2nd Quarter 2010 Commentary
Stock market volatility reappeared during the second quarter as investors faced a series of events that raised uncertainty within equity markets. First, it was the Greek debt crisis and the fear that it could lead to contagion. Second, came the May 6 "Flash Crash" when the Dow Jones Industrial Average fell nearly 1,000 points in a matter of minutes, raising doubts about the proper functioning of the financial markets. Third was the BP oil spill and questions about its lasting environmental and economic impact. Fourth was the stalling out of the jobs recovery that began during the third quarter of 2009. Last, but certainly not least, was concern about the slowing Chinese economy, where policy makers have taken measures to prevent a real-estate bubble and runaway inflation. This last issue is perhaps of greatest concern considering how important China has become to the sustainability of the global economic recovery. The result of all these factors was a sharp increase in risk aversion during the quarter as exemplified by a near doubling of the Chicago Board Option Exchange's Volatility Index (VIX), a measure of the implied volatility of the S&P 500 Index.
Although the Fund delivered negative returns for the quarter, performance outpaced the portfolio's Russell Mid Cap Growth Index benchmark by a fair amount. Stock selection had the biggest positive impact on relative performance led by holdings in the Consumer Discretionary, Industrials, and Technology sectors. Notable performers included O'Reilly Automotive, Core Laboratories, Stericycle, Fastenal, Tractor Supply Co., and Chipotle Mexican Grill. Conversely, holdings within Healthcare and Financials served as a modest drag on relative performance, with Oceaneering International, Juniper Networks, L-3 Communications, Cameron International, Lazard, and MSCI weighing on returns the most.
New positions initiated during the quarter included publisher John Wiley & Sons, advertising holding company Omnicom Group, electronic futures, options, and derivatives exchange IntercontinentalExchange, and spices and seasonings maker McCormick & Co. Following strong stock performances, we eliminated the portfolio's Marriott position and trimmed several other Consumer Discretionary holdings purely on valuation. The Fund also exited Covance following an earnings disappointment and Affiliated Managers Group owing to a compliance requirement related to AMG's purchase of Aston Funds, advisor to the Fund.
After advances of +5.6% and +2.7% in real Gross Domestic Product (GDP) in the preceding two quarters, we believe growth in the second quarter was approximately +3.0%. More recent economic data, however, indicates that growth is slowing. Leading economic indicators have rolled over, signaling decelerating growth in the second half of the year. Whether this "soft patch" leads to a "double-dip" recession was the key debate at the end of the second quarter.
We continue to believe U.S. economic growth is sustainable but is likely to remain sluggish for an extended period of time given the ongoing deleveraging of the household, financial, and public sectors, along with higher taxes and increased regulation. The positive impact from government stimulus, fulfillment of pent-up consumer demand, and inventory restocking have likely run their course, and a stronger dollar is likely to become a headwind for export growth. Therefore, growth will now become even more dependent on business hiring and capital investment. For the second half of the year, we still believe that real GDP growth of 2% to 3% is likely. This is less than what would be expected after such a severe recession and is also less than needed to bring down high rates of unemployment and government deficits and debt. Meanwhile, low inflation should reduce pressure on the Federal Reserve to raise interest rates for the time being.
We believe a more volatile stock market and greater uncertainty about the economic outlook have set the stage for a rotation to high-quality growth stocks. In fact, we saw signs in the second quarter that a shift in market leadership may be underway. While the second quarter marked yet another quarter where low-quality issues (defined as S&P ranked B or worse) beat high-quality (ranked B+ or better), the performance gap narrowed to just 10 basis points—its smallest margin since the rally off the March, 2009 lows began. And that comparison is distorted by the superior performance of non-ranked issues, which are included in the low-quality category. When looking more closely at performance segregated by individual ranking, especially over the past two months, one can discern a decided gap opening up between the highest and the lowest quality issues. Additionally, the second quarter was characterized by strong relative performance of low-beta (volatility), high dividend-yield, and high-ROE companies, another positive sign for quality. We expect the combination of attractive relative valuations, decelerating profit growth, declining earnings estimate revisions, and rising market volatility will lead investors to seek out higher-quality, more consistent growers, especially those offering strong balance sheets, healthy cash flows, high returns on capital, and attractive dividend yields.
We expect continued stock market volatility over the coming months as investors grapple with the possibility of slower than expected growth in the second half of 2010 and in 2011. Corporate profits, which have been stronger than expected so far this recovery, will face increasing headwinds, including tougher comparisons, a weaker economy, a stronger dollar, near-peak profit margins, and a return of certain business expenses that were cut during the worst of the downturn. On a positive note, following a 15% correction from the April highs for the S&P 500, the overbought market condition has been worked off and valuations are now more attractive. Furthermore, cash levels remain historically high, investor sentiment has turned more cautious, and monetary policy can be expected to remain accommodative. We believe our portfolio remains well-positioned to benefit from a rotation to high-quality growth stocks.
M. Scott Thompson, CFA
Andrew W. Jung, CFA
July 1, 2010
As of June 30, 2010, O'Reilly Automotive comprised 1.84% of the portfolio's assets, Core Laboratories – 1.77%, Stericycle – 2.03%, Fastenal – 2.01%, Tractor Supply – 1.81%, Chipotle Mexican Grill – 0.97%, Oceaneering International – 1.70%, Juniper Networks – 1.16%, L-3 Communications – 1.62%, Cameron International – 1.79%, Lazard – 1.13%, MSCI – 1.33%, John Wiley & Sons – 1.04%, Omnicom Group – 1.80%, IntercontinentalExchange – 1.49%, and McCormick & Co – 1.02%.
Note: Small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.