4th Quarter 2013
It was a banner year for equities in 2013, the fifth consecutive year of positive returns. Despite beginning the year at a level more than twice the lows reached during the heart of the financial crisis in 2009, major U.S. stock market indices gained more than 30% for the year. Using the broad market S&P 500 Index as a proxy, only 14 years have yielded better returns for the equity market since William McKinley was President in 1900. Underpinning 2013’s gains was an estimated 11% increase in S&P 500 earnings, implying that roughly two-thirds of returns were driven by multiple expansion in the price paid for earnings. Although scar tissue from the financial crisis and recession certainly remain, clearly the fear that gripped investors and the nation in 2008 and 2009 has faded into the background, giving way to greed that may become a problematic development from an investment standpoint. Looking back at the past year, the combination of moderate corporate profit growth, extremely accommodative monetary policy, and benign inflation was able to overcome a material fiscal headwind in the form of sequester-related budget cuts and tax increases, as well as a mid-year surge in interest rates (though from arguably artificially suppressed levels).
The fourth quarter did little to alter the market trends we have previously commented upon in that more highly leveraged, low priced, higher beta issues continued to outperform. As such, the Fund and its holdings of what we consider high quality, financially secure companies have failed to keep pace in the current market environment. Underperformance for the quarter relative to its Russell Midcap Growth Index benchmark was almost exclusively due to stock selection, while the deviation of full year relative results can be roughly split 60/40 between stock selection and sector allocation.
During the quarter, positive stock selection within Financials and Consumer Staples was unable to offset weakness in Technology, Industrials, and Healthcare. The largest individual detractor from relative performance was data storage firm Teradata, which suffered an earnings shortfall due to weakness in emerging markets. We reduced the position in recognition of the fact that it will likely take some time for investors to regain confidence in the company’s growth outlook. We remain confident in the firm’s long-term prospects, however, and expect a potential rebound in activity in the first half of 2014.
Similar to the quarterly attribution, Healthcare, Technology and Industrials were also the largest detractors relative to the benchmark for the full year. Healthcare and Technology suffered from a couple of disappointing investments. In addition, the portfolio did not have exposure to any biotechnology or Internet plays, among the strongest performing sub-industries, as many of these companies within the mid-cap universe have low-to-no current earnings power and/or extremely high valuations. Although there were no major stock specific issues affecting performance within Industrials, some of the Fund’s larger weighted positions such as Expeditors International and Stericycle underperformed the sector.
We added three new companies to the portfolio during the fourth quarter—IHS, Westinghouse Air Brake Technologies (Wabtec), and Quintiles Transnational Holdings. IHS is a global provider of critical technical information, related decision-support tools, and strategic operational services. The company operates a compelling business model with a high level of recurring revenue and high returns despite having no debt on its balance sheet. We believe the stock trades at an attractive valuation with accelerating earnings prospects. Wabtec offers technology-based products and services for the freight and rail transit industries worldwide. Its business is closely tied to the fortunes of the economy, which should continue to benefit the company in 2014 along with favorable structural tailwinds for the rail industry and its suppliers. Lastly, Quintiles is the largest contract-research organization (CRO) that provides biopharmaceutical development and commercial services. Although the CRO industry can no longer rely on strong growth in pharmaceutical R&D budgets, Quintiles and peers will continue to benefit from a rising trend toward outsourcing.
We sold our stocks from the portfolio during the quarter. Cameron International, Expeditors International, and Varian Medical were eliminated after reporting weaker than expected earnings. Consistent with our process of either adding to or cutting positions after earnings disappointments, our assessment that fundamentals were likely to remain soft for the intermediate-term led us to exit each of the positions. Altera was liquidated due to concerns that the company would continue to lose market share to competitor Xilinx, which in turn led us to bolster that existing position.
Looking ahead to 2014, the outlook for the stock market remains generally favorable, though we do expect returns to be more moderate and volatility to increase. As noted previously, investor sentiment, which often acts as a contrary indicator, has become almost universally bullish, stocks are fair-to-fully valued on an earnings level that incorporates historically elevated profit margins, and the Federal Reserve started to take its foot off the gas pedal in December by commencing the tapering of its experimental quantitative easing (QE) program. On the latter point, each time the Fed has attempted to halt QE, in 2010 and again in 2011, market volatility increased. Even New York Fed President William Dudley admitted that the Fed does not, “… understand fully how large-scale asset purchase programs work to ease financial market conditions.” We believe that the side effects of QE have been to boost asset prices and reduce investor sensitivity to risk. Consequently, the reduction/elimination of QE may in turn reduce investor risk tolerance.
Despite these potential short-term headwinds, underlying fundamentals for the stock market are still positive. Growth in the economy is poised to accelerate to 2.5% to 3% in 2014, up from the estimated 1.8% to 2.0% in 2013. The drag from fiscal policy is expected to lessen, there are few signs of inflation that would prompt the Fed to reconsider its level of monetary accommodation, and corporate profit margins are likely to remain elevated, thereby allowing corporate profits to register another year of growth.
While the current market environment may not be conducive to our particular investment approach, one centered on quality, valuation, and earnings growth, we continue to believe that the portfolio is well positioned for the long-term, which we think is most accurately measured over the course of a full investment cycle.
M. Scott Thompson, CFA Andrew W. Jung, CFA
As of December 31, 2013, Teradata comprised 1.46% of the portfolio’s assets, Expeditors International – 0.00%, Stericycle – 2.49%, %, IHS – 1.05%, Wabtec – 1.05%,Quintiles Transnational Holdings – 1.06%, and Xilinx – 2.56%.
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.