4th Quarter 2013
Recently completed 2013 was a very successful year for investors in U.S. stocks, with the Fund’s benchmark Russell 1000 Index up 33.1%. It was the strongest gain in the index since 1995. Although we were correct in anticipating a favorable environment for equities in 2013, 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. While the long-term impact of the Federal Reserve’s effort was unknowable, it sufficiently offset the headwind of fiscal policy to keep the economy expanding, albeit at a moderate pace.
Strong Tech, Weak Financials
All sectors in benchmark and the portfolio delivered positive absolute returns during the fourth quarter, as the Fund performed exactly in-line with the index. A positive sector allocation effect from the lack of exposure to Utilities, the worst performing sector in the benchmark, and an overweight to Industrials aided returns overall. Stock selection was neutral, with strength in the Technology and Industrials sectors offset by weakness in Financials and Consumer Discretionary.
Top individual performers included Amazon.com, Chicago Bridge & Iron, and Seagate Technology. Sequential acceleration in top-line revenue growth and gross margin improvement helped Amazon to offset increased investment spending in fulfillment, technology, and content. Although the increased spending will likely challenge near-term profitability, we believe these investments present a margin and free cash flow trough that should allow for attractive improvement in operating fundamentals and long-term revenues. We view Amazon as a best-in-class, disruptive innovator led by visionary management that will continue to take share from brick and mortar retailers.
Chicago Bridge & Iron reported much better than expected third quarter earnings and provided order guidance that exceeded expectations. Seagate’s shares increased as the company executed on its stated goal of returning 70% of cash from operations to shareholders.
Among the biggest detractors from performance were real estate investment trust (REIT) Redwood Trust, Temper Sealy International, and Itau Unibanco Holding. A tightening in the securitization market affected company financials at Redwood. Temper Sealy dropped on industry concerns surrounding the weak quarterly performance of a rival leading to consensus earnings estimates being reduced for the company. Finally, Brazilian bank Itau traded lower with many Emerging Market related names on concerns about the impact of the Fed’s tapering decision, in this instance the affect it would have on the company’s home currency. All three positions were eventually sold, Redwood and Itau given their challenging operating environments and Temper Sealy due to reduced confidence in management’s ability to execute its strategy.
The Fund is broadly diversified, with sector allocations resulting from opportunities we identify at the company level through our bottom-up fundamentals analysis and valuation work. Consumer Discretionary, Financials, and Industrials were the largest sectors in the portfolio at year-end, as the areas where we identified the most attractive opportunities. Major changes during the year included increases in the Industrials and Technology sectors and a reduction in Consumer Staples and Materials. Industrials finished the year in the top three in part through superior relative stock selection and due to the addition of a transportation stock with an opportunity to benefit from consolidation in the airline industry. The reduction in Consumer Staples owed to profit taking after a period of superior performance. We reduced Materials due to poor stock selection in the mining industry early in the year, assets that were later redeployed elsewhere.
During the fourth quarter, six stocks became full positions and seven holdings were sold. Of those added, Chinese Internet search firm Baidu, Hewlett-Packard, and commercial kitchen equipment provider Middleby were the most notable. Like Google, Baidu has an advertising-heavy business model and counts more than 400,000 small to medium-sized businesses as customers. The company generates significant free cash flow and continues to invest heavily in the business, particularly in its mobile offering. As China’s economy and middle class both continue to develop, we think Baidu should see healthy growth in revenues and earnings.
For several years, Hewlett-Packard was in a state of flux as CEOs came and went, and the company lurched from one operating strategy to another. The board finally hired seasoned industry executive Meg Whitman as CEO in the fall of 2011. Under her leadership, the firm has been cutting costs, improving its financial profile, and judiciously investing back in the business. In our opinion, as IT spending improves, so too should the company’s revenues and margins. Middleby has built a strong reputation for delivering both high and consistent returns on invested capital. This performance is due to a focused and dedicated management team that continuously strives to gain a deeper understanding of what makes its customers successful and then allocating capital effectively to meet high demand. Despite a tepid restaurant growth environment the last decade, Middleby has delivered double-digit growth and is maintaining it with its focus on quick-serve and fast casual restaurants as well as international markets.
In addition to the three previously mentioned sales, challenging operating or macroeconomic environments led to the sale of third party logistics company C.H. Robinson Worldwide and tech infrastructure firm EMC. Exxon Mobil and Safeway were sold to fund purchases in other companies that we believe represented better relative opportunities.
2013 Year-End Review
The Fund underperformed its benchmark for the full year 2013. U.S. and international developed market stocks benefitted from unconventionally accommodative monetary policy and stabilizing economic conditions. Higher beta (volatility) stocks were favored over more stable, higher quality stocks. Industrials, Healthcare, and Consumer Discretionary were the strongest sectors in the large-cap, with Healthcare boosted by biotechnology stocks that had their strongest year in more than a decade.
A positive sector allocation effect was not enough to offset negative stock selection during the year. The largest shortfall came from Healthcare, where our omission of opportunities in the biotech industry detracted from performance, while stock selection miscues in Materials also hurt performance. Picks in Consumer Staples and Industrials aided relative performance, as did underweight stakes in Utilities, Telecommunications and Technology and an overweight in Industrials.
After a strong last 12 months, we believe 2014 should be moderately positive—though with more volatility, which was mostly nonexistent last year. Less accommodative monetary policy from the Fed could be offset by accelerating economic growth in the U.S. We could also see an uptick in interest rates and a steepening of the yield curve. Even with a decent pickup in economic growth, though, the recovery would still be subpar relative to prior post-recession expansions. Therefore, we still believe the environment favors domestic stocks. Inflation, which has been subdued for the past five years, should remain so. We expect falling food commodity prices from a bumper harvest and lower energy prices from record domestic oil and gas production to benefit the consumer and help offset fiscal headwinds.
TAMRO Capital Partners
As of December 31, 2013, Amazon.com comprised 3.05% of the portfolio's assets, Chicago Bridge & Iron – 2.70%, Seagate Technology – 2.21%, Redwood Trust – 0.00%, Temper Sealy International – 0.00%, Itau Unibanco – 0.00%, Baidu – 2.02%, Hewlett-Packard – 1.50%, and Middleby – 1.94%.
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.