1st Quarter 2014
The 1% to 3% increase in U.S. equities, depending on one’s choice of index, belied the turbulent nature to the first quarter of the year. Equity performance spanned a five-percentage point decline to begin the quarter to a late-March rebound to new highs. The early decline seemed more bent on consolidating gains than on any particular piece of domestic news. Market pundits pointed to concerns outside the U.S. (China and Ukraine) contributing to investor angst.
Within the Fund’s Russell 2000 Value Index benchmark, Energy and Utilities were the notable outperforming sectors, while Consumer Discretionary, Technology, and Industrials were relative laggards. Quality trends were mixed, with the first two months of the period favoring lower quality issues and higher quality rebounding in March.
The Fund underperformed the benchmark during the quarter owing to lackluster stock selection. Sector allocation in terms of over- and underweight positions, did not have a material impact on our relative performance, but stock-picking lagged within six sectors—notably Healthcare and Consumer Discretionary. West Pharmaceuticals hurt as it reported modestly disappointing fourth quarter results and guidance. We had been reducing the position as the shares appeared close to our estimate of current fair value and carried one of the portfolio’s larger market capitalizations. Biotechnology was a strong sub-sector performer within Healthcare, an industry we generally have difficulty finding investable ideas and consequently tend to have little or no exposure.
Consumer Discretionary stock ReachLocal was the second worst performing stock in the portfolio during the quarter, but a relatively small position limited the damage. Although the shares have been a disappointing investment to date, we do think there is value in the name. We are hopeful that a newly named CEO will help improve current results and/or a strategic buyer will emerge. La-Z-Boy, a more meaningful position succumbed to profit taking following huge gains in 2013. The impact of harsh winter weather on near-term results also raised concerns. We think La-Z-Boy remains on track and stands to benefit from improving consumer spending and better execution despite temporary weakness from poor weather.
The portfolio’s picks in Energy and Consumer Staples modestly outperformed the benchmark, while Technology provided the greatest relative outperformance. M/A Com Technology Solutions was the Fund’s second best performer following some positive portfolio restructuring.
Buys and Sells
New positions purchased during the quarter included Cambrex, One Gas, Greatbatch, and Bank of the Ozarks. Pharmaceutical supplier Cambrex manufactures trial-scale quantities for late-stage pre-approval drugs, as well as commercial-scale quantities for approved drugs. We think the company has improved its business and expect steady margin improvement to yield mid-to-high teen earnings growth over the next few years. One Gas is a recent spin-off from ONEOK and is the third largest publicly traded natural gas local distribution company in the U.S., serving mostly residential customers in Oklahoma, Kansas, and Texas. The appeal here is a strong balance sheet and a dividend payout ratio with room to grow, backed by a solid service area that can aid in gradual improvement of the company’s return-on-equity (ROE).
Greatbatch develops and manufactures components used primarily in medical devices. Its legacy expertise is as a supplier of batteries and power supplies to the major manufacturers of implantable devices, such as pacemakers and defibrillators. The firm produces strong free cash flow and manageable net debt, while from a valuation standpoint it sells at what we believe is an unwarranted discount to its medical device peer group.
Bank of the Ozarks operates mostly in the South and New York, and has exceptional profitability metrics plus a history of earnings stability that is among the best in the industry. We think there is an opportunity for estimates to be revised upward based on two acquisitions that will close this year. The shares are not cheap, nor should they be in our view, based on the bank’s exceptional management, superior profitability, and history of growth. We think earnings can grow substantially over our investment horizon based on its soon-to-close acquisitions, organic loan growth, and future acquisitions.
We sold four stocks from the portfolio during the quarter, Bob Evans Farms, Fair Isaac, FirstMerit, and TAL International Group. We had been trimming Bob Evans holding as the shares moved higher partly due to an activist shareholder. With valuation fair and deteriorating fundamentals, we decided to eliminate the balance of the position. Fair Isaac reached what we believe to be a fair valuation. We eliminated FirstMerit for size, as it was one of the portfolio’s largest market-capitalizations. TAL was the worst performer during the period, declining in part due to a short-seller’s report. Although we disagreed with much of that report, with weakening fundamentals we decided to eliminate the holding and move on.
Although absolute valuations have certainly moved up over the past couple of years, and the relative valuations of small-cap stocks have advanced, we think the portfolio is reasonably valued given the current level of inflation, interest rates, and corporate balance sheet strength. In talking with company management teams, adverse winter weather aside, business in the U.S. seems to be improving at a moderate pace. Many opine that the worst is behind Europe, while trends in China are mixed. Balance sheets generally are in excellent shape, and we remain hopeful of increasing merger and acquisition activity. Perhaps the apparent increase in shareholder activist activity is a precursor to a more robust acquisition environment. Elevated levels of volatility and lofty valuations of some “story” stocks does give us pause, but we feel the portfolio may be somewhat insulated given our investment style and think we can build on the modest gains of the first quarter as the year progresses.
Silvercrest Asset Management Group
New York, NY
As of March 31, 2014, West Pharmaceuticals comprised 1.20% of the portfolio's assets, ReachLocal – 0.77%, La-Z-Boy – 2.06%, M/A Com Technology Solutions – 1.89%, Cambrex – 1.10%, One Gas – 1.49%, Greatbatch – 1.49%, and Bank of the Ozarks – 1.31%.
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.