reserve’s effort is unknowable, it sufficiently offset the headwind of fiscal policy to keep the economy expanding, albeit at a moderate pace in 2013. 

The Frustrating
An investment firm is typically pleased to report to shareholders sizeable double-digit returns in a calendar year. We are not pleased. Rather, we are quite frustrated with the Fund’s 2013 performance and disappointed to report a significant shortfall relative to the Russell 2000, especially after outperforming in six of the last seven years (and underperforming by only six basis points—0.06%—the one year it didn’t outperform). We expect more of ourselves, and we know shareholders do as well. As we look back on 2013, we believe the appropriate question is, “What happened?”  We believe it was a combination of two factors. We missed the mark on stock selection and a market fueled by a torrent of liquidity that levitated both low-quality companies (as defined by leveraged balance sheets and weak market positions) and speculative growth stocks.   

At TAMRO, we focus on identifying companies that possess a sustainable competitive advantage where, by our calculation, the valuation at the time of initial purchase provides at least three times more upside potential than downside risk. While a number of our holdings worked well last year, many of the stocks that led the small cap universe higher possessed neither the fundamental nor the valuation characteristics that would justify an investment on our part.  Furthermore, as the market rose, our discipline led us to sell several positions after they reached a market capitalization of $5 billion, which we consider graduating into mid-cap territory. As we maintained our focus on strong fundamentals and valuation support, we did not want to chase stocks that fell outside our parameters as replacements. 

We feel it is important to provide specific details regarding the Fund’s underperformance. The story during the fourth quarter was similar to that of the first three quarters. So below, we review the three most challenging sectors in the portfolio for 2013, and explain what we refer to as our sins of commission and omission—stocks we owned that did not do well and stocks we did not own that had some of the highest returns last year. 

Much of the self-imposed miscues came from poor stock selection in Technology, where more than 50% of the annual stock selection shortfall took place. Specifically, Cirrus Logic, Netgear, and Aruba Networks were the major detractors. As the economy grew at a more modest rate relative to prior expansions, businesses were slow to increase capital spending. While there were company-specific missteps, these three enterprises were the casualties of a hesitant business cycle. Conversely, and frustratingly, the strongest Technology stocks within small-caps were in the solar industry. These stocks were up 260%, on average, yet from our perspective did not have the fundamental underpinnings of a sustainable competitive advantage (limited, if any profitability) nor the valuation support (extended multiples relative to top-line growth) for us to consider them as potential investments.  

The next largest detractor from performance was Industrials. Two stocks that declined over the course of last year were Titan International and Westport Innovations. With Titan, the company’s previous long-term record of success was not enough to overcome challenges associated with building the business into a global leader. We lost confidence in management after several quarters of guidance being established and then cut. With Westport, the company also poorly communicated expectations, but did a good job of executing on what was within its control. Westport is building an entirely new and compelling market (natural gas-fueled truck, rail, and marine engines) and we are confident in the company’s ability to take advantage of this unique opportunity. In addition, we sold four Industrials stocks that had exceeded our $5 billion market-cap ceiling. Of those, Colfax, Wabtec (now Westinghouse Air Brake Technologies), and Chicago Bridge & Iron had been held in the portfolio since at least 2010. The market has yet to appreciate the replacements we purchased for the portfolio.   

Healthcare was the third sector that detracted most from portfolio performance, owing primarily to two stocks—Healthways and HMS Holdings. Healthways is a company that provides specialized comprehensive care and disease management services to health plans. The company was restructuring after its largest client took its business in-house and was making encouraging progress. Management’s optimism, however, did not match their execution, and we sold the stock due to market-cap and liquidity considerations after the shares corrected. HMS Holdings, the leader in cost containment services to government and private health payers, experienced an overhang throughout the year related to a delayed contract with the Federal government. This state of limbo created an earnings and revenue shortfall. We added to the position on weakness because we continue to view the company as a best-in-class leader with minimal competition and high barriers to entry. Eventually, the Federal contract issue will be resolved. Finally, biotech stood out as one of the strongest industries in the sector, but the lack of a critical history of drug development within small-caps, unlike many larger companies in the industry, made the fundamentals too challenging for us to consider as an investment opportunity. 

