4th Quarter 2010 Commentary
The fourth quarter saw a continuation of the stock market rally that began in late August following Federal Reserve Chairman Ben Bernanke's Jackson Hole speech in which he first laid out the rationale for a second round of Federal Reserve bond purchases, known as quantitative easing (QE2). This added monetary stimulus, officially launched in early November and expected to last until June 2011, along with additional tax relief passed by Congress in December supported higher stock prices. Since Bernanke's speech, the S&P 500 Index rallied 18%, while small- and mid-cap stocks, as represented by the Russell 2000 and Russell Midcap indices, were up even stronger, 27% and 22%, respectively.
We continue to see an economic recovery that is constrained by the ongoing financial deleveraging of the private and public sectors both domestically and in other parts of the developed world. The economic recovery has not been sufficient to reduce high levels of unemployment and was at risk of stalling towards the end of summer, which necessitated the additional monetary and fiscal stimulus. Given these additional policy actions and recent encouraging economic data, we now believe Gross Domestic Product (GDP) may increase at an annualized rate of about 3% during 2011. Meanwhile, inflation remains well contained.
The past year was marked by a wide disparity in performance between the growth “haves” and “have nots”. Those companies perceived by investors as true secular growers were awarded rich premium valuations relative to those deemed mature or more cyclical. It was also another year where low-quality stocks beat high-quality names. According to Bank of America/Merrill Lynch, stocks with a quality ranking of B or worse outperformed those stocks ranked B+ or better by more than five percentage points in 2010. We view it as encouraging that despite this quality headwind the Fund was still able to post returns that exceeded its Russell Midcap Growth Index benchmark for the year. With nearly three-quarters of the stocks in the portfolio ranked B+ or better we look forward to a time when quality returns to favor with investors. Such a rotation may unfold in 2011, as the market begins to anticipate steps by policy makers to withdraw stimulus. In a moderate growth environment, we would expect investors to increasingly gravitate towards those companies that can produce above-average earnings growth due to strong balance sheets, exposure to faster growing end-markets and geographies, and market share gains.
Quarter and Year-End Review
The Fund slightly lagged the benchmark during the fourth quarter, while modestly outperforming over the course of the full year. For both the quarter and the year, the biggest contributors to relative performance came from holdings in the Technology and Industrials sectors, with individual stock selection providing the biggest boost. Individual stocks delivering the biggest lift to fourth quarter performance included BorgWarner, Ametek, and Polycom. We trimmed the portfolio's stake in BorgWarner late in the period based on a full valuation.
The Materials sector was the biggest laggard for both the quarter and 2010. Among the worst performing individual stocks during the quarter were Kohl's, Amphenol, and Ecolab. With Ecolab, we viewed share price weakness as an opportunity to increase the portfolio's position in anticipation of improving organic growth and profit margins in 2011.
New positions initiated during the quarter included fashion apparel company Phillips-Van Heusen and proprietary risk analytics firm Verisk Analytics. A position in Xilinx was eliminated during the quarter as we opted to shift those funds into competitor Altera, which appears to be executing better and taking market share. We also sold three other positions from the portfolio following earnings disappointments—Techne, Avon Products, and L3 Communications. In addition, the position in Alberto Culver was liquidated after an announced takeover by Unilever pushed the stock price past our estimate of fair value.
Following two years of outsized gains, mid-cap stock valuations now appear full by our work. As a result, we think 2011 will likely deliver more modest, though still positive, returns. With the run-up in share prices during the second-half of 2010, we would not be surprised to see a consolidation of stock market gains or even a temporary setback in share prices. The market is technically overbought, and numerous indicators imply that investor enthusiasm has reached elevated levels. Accordingly, we recently established some modest buying reserves in the portfolio by trimming a handful of the most overvalued positions in hopes of taking advantage of any such pullback in the new year. We do expect share prices to subsequently grind higher along with sustained economic growth that is being further supported by additional fiscal and monetary stimulus. We continue to believe that the Fund is well positioned to benefit from a rotation to high-quality growth stocks.
M. Scott Thompson, CFA
Andrew W. Jung, CFA
January 4, 2011
As of December 31, 2010, BorgWarner comprised 1.52% of the portfolio's assets, Ametek – 2.38%, Polycom – 2.63%, Kohl's – 1.39%, Amphenol – 3.01%, Ecolab – 2.61%, Phillips-Van Huesen – 1.90%, Verisk Analytics – 1.02%, and Altera – 1.95%.
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.