1st Quarter 2014
In our two previous quarterly commentaries we suggested that valuations were full and pockets of excess had developed across the mid-cap space, while the winding down of the Federal Reserve’s Quantitative Easing program could serve as a catalyst for heightened market volatility. The market appeared to concur as a number of high growth/momentum names came under pressure during the first quarter of 2014. Despite the increased volatility, both the broad market S&P 500 Index and the Fund’s Russell Midcap Growth Index benchmark managed to post modest gains, however. Market leadership continued to favor many of the factors that have recently driven equity market returns, namely smaller-sized companies and value oriented names as the Dow Jones Industrials index of leading blue chip stocks declined slightly. According to Bank of America/Merrill Lynch research, the smallest companies by market capitalization, companies without earnings, those with returns-on-equity (ROE) in lowest quintile, and companies with single-digit stock prices were among the best performing stocks within the Russell Midcap Growth.
The Fund performed roughly in line with its benchmark during the quarter. The relative performance was a refreshing change of pace from recent history in which the portfolio’s high-quality mid-cap growth issues lagged the index as investors chased high growth (at any price), lower quality, more-cyclical issues. Stock selection drove returns, with sector allocation offering a modest drag on relative performance.
Stock selection in the Technology, Financials, and Consumer Discretionary sectors was positive, though there was no clear overarching “theme” that drove performance during the quarter, as individual stock correlations appear to be declining. Notable outperformers included Xilinx and F5 Networks in Technology, financial company Signature Bank, auto-related stocks Harman International and O’Reilly Automotive, and healthcare service company Mednax. Each of these stocks rose in excess of 15%.
Stock-picking within Industrials and Energy was weaker, partially offsetting the above gains. Four stocks in the portfolio fell by more than 10%, including engineering software maker ANSYS, recycled auto parts provider LKQ Corporation, trucking company JB Hunt Transport, and financial exchange company Intercontinental Exchange. LKQ Corporation fell sharply following the release of a sell recommendation report by Prescience Point, a research firm that held a short position in the stock, alleging accounting irregularities. Although we are not convinced of the veracity of the report’s allegations, we recognized the stock’s appreciation potential was limited in the intermediate-term and reduced the position.
Portfolio activity was low during the quarter, with merely some minor tweaking to the position sizes of a few holdings. No new holdings were initiated in the portfolio nor any sold.
Following two years in which stock price gains materially outpaced the growth in corporate profits, the market appears fully valued, in our opinion, and we continue to see evidence of froth in certain pockets. Metrics such as margin debt (at new all-time highs) and quality of initial public offerings (IPOs)— according to Bank of America/Merrill Lynch, 80% of 2014 IPOs have been unprofitable versus an average of 42% since 2000—suggest to us a certain level of investor insensitivity to risk.
Other subtle reminders of the insanity of the technology bubble era creeping into today’s market environment are also evident. Consider, for example, a leading social media company paying more than $20 billion in the span of two weeks for two acquisitions with questionable revenue-generating capabilities. Or, our personal favorite, a brokerage firm upgrading a leading “cloud-based” healthcare IT stock in which the analyst wrote that it was “not without some reservation” that they were “trashing our traditional valuation approach” in favor of an alternative method. We lived, worked through, and survived the technology bubble. Analysts throwing in the towel on tried and true valuation measures in favor of alternative techniques to justify support for high-flying stocks is a sure sign of speculation. While anecdotal on their own, these observations in aggregate suggest to us that investors are still all too willing to embrace risk. We continue to err on the side of diligence and discipline, focusing on high-quality mid-cap companies with sustainable growth and return characteristics trading at reasonable valuations. We believe this approach is the prudent way to add value over the course of a full market cycle.
M. Scott Thompson, CFA Andrew W. Jung, CFA
As of March 31, 2014, Xilinx comprised 2.29% of the portfolio’s assets, F5 Networks – 1.91%, Signature Bank – 2.18%, Harman International – 2.39%, O’Reilly Automotive – 2.61%, Mednax – 1.54%, ANSYS – 1.16%, LKQ – 1.30%, JB Hunt Transport – 1.68%, and International Exchange – 1.53%.
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.