3rd Quarter 2010 Commentary
Strong Gains in Equities
Equity markets were up double-digits during the third quarter as fears of a double dip recession subsided. Investors moved to equities after the Federal Reserve raised the possibility of additional quantitative easing, bipartisan support grew to extend the Bush tax cuts, and Republican election prospects for Congress improved. Within mid-caps, value indices lagged their growth counterparts owing to a smaller weighting in stronger performing technology stocks and a higher stake in poorly performing financial services equities.
U.S. economic growth remained anemic during the period, though leading indicators still pointed to modest growth. The unemployment rate stayed high and fiscal policy was dominated by financial reform which was negative for most financial institutions due to the likelihood of added costs and regulatory complexity. Although challenging, the current economic environment is favorable for equities due to attractive valuations and very low interest rates and inflation. The growing number of merger and acquisition (M&A) transactions is the best testament to this as companies increasingly used their record high cash balances to make accretive acquisitions or repurchase stock.
Winning Tech Picks
The Fund outperformed its Russell Mid Cap Value Index benchmark during the quarter, though it continues to lag by a substantial margin for the year-to-date through September 30. Positive stock selection in the Technology and Consumer Discretionary sectors aided returns during the quarter. Hewitt Associates and Intuit were the largest contributors within Technology, with Hewitt having been acquired by insurance company Aon at a 50% premium. Intuit's share price rose due to better than expected earnings and guidance.
Among Consumer Discretionary stocks, Virgin Media was the best performer as the company completed refinancing its debt and began to take steps to directly enhance shareholder value. Retail holdings, such as American Eagle Outfitters and Tiffany & Co., as well as tool-maker Stanley Works also performed relatively well in the quarter as consumer spending picked up and valuations bounced back.
Detractors to returns came from stock selection in the Healthcare and Industrials sectors. Health equipment and service stocks lagged the overall sector as more volatile biotech and pharmaceutical stocks outperformed. Beckman Coulter, a maker of diagnostic equipment for hospitals and laboratories, was the biggest laggard. The FDA required that one of the firm's key tests be re-certified due to small technical changes that had not been preapproved. Although there were no customer complaints, the inability of some customers to use the test was more disruptive to its business than management originally forecast. Beckman expects the test to be approved next year and business to return to normal thereafter. Although no single stock accounted for much of the return difference within Industrials, several holdings did not keep pace with the market as their businesses did not have the economic sensitivity that investors were looking for.
Outlook and Strategy
As a long-term fundamental investor, Cardinal focuses on finding and following companies that meet our high business and financial hurdles. Although close attention is paid to current business and market conditions, we spend less time worrying about short-term trends and instead focus on investing in superior businesses over the entire economic cycle. We do, however, monitor the attractiveness of stocks relative to bonds, and when our universe of stocks is inexpensive we inevitably find more and higher quality investment ideas. While we regularly mention the relative attractiveness of stocks is in our quarterly letters, we have rarely elaborated. Now, however, we want to share our thoughts on some common misperceptions of stocks, bonds, and risk because those misperceptions could lead investors to make poor investment decisions.
The root of our concern is that the riskiness of an asset cannot be properly assessed by looking at its price history, price volatility, or a liability to which it is related. Risk models must include fundamental factors that determine value or the output is simply not useful. We think that one need look no further than the current housing debacle to see how dangerous models based upon price and volatility can be. Banks, rating agencies, and policymakers all treated home mortgages as low risk assets, despite the sharp run-up in home prices and deterioration in underwriting standards because the risk models were all based on historically rising housing prices. They ignored reduced affordability in many communities and the ability for homeowners to get mortgages without having to document their ability to service, let alone pay back, their loans. Simply put, these risk models did not work because they relied entirely on historic prices and left out factors affecting creditworthiness and current housing values.
In this context, most fixed-income securities, particularly government bonds, seem quite expensive to us. Held to maturity, the 10-year government bond currently will return its principal and a nominal yield of 2.5%, but offers no inflation protection. We regularly hear that bonds are low risk as they have recently only risen in value and price volatility has been low. Inflation which today is only 1% is likely to rise, however, if government deficits remain large. In contrast, stocks, particularly small- and mid-caps are said to be risky because their prices have been volatile and their yields fluctuate with competition and the business cycle. Little attention is given to their relative valuation, which we find compelling because equity multiples are near long-term averages despite very low interest rates. As a result, the expected return of stocks relative to bonds is near a multi-decade high. It is so high in our view because most investors are comfortable owning what has worked and that is currently bonds. In contrast, equities have returned little over the last decade. After taking big losses in 2008, many investors simply lost patience, sold out, and put their money elsewhere. What is important is that perceptions change with time and circumstances.
No single event will change investor perceptions quickly but many strategists believe that the relative valuation gap between stocks and bonds will narrow when it is clear that inflation rather than deflation is a bigger risk to the U.S. economy. This could arise from a political change that is pro-business and leaders willing to spend more to promote growth or from signs that employment is rising and real estate markets are stabilizing without temporary government assistance. Although higher inflation is inevitable, funds are not likely to flow into equities and out of bonds unless investors suffer large losses in bonds while stock prices hold steady, or equity prices run up materially and bond prices tread water. In any case, investors as a group always gravitate toward the asset class that performed best recently and risk gets redefined.
As seasoned value investors, we at Cardinal have been entrusted to invest in companies with fundamentally sound businesses in order to generate attractive long-term returns. We have done so successfully in the past and remain confident that we can do so in the future.
The Cardinal Capital Team
As of September 30, 2010, Hewitt Associates comprised 0.00% of the portfolio's assets, Intuit – 4.24%, Virgin Media – 4.12%, American Eagle Outfitters – 2.00%, Tiffany & Co. – 1.39%, Stanley Black & Decker – 3.74 %, and Beckman Coulter – 1.80%.
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.