4th Quarter 2010 Commentary
The Fund delivered strong absolute performance during 2010, but fell short of its S&P Midcap 400 Index benchmark. The marginal underperformance followed the portfolio's dramatic outperformance in 2009. During both years, mid-cap stocks outperformed large-caps by a significant margin. Indeed, the S&P Midcap 400 has outperformed the large-cap oriented S&P 500 Index in 10 of the past eleven years. During the 11-year period ending December 2010, the Fund delivered double-digit returns in outperforming the benchmark by nearly four percentage points and the S&P 500 by more than eleven percentage points. We think this is quite a testament to the opportunities and diversification benefits that a pure mid-cap portfolio can offer.
Fourth Quarter Review
Equity markets staged a significant rally during the fourth quarter, a rally in which the Fund fully participated. The vast majority of the portfolio's holdings produced positive returns, with 10 holdings appreciating more than 20%. The best performing stocks in the portfolio were Beckman Coulter, BorgWarner, and Boston Scientific. Medical instrument manufacturer and biomedical lab supplier Beckman Coulter jumped sharply on news that Goldman Sachs had been hired to assist in selling the company. The stock was one of the worst performing holdings for the Fund during the third quarter after a bad earnings miss, but we stuck with the stock based on our work indicating that the company remained notably undervalued.
Leading automotive engineering firm BorgWarner reported strong new business growth, solid backlog, and improved operating margins. The company continues to exceed expectations, helped by a rebound in U.S. auto production. Boston Scientific, a medical device company specializing in cardiovascular, endosurgery, and neurovascular markets, is benefitting from its attempts to reposition itself for growth. The valuation remains attractive relative to the company's own history and its peer group.
Five stocks posted negative returns during the quarter—Lexmark International, H&R Block, Unisys Corporation, Akamai Technologies, and Southwest Airlines. Lexmark declined during the quarter after reporting modestly disappointing results, with revenue falling short of consensus estimates. The company also announced that its CEO would retire, to be replaced by a 20-year Lexmark veteran. We added to the Fund's position during the recent weakness based on its attractive valuation. Despite the recent setback, this long-term holding finished the year significantly higher.
H&R Block's weakness is a reflection of lower tax filings due to high unemployment levels. Although this turnaround story continues to struggle as management re-aligns its business model, the strategic acquisition of online tax preparation service 2SS Holdings should double the number of digital returns for the firm, and we like the stock's attractive valuation and sizeable dividend.
After a strong third quarter as one of the Fund's top performers, IT servicing and solutions provider Unisys gave some of it back during the final quarter of the year. We think the company remains significantly undervalued at current levels and positioned to benefit from a growing focus on data center transformations, "cloud computing", and related security issues. New management has made significant strides in improving the balance sheet, restructuring worldwide operations, and growing margins. The company recently signed an alliance with Apple to provide systems integration on some of Apple's technology, primarily in the federal marketplace.
Portfolio Notes and Outlook
We did not purchase any new holdings or eliminate any positions from the portfolio during the quarter. We did significantly reduce the Fund's position in Intuit, however, based on valuation. In addition, we took advantage of short-term stock price fluctuations to add to and reduce a number of positions across the portfolio. This rebalancing resulted in improved valuation metrics for the portfolio overall. The consensus analyst estimate based price/earnings-to-growth rate or PEG Ratio of the portfolio improved from 1.3 at the end of the third quarter to 1.1 by the end of the year. The improvement in valuation on a relative basis was even more dramatic, as the PEG Ratios of some notable mid-cap indices, the benchmark S&P Midcap 400 Index and the Russell MidCap Index, increased to 1.4 and 1.5 respectively.
The recent decline in unemployment is an encouraging sign of an improving economic outlook in the U.S. Quarterly earnings reports should continue to provide important evidence as to the strength of the recovery. A rebound in merger and acquisition activity is also a positive sign of business confidence and recovering capital markets. This trend is particularly positive for the mid-cap space as larger companies look to enhance growth by expanding into adjacent products and technologies. Although we do not explicitly look for stocks that might be take-over candidates, our strategy of investing in focused companies with leading market positions and strong balance sheets often makes the Fund's holdings candidates for this re-emerging trend.
As always, we thank you for your continued support and confidence in our portfolio management capabilities.
Thyra E. Zerhusen, Managing Director and Portfolio Manager
Marie L. Lorden, Co-Portfolio Manager
Mary L. Pierson, Co-Portfolio Manager
As of December 31, 2010, Beckman Coulter comprised 3.12% of the portfolio's assets, BorgWarner – 2.95%, Boston Scientific – 4.76%, Lexmark International – 2.81%, H&R Block – 3.64%, Unisys – 2.23%, Akamai Technologies – 3.00%, Southwest Airlines – 2.56%, Apple – 0.00%, and Intuit – 0.25%.
Note: 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.