3rd Quarter 2010 Commentary
Following a choppy July and August, equity markets embarked on a powerful rally that resulted in the strongest September performance since the 1930s. After a series of economic data throughout late spring and early summer left investors wondering whether a double-dip recession was imminent, August reports on the economy showed stabilization, easing investor anxiety. Coupled with reassurances from fiscal and monetary policy authorities that they stood ready with additional stimulative measures should the economy show continued signs of weakening, the stage was set for the strong September gains.
While the economic recovery has been in place for more than a year now, 2010's weakening growth trend and still high level of unemployment are disappointing developments. The prior benefits of fiscal stimulus and the inventory cycle are fading and economic growth continues to be restrained by the ongoing financial deleveraging of the private and public sectors. Below trend growth is not unusual following a financial crisis as the economy must undergo a deleveraging process that can persist for some time. Importantly, however, we do expect modest growth to be sustained and for the equity markets to grind their way higher.
As mentioned in previous commentaries, since the market bottomed in March 2009 lower quality stocks have outpaced higher quality stocks. The third quarter may have offered a glimpse of a slow turn toward higher quality names. According to performance data on the Russell midcap indices provided by Bank of America/Merrill Lynch, stocks with higher return-on-equity (ROE) outperformed those with lower ROEs during the quarter. We also saw larger-sized companies within the Russell Midcap Growth Index outperform smaller names, a departure from quarters past when the smallest stocks outperformed. Still, the biggest factor influencing performance this quarter was volatility as high beta (volatility) names outpaced lower beta names. Even so, we're encouraged by the outperformance of higher ROE mid-cap stocks this quarter. Perhaps the high beta outperformance during the third quarter will prove to be one of the last vestiges of the more speculative market environment we've experienced since the March 2009 lows.
We added two new stocks to the portfolio during the third quarter while exiting three others. The Fund initiated a new position in auto parts supplier BorgWarner as we believe the company will benefit from increased demand for fuel-efficient and low emission technologies. The company is a leader in turbochargers and transmission technologies which are essential components in making car engines more efficient. The Fund also initiated a position in Robert Half International which we believe should benefit from improved temporary staffing trends, particularly in the fields of finance and accounting. While employment growth has been modest, we believe that hiring managers may look to employ more flexible labor strategies, playing to Robert Half's strength as a staffing company.
Positions sold this quarter included F5 Networks, DeVry, and FTI Consulting. F5 exceeded our estimate of fair value by more than 20%, which forced us to reduce or eliminate the position per our investment process. Although this sometimes leaves some "profits on the table" this discipline has been indispensible over the years in helping to avoid overvalued stocks that are susceptible to big declines on even modest disappointments in underlying company fundamentals. We sold for-profit education company DeVry based on the uncertainty associated with potential government regulation of the industry.
Finally, FTI Consulting was sold following a significant earnings disappointment and downward revision to guidance. Another hallmark of the Montag & Caldwell investment process is to reassess our investment thesis following major earnings disappointments. If we believe the earnings setback will prove temporary, we use any associated stock price weakness to add to the position. If we don’t have that confidence, we take action to sell the position entirely. FTI Consulting fell into the latter category as we misjudged the ability of the company's "pro-cyclical" businesses such as economic consulting to offset its large, counter-cyclical corporate restructuring and bankruptcy business.
With respect to performance, the Fund lagged its Russell Midcap Growth Index for the quarter, though it still leads the index for the year-to-date through September 30. Both sector allocation and stock selection were negative contributors to relative performance during the quarter. Modest cash reserves were the biggest drag in sector allocation, while weightings in Technology and Consumer Staples also hurt. Among the Fund's best performing individual stocks were F5, Alberto Culver (which agreed to be acquired by Unilever late in the quarter), Tractor Supply, Joy Global, Expeditors International, and Core Laboratories, all of which appreciated significantly. Laggards during the quarter were Southwestern Energy, JB Hunt, Intercontinental Exchange, Flir Systems and Polycom, all of which lost value. We took advantage of the weakness and added to positions in Southwestern, Intercontinental Exchange and Flir.
We think the outlook for high quality mid-cap growth stocks is quite attractive, particularly as the market turns its focus toward 2011 earnings and the prospect for continued, albeit quite modest, economic growth. We think the portfolio is well-positioned for a rotation to higher quality stocks in the period ahead. Thank you for your continued confidence.
M. Scott Thompson, CFA
Andrew W. Jung, CFA
October 4, 2010
As of September 30, 2010, BorgWarner Automotive comprised 0.78% of the portfolio's assets, Robert Half International – 1.32%, F5 Networks – 0.00%, Alberto Culver – 2.86%, Tractor Supply – 2.10%, Joy Global – 2.62%, Expeditors International – 2.00%, Core Laboratories – 1.40%, Southwestern Energy – 1.25%, JB Hunt – 1.70%, IntercontinentalExchange – 1.60%, Flir Systems – 1.05%, and Polycom – 2.11%.
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.