2nd Quarter 2010 Commentary
Correction Continues, But Fundamentals Improving
After rising almost uninterruptedly since the market trough in March 2009, stocks corrected sharply during the second quarter of 2010—wiping out gains from the first quarter. Weakness was widespread across the market-cap spectrum, with large-cap stocks retreating more than small-caps. Sector weakness was severe within the commodity sectors, namely Energy and
Materials, but large-cap Financials and small-cap Consumer Discretionary also suffered noticeably. The sharpness of the correction surprised many, but it should not be viewed as unusual when put in the context of the rise from the March 2009 lows. We continue to be optimistic that the economic expansion will progress based on the fiscal and monetary stimulus, low inflation, improving corporate balance sheets, and three quarters of positive economic growth. Although employment growth has been a laggard at this stage in the cycle, hours worked continues to creep upward, increasing the probability that job growth will eventually follow.
The previously identified headwinds of increased regulation and taxation are still a concern and to this we add the potential delay in recovery in Europe. This reinforces our thesis that the overall recovery will be slower than normal, with the sharp correction in stocks corroborating this premise. While we did not expect a linear march upward in stocks, the correction in May and June was more severe than we had expected. There is a silver-lining, however—the improved valuation of many leading companies. Yes, it is a fearful recovery. Still, we remain ever vigilant for attractive long-term investment opportunities.
The Fund slightly outperformed its Russell 2000 Index benchmark during the second quarter, as the index suffered a nearly double-digit loss. All sectors of both the portfolio and the index had negative absolute returns during the period. The Fund outperformed on a relative basis due to positive stock selection primarily in the Healthcare, Technology, and Materials sectors. Best-practice health research firm Advisory Board Company reported accelerating revenues and management raised guidance for the year. The recent economic turmoil has interrupted the company's growth trajectory from earlier in the decade, but we believe healthcare reform is likely to increase demand for the its programs from both existing and new customers. Data storage provider Netezza announced strong revenue growth while software firm Seachange International delivered improving profit growth within Technology.
An overweight position in Consumer Discretionary plus weak stock selection was the main detractor from relative performance. Liz Claiborne missed revenues and earnings targets as its corporate restructuring continues to unfold. Uncertainty in demand for big ticket purchases dragged Winnebago Industries lower. The firm's bottom line results remain steady, however, as it continues to execute well. Among individual holdings, Janus Capital was a major detractor as outflows at its INTECH unit were not sufficiently offset by other business units. Loss of confidence in the firm's execution as evident by management/employee attrition and the need for the development of additional product offerings led us to sell the stock from the portfolio.
It is very easy to cite reasons to be fearful about the current environment. We learned long ago not to discuss fundamentals irrespective of valuation, however, and we believe the market has discounted most of the concerns on which investors are focused. We consider the recent downdraft an opportunity to own leading companies in diverse sectors at very attractive values.
Through our bottom-up analysis, we have identified the most opportunities within the Consumer Discretionary sector, followed by Financials and Technology. These sectors represent the largest weightings in the portfolio. The lowest sector weights, on both an absolute basis and relative to the benchmark, are in Utilities, Energy, and Materials. Shifts in portfolio positioning have been modest over the last quarter and are the result of company-specific decisions rather than any macroeconomic call. One stock that became a full position during the quarter was casual dining restaurant Texas Roadhouse. The company is one of the few in the industry that grew revenues and earnings in both 2008 and 2009. While such a performance is admirable amid a tough economic environment, we believe performance could improve when the consumer spending freeze of the past two years begins to thaw. Returns should be further enhanced by falling development costs.
Other positions sold from the portfolio, in addition to Janus mentioned above, included Gannett, Hornbeck Offshore Services, and NBTY. The Fund took profits on Gannett as its market-cap approached $5 billion and we identified other stocks with better upside to downside potential. Hornbeck Offshore got caught in the travails of the Gulf of Mexico spill disaster, which clouded the outlook for deep water drilling operations—a source of much of the firm's clientele. The Fund also took profits in nutritional supplement provider NBTY after a strong 12-month run and news that future margins may be depressed by a shift in product mix.
We do not have a crystal ball that signals when the correction will have run its course, but we do have confidence in the investments we have identified for the upturn. Overall, the Fund has not veered from its investment strategy, as companies we classify as Leaders or Innovators comprised 83% of portfolio assets as of the end of the quarter.
TAMRO Capital Partners
As of June 30, 2010, Advisory Board Company comprised 3.14% of the portfolio's assets, Netezza – 2.50%, Seachange International – 1.15%, Liz Claiborne – 0.78%, Winnebago Industries – 1.20%, and Texas Roadhouse – 1.71%.
Note: Small-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.