The Future
We believe the outlook for equities remains attractive in 2014. We also believe that as the liquidity environment normalizes, the opportunities in the market will rebalance away from the extremes we saw in 2013 and toward company-specific catalysts. As we look across the portfolio, we see many reasons to be encouraged about potential future returns specifically and the economy generally.  Some examples…

  • One of the fastest growing diseases in America and internationally is diabetes. The largest position in the portfolio is DexCom, an Innovator that has developed the most accurate, reliable and fastest growing device to continuously monitor an individual’s blood sugar. Unless properly treated, diabetes leads to the deterioration of vital organs and can cause dire consequences if blood sugar levels fall too low. Thousands of diabetics have adopted DexCom’s continuous glucose monitoring device, yet the company serves only about 6% of the total population of 1.5 million Type 1 diabetics, leaving it an enormous audience of potential users.
  • The old saying “you are what you eat” is the cornerstone of good health and the consumption of organic and healthy foods has been one of the fastest growing trends within the Consumer Staples sector for years. The Fund has invested in the largest distributor of organic food products since 2007, namely United Natural Foods. The company has expanded both organically, pardon the pun, and through acquisition to build out a distribution platform that is second to none. We believe in good times and bad the demand for healthy food products should continue to grow and UNFI, as we refer to it, will continue to expand its reach.
  • Amid the depths of the Great Recession, we wondered whether any small regional banks had the foresight to husband capital during the bubble years and escape the vortex that was then consuming so many financial services firms. Indeed, several institutions stood out, but Bank of the Ozarks and Glacier Bancorp were the two that most impressed us and they remain the portfolio’s largest Financials sector positions at the end of the year. Led by particularly thoughtful and insightful management teams, both banks remained profitable during the downturn and maintained, if not grew, their respective dividends. Their strong capital positions then enabled a series of acquisitions that economically and strategically expanded their respective footprints. As interest rates and loan demand continue to increase, we would expect both companies to continue to grow earnings and book value per share.
  • A new position in 2013, and the Fund’s largest within Consumer Discretionary by year-end, was Monro Muffler Brake. What began as a one-store Midas franchise 55 years ago has grown into the largest chain of company-owned under car care facilities in the country. Not only is Monro the largest, they are also among the most profitable companies in the automotive repair space. With the industry still highly fragmented, and Monro holding less than 10% market share, we envision many years of substantial growth for the company.

One of the reasons we are optimistic about the future is our ongoing analysis of leading and innovative companies. Most of the innovation and growth in the U.S. economy takes place among small companies. For us, that creates the opportunity and excitement that, as Warren Buffet phrased it, makes us want to tap dance to work and ask our clients to join us for the next dance.

We do not believe that 2013 heralded a new market led by low quality, speculative companies.  Investing in companies with strong market positions, capable and experienced management teams, solid balance sheets and attractive valuations has been and will continue to be the underpinning of our investment strategy. We are never complacent. We understand that delivering strong long-term performance is Job #1 and we are appreciative of shareholders’ continued confidence in and commitment to the Fund. 

TAMRO Capital Partners
Alexandria, Virginia

As of December 31, 2013, Cirrus Logic comprised 0.00% of the portfolio's assets, Netgear – 0.00%, Aruba Networks – 0.00%, Titan International – 0.00%, Westport Innovations – 1.60%, Healthways – 0.00%, HMS Holdings – 1.69%, Dexcom – 2.92%, United Natural Foods – 2.69%, Bank of the Ozarks – 2.77%, Glacier Bancorp – 2.84%, and Monro Muffler Brake – 2.21%.

Note: Small-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.


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