4th Quarter 2010 Commentary
The Fund had a strong year on both an absolute and relative basis in 2010, finishing the up more than four percentage points over its Russell 1000 Index benchmark. It was a good year for U.S. investors, as our own backyard proved the best place to invest. Monetary and fiscal policy played a large role in helping investors navigate a steady course, albeit with a few bumps. Bypassing concerns of a potential double dip recession made for a strong second half of the year in the stock market. Last year also saw a marked acceleration in merger and acquisition activity fueled in part by the sluggish pace in economic growth and bulging corporate cash coffers approaching $2 trillion.
Strong stock selection within the Technology and Consumer Discretionary sectors were the driving force behind the Fund's performance for the full year in both relative and absolute terms, with stock-picking in the Healthcare and an overweight stake in Consumer Discretionary also aiding returns. Two technology stocks, two consumer stocks, and one industrial stock topped the leader board in 2010. The trend in increased capital investment in the corporate enterprise segment, where cloud computing is capturing much of corporate spending, figured prominently in the best-performing stocks for the year. Data storage provider 3Par received a buyout offer and is no longer in the portfolio. Another firm involved in the growing field of cloud computing was Internet networking firm F5 Networks, which delivered performance and guidance that exceeded expectations. A renaissance in the automotive industry boosted shares of BorgWarner, while the value proposition offered by Dollar Tree resonated well with cost-conscious consumers. Shares of mining equipment maker Joy Global moved higher as investors made a bet on growth in Emerging Markets.
Stock selection in the Financials, Materials, and Utilities sectors, as well as an underweight position in Telecommunications detracted from performance for the year. Changing regulations played a key role for three of the stocks that weighed most heavily on the portfolio. Bank of America and regional bank BB&T were weak in part due to onerous new financial regulations, while new regulations for non-profit education companies negatively affected Washington Post through its Kaplan subsidiary. Although small-cap technology stocks had a banner year, large-cap tech lagged behind. Shares of both Dell and NVIDIA did not resonate with investors. We appear to have been early as to the fundamental follow through, but like both companies for the long-term.
Fourth Quarter Rally
During the fourth quarter, good news came on several fronts. From the Federal Reserve's announcement of a second round of quantitative easing, that will pump additional liquidity into the financial system, to the November elections that signaled a move towards the center in regards to Washington fiscal policy the news helped to reduce uncertainty as it relates to taxes, regulations and the domestic economy. The quarter saw another strong period of sharply rising stock prices across the market-cap spectrum, with small- and mid-cap stocks leading large-caps.
All sectors in the portfolio and the Russell 1000 Index delivered positive absolute returns, with the Fund leading the benchmark due to strong stock selection across most sectors. The strongest relative returns were provided by the Consumer Discretionary, Technology, and Energy sectors. National Oilwell Varco was the biggest individual contributor as the company reported earnings that beat expectations and benefitted from better than expected demand for offshore drilling equipment. Previously mentioned BorgWarner, along with fellow auto-related holding Johnson Controls, also aided returns. Lastly, fertilizer producer The Mosaic Company outperformed as surging grain prices during the quarter boosted agriculture-related stocks.
With stocks surging ahead during the quarter, the biggest detractor was a small amount of cash held in the portfolio. Among holdings that marginally detracted from performance was Regional bank BB&T, which was sold during the quarter given concerns over the impact of new financial regulations. Healthcare information company Quality Systems missed its earnings target and document storage firm Iron Mountain released weak guidance, weighing down each stock. We sold both from the portfolio during the quarter to invest in more compelling opportunities.
We think the portfolio is positioned to benefit from several powerful trends going forward—cloud computing, an emerging global middle class, and global industrialization. Cloud computing has become a popular term for describing what is essentially using the internet to deliver more goods and services. Corporations are embracing cloud computing because it speeds up delivery times and reduces costs. We believe that cloud computing, along with mobile devices, will have a long-lasting impact on how business evolves globally and we have identified a number of well-positioned software and hardware companies in the space.
As emerging economies such as China and India develop, their respective populations move up the economic scale. That progression in wealth drives dramatic changes in behavior, particularly in regards to diet and transportation. As people become wealthier they consume more food, especially protein. More protein production requires more grain production to fatten herds (it takes six pounds of grain to produce one pound of beef). The only way to produce more grain per acre is through the use of better seed technology, crop nutrients, and agricultural equipment. We have invested in companies at each one of these points along the agricultural food chain, including new holdings in agricultural equipment manufacturer AGCO as well as seed and herbicide provider Monsanto. As people become wealthier they also become more mobile, trading communal or unmechanized forms of transportation for automobiles. Today, China has surpassed the U.S. as the world's largest automobile market despite an ownership penetration rate that remains well below that of developed nations. The Fund owns two best-in-class auto parts manufacturers in BorgWarner and Johnson Controls that are seeing revenue growth accelerate due to demand from key emerging markets.
