2nd Quarter 2010 Commentary
Equity markets dropped sharply during the second quarter of 2010, giving back gains made during the first quarter. Stocks were negatively affected by investors' risk aversion stemming from the European debt crisis and considerable data that suggests that the U.S. economic recovery is losing momentum. After making steady progress, the U.S. economy hit several obstacles to growth during the period. The onset of the European debt crisis raised concerns that fiscal austerity actions by several European governments would dampen economic growth on the Continent as well as the prospects for U.S.-based multinational companies. Domestic employment and manufacturing data was also unimpressive, albeit still at levels consistent with modest economic growth. U.S. fiscal policy became less supportive as Congress did not reauthorize the home buyer tax credit or extend unemployment benefits. Finally, the President's anti-business rhetoric and higher taxes to support health care and other reforms are keeping firms from making additional hires in the U.S.
Nonetheless, most economists are still forecasting slow growth in the U.S., not a double-dip recession. Although not ideal, this environment is favorable for equities as valuations are attractive and interest rates and inflation remain low. Moreover, companies are sitting on record cash balances, which they are beginning to deploy as evidenced by the increased M&A activity during the year.
Shift to Quality
The value component of the Russell Midcap Index declined slightly less than its growth counterpart during the quarter owing to stronger returns in the Financials, Utilities, and Energy sectors. In a reversal of recent performance trends, the return of high-quality stocks was better than that of low-quality stocks. Although all sectors had negative returns, the most defensive ones such as Utilities and Telecommunications declined the least.
The Fund lagged its Russell Mid Cap Value Index benchmark during the period, adding to its underperformance for the year. Returns trailed during the quarter largely due to an adverse sector mix, specifically a higher-than-index weighting in Technology and the absence of Utilities in the portfolio. Stock selection was a neutral factor on balance, though several investments are worth noting.
The portfolio's two defense industry stocks fell sharply owing to heightened concerns over future government budgets, a small but well publicized business issue at L3 Communications, and pessimism over the fate of Alliant Techsystem's NASA programs, which the President has slated to terminate. R.R. Donnelly also weakened, despite good financial results, as economic concerns and the FTC's request for additional information on its Bowne acquisition weighed on the stock. Our investment in asset management companies also depreciated due to the equity market correction and was the major detractor within Financials. On the positive side, investments in Progress Software and Intuit performed much better than the Technology portion of the benchmark on solid results and positive financial guidance. In addition, several Healthcare equipment and service stocks, especially Laboratory Corporation of America, Beckman Coulter, and Henry Schein held up well. Finally, investments in Silgan Holdings and FMC Corporation in the Materials sector declined more modestly than their commodity oriented peers.
At Cardinal, we focus on finding companies with solid fundamentals at opportunistic valuations. Virgin Media is a significant UK media and telecommunications company formed through the merger three years ago of two cable operators and Virgin Mobile, a prepaid cellular company. The company has exploited the advantages of its extensive cable network to offer enhanced services and increased speed and quality in its TV and internet products. These developments have resulted in improved customer satisfaction and retention metrics, and thus, improved financial performance since the merger. As expenses related to the merger decline and prices rise, the company's free cash flow should improve substantially. The company is positioned to potentially return a meaningful portion of this growing free cash to shareholders through dividends or share repurchases. As Virgin Media executes its business plan and begins to return cash to shareholders, we think its share price will rise and the valuation discount to other cable/telecom companies should narrow significantly.
The J.M. Smucker Company produces and markets major food products in North America, including such well known brands as Folgers, Crisco, Pillsbury, Jiff and Smucker's. As an operator in mature markets, management has pursued growth through acquisitions of large but neglected leading brands that fit well with its product portfolio. Smucker's goal is to reinvigorate the acquired brands to drive mid single-digit revenue and high single-digit earnings growth. We became interested in Smucker’s following the announcement of the acquisition of the Folgers and Dunkin Donuts brand coffee businesses from Proctor & Gamble. The stock sold off due to concerns over the large equity issuance associated with the transaction and management's ability to run the coffee business successfully. We were confident that the short-term stock price pressure would abate and that the acquisition would prove successful based on management's previous transactions. Most importantly, Smucker's generates substantial and growing free cash flow that management has a record of using astutely to increase its dividend and repurchase shares. Since consumers are faced with tight household budgets, we are convinced that the trend towards eating at home will persist for some time.
Despite the recent soft patch and continuing economic challenges, the sharp correction in equity prices and widespread pessimism has created the proverbial "wall of worry", which often sets the stage for higher stock prices. Money market rates and bond yields remain low, so that equities are an increasingly attractive investment alternative. In addition, the Federal Reserve is not likely to raise interest rates this year, or next, given the current economic uncertainties and tame inflation. Low interest rates and improving credit conditions are critical to stimulating economic growth in the private sector, which will ultimately reinvigorate the U.S. economy. In the interim, corporations are flush with cash and lower equity prices only make mergers and acquisitions more attractive.
As for the impact of the economic slowdown on the portfolio, we are confident that it should not be too significant as most of the Fund's holdings were already cautious in their planning. In this regard, we think Cardinal's approach of opportunistically buying high-quality, free cash-flow generating businesses at attractive valuations could prove timely. The rebound in mergers and acquisition activity also bodes well for the portfolio's future success. Two portfolio companies received acquisition offers during the quarter and one is exploring strategic alternatives. Although company management teams continue to be guardedly optimistic, many are building cash in order to maintain financial flexibility should attractive business opportunities arise.
The Cardinal Capital Team
As of June 30, 2010, L3 Communications comprised 2.52% of the portfolio's assets, Alliant Techsystems – 1.04%, R.R. Donnelley – 3.07%, Progress Software – 3.39%, Intuit – 3.81%, Laboratory Corp of America – 2.52%, Beckman Coulter – 2.52%, Henry Schein – 1.89%, Silgan Holdings – 4.36%, FMC Corporation – 1.68%, Virgin Media – 3.38%, and The J.M. Smucker Company – 3.52%.
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.