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Apr 21 2014

1st Quarter 2014 Commentary - ASTON/Fairpointe Mid Cap Fund

1st Quarter 2014

Following a very strong 2013, the U.S. stock market continued its upward trend during the first quarter of 2014, albeit in a more turbulent fashion. Mid-cap indices such as the Fund’s S&P Midcap 400 Index benchmark and the Russell MidCap Index, finished up 3.0% and 3.5%, respectively. The large-cap oriented S&P 500 Index gained 1.8%, while the small-cap Russell 2000 Index increased 1.1%. The Fund outperformed all of them by a sizeable margin. 

Akamai Dominant
Performance contribution continued to be broad-based, with 17 stocks up more than 10% and only five stocks down more than 10%. The top contributor was Akamai Technologies on the back of strong secular tailwinds as Internet traffic growth favors Akamai as a leader in accelerating content delivery. The company announced better than expected quarterly results and the renewal of a large contract with an important client. At a recent investor presentation, Akamai discussed ongoing investments in sales to address the international market and research and development investments to tackle the fast growing Internet security market. Akamai has an extensive global network of servers and intelligent software that accelerates more Web traffic than any other participant. As a result, the company is uniquely positioned to identify, absorb, and block cyber-attacks before they reach their client’s servers.

Other top contributors included pharmaceutical company Forest Laboratories and tech company Juniper Networks. Forest Labs soared after receiving a take-over offer from Actavis, a larger pharmaceutical company based in Ireland. We sold the position from the portfolio as the price premium unlocked the value of Forest’s strong pipeline of pharmaceutical products. Juniper benefitted from renewed demand for its routers and switches as long-awaited telecom infrastructure spending resumed. 

Staples Suffers
The primary detractors to first quarter performance were Staples, Itron, and McDermott International. Staples was the worst performer after reporting weak fourth quarter results, particularly in its North American stores. We were disappointed that shares were back to levels at which the Fund initially purchased them in August 2012. Our thesis remains intact, however, as we think that as the largest global office-products company and second largest Internet retailer behind Amazon, the firm should be able to offset secular and cyclical headwinds through expanded product offerings, market share gains due to fallout from the Office Max/Office Depot merger, stabilized international operations, and aggressive downsizing of its retail footprint. We believe the stock remains attractively valued relative to revenues and forward earnings, and maintains a solid dividend yield. 

Itron is the only remaining pure play smart-metering company offering energy and water usage monitoring technologies to municipalities and utilities globally. Weak economic conditions in Europe, the market with the greatest growth opportunities, have delayed the adoption of these technologies. Itron’s stock is trading near its historical lows in terms of valuation. We increased the Fund’s position during the quarter as we expect adoption rates and revenues to grow along with improving economic conditions.

Energy services company McDermott’s strategic move into subsea drilling has been plagued with execution issues. The company’s new CEO is addressing these issues with a comprehensive review. Recent financial restructuring should allow the company to prefund their needs for the next two years. We think the stock is attractively valued at current levels. 

Portfolio Changes
We added four new stocks to the portfolio during the quarter—Quest Diagnostics, Mattel, U.S. Steel, and Cooper Tire & Rubber. Quest Diagnostics is a leading provider of laboratory services that assist physicians in making healthcare decisions. Quest has a network of more than 2000 patient service centers across the country, providing scale and cost advantages relative to regional competitors and hospitals. The company’s stock has underperformed the market due to investor fear of future medical reimbursement cuts. We believe these risks to be already discounted in the current stock price. Mattel, a previous holding in the portfolio, declined to an attractive valuation level following a disappointing fourth quarter 2013 earnings announcement.

U.S. Steel has a market value of $3.9 billion and depressed revenues of $17.4 billion. We started buying the stock in February and it has already contributed to performance. The company, under a new and very experienced CEO, is implementing a major transformation to improve results independently of a cyclical rebound. The company should also benefit from lower energy costs and a return of manufacturing to the U.S. 

Cooper came into focus after a failed takeover last year by India’s Apollo Tyres, which originally agreed to pay $35 per share for the firm. One of Cooper’s joint venture partners in China shut down due to a strike, which may have been in protest of the pending acquisition. As this all played out, the stock went from $24, up to nearly $35, and right back down to below $24. Cooper is the fourth largest U.S. tire manufacturer focusing primarily on replacement tires at mid- to low-price points. Roughly 70% of sales come from North America. Cooper has recently entered the original equipment market in the U.S. with a contract to supply tires for the Ford Focus.

H&R Block and McGraw Hill Financial were eliminated from the portfolio in addition to the aforementioned Forest Labs. All three stocks had appreciated significantly during the Fund’s holding period. 

Perspective and Outlook
As we discussed in last quarter’s commentary, a number of key trends continue to unfold in the economy and market. Supported by low interest rates, the domestic economy is in recovery mode. The cyclical recovery in housing and auto related industries persists, while stronger employment trends support consumer income growth and spending activity. Manufacturing is returning to North America as companies position their production closer to demand and take advantage of lower transportation and energy costs, as well as a more favorable labor environment. As capacity utilization in the U.S. increases, we look for additional capital spending and subsequent growth throughout the economy. We also expect merger and acquisition activity to accelerate. Companies with leading market share positions and strong balance sheets, such as those we seek for the portfolio, have been and will continue to be attractive acquisition targets.

We think the portfolio remains attractively valued relative to its S&P Midcap 400 benchmark. Although valuations have moved up across the equity market, we continue to find undervalued stocks, as evident by recent additions to the portfolio that have already contributed to performance, with four of the 10 best performing stocks this quarter having been purchased since the beginning of 2013. 

Fairpointe Capital

Thyra E. Zerhusen, Chief Investment Officer
Marie L. Lorden, Portfolio Manager
Mary L. Pierson, Portfolio Manager

As of March 31, 2014, Akamai Technologies comprised 2.30% of the portfolio’s assets, Forest Laboratories – 0.00%, Juniper Networks – 2.66%, Staples – 2.90%, Itron – 2.30%, McDermott International – 1.96%, Quest Diagnostics – 1.97%, Mattel – 2.00%, U.S. Steel – 2.15%, and Cooper Tire & Rubber – 2.76%.

Note: 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.


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