Finally, as Emerging Markets develop they require massive infrastructure investment to sustain an accelerated pace of economic growth and ensure the benefits of that growth accrue to society overall. To that end, tens of billions of dollars are being invested in China and Brazil and other Emerging Markets to modernize water, energy, and transportation systems. Although significant, that level of investment only begins to address the needs of rapidly growing countries (it is estimated that half of the urban population in Asia and Africa lack access to healthy water). That ongoing industrialization creates tremendous opportunities for U.S. companies providing engineering and construction services and the heavy equipment used in hard commodity extraction and large scale infrastructure projects. We have identified several industrial concerns that have and should continue to benefit from this very powerful global trend.
Five stocks became full positions during the quarter as near-term concerns depressed stock valuations to where, by our calculation, the upside opportunity versus the downside risk made them attractive opportunities. Two notable mentions in addition to the agriculture stocks noted above were Goldman Sachs and Research-in-Motion. Although Goldman must adapt to a regulatory environment likely to limit the profitability of some business units (which appears to be fully priced into the stock), we believe the firm's robust capital position and talent base will enable it to outperform its peers, take market share, and drive earnings higher as the economic environment improves. The valuation of Research-in-Motion is at historic lows across all metrics despite revenue and earnings growth in excess of 20%. We believe this lack of optimism for the firm underestimates the difficulty in penetrating the corporate environment, where it has earned its share by focusing on security—a critical component to success in business environments. A catalyst for a potential acceleration of revenues is the upcoming launch of its tablet device, named the Playbook.
The Fund sold five positions during the quarter. In addition to the three mentioned above, we sold real estate investment trust Redwood Trust and Salesforce.com, the former to fund more compelling ideas and the latter owing to valuation—the stock's price having tripled since its initial purchase during the fourth quarter of 2008.
Large-Caps Could Be Big in 2011
We believe the leadership baton could pass from small-cap stocks to large-caps in 2011. We have identified several reasons for this to occur:
- Sentiment for large cap stocks remains negative largely because returns have lagged just about every other asset class, including fixed-income during the past 10 years. In fact, as of the end of 2010, the value of the Russell 1000 Index was below where it was at the end of 2000, and is significantly below peaks reached in August 2000 and October 2007. The result is that many investors have either underweighted or indexed large-cap stocks to the point that it is an under-owned universe.
- The valuations and fundamentals of many large-cap stocks make them look like compelling investments. We find many high-quality companies that meet the criteria of our Leaders investment category to be attractively priced.
- The balance sheets of many large-cap companies show high levels of cash and low levels of debt. Furthermore, there is the current low dividend payout ratio to shareholders, and the prospect that company management teams could use their liquid positions to raise dividends, buy back stock, make acquisitions, or increase capital spending—any of which would be positive for stock prices.
In addition, looking at the global competitive landscape, there are many large-cap companies with the fundamental leadership and market share that would benefit from a renaissance in a global recovery—such as US-based companies that lead in Technology, Aerospace, and Energy. Ten years ago the U.S. economy was the driving engine in the global market. Today, putting things in perspective, the largest metropolitan areas of China are eight times larger than the largest metropolitan areas in the U.S. The scope of that market has grown significantly and necessitates the scope and scale of large companies to service a global population. With the largest economy in the world, the U.S., beginning to transition from recovery to expansion we should see revenues accelerate for large U.S.-based companies.
The portfolio remains broadly diversified, with sector weightings resulting from opportunities we see at the stock level through our bottom-up fundamental analysis and valuation work. There were no dramatic changes within the portfolio during the fourth quarter, the most notable shift being an increase in the weighting in Energy that brought it closer to a market weight. In absolute terms, Technology, Consumer Discretionary, and Industrials continue to be the largest sector weightings in the Fund.
Following our mantra to "buy the best when they’re depressed" the current portfolio continues to reflect our fundamental focus on higher quality companies, a stance we have maintained for the past two years. Of TAMRO's three investment categories, the two focused on low cost operations and efficiency—Leaders and Innovators—comprise 91% of portfolio assets, while companies undergoing restructuring make up 9%.
In 2010, TAMRO celebrated its 10-year anniversary. While that is a significant milestone, more importantly it marked 10 years of serving investors in the Fund with excellent performance that has outperformed its benchmark since inception (N shares).
TAMRO Capital Partners
As of December 31, 2010, F5 Networks comprised 1.90% of the portfolio's assets, BorgWarner – 2.33%, Dollar Tree – 1.54%, Joy Global – 1.94%, Bank of America – 0.00%, BB&T Corporation – 0.00%, Washington Post – 2.22%, Dell – 2.18%, NVIDIA – 2.21%, National Oilwell Varco -2.76%, Johnson Controls – 3.06%, The Mosaic Company – 2.33%, AGCO – 2.03%, Monsanto – 1.89%, Goldman Sachs – 1.83%, and Research In Motion – 2.39%.
Note: Small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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.