4th Quarter 2010 Commentary
The attractive valuation of U.S. equities relative to bonds compelled investors to reallocate their investments towards stocks during the fourth quarter. Fiscal policy was the main driver as Republicans regained control of the House of Representatives in the November mid-term elections. In reaction, President Obama agreed to extend the Bush tax cuts, temporarily reduce social security withholding taxes, and adopt a more cooperative tone toward business. Monetary policy remained supportive as the Federal Reserve kept rates low and announced further quantitative easing. Investors reacted favorably to these developments. Despite the challenges of high unemployment rates, weak real estate markets, and large local government budget deficits, the economic environment remains favorable for equities in light of their attractive relative valuation.
Small-, mid-, and large-cap stock indices all delivered double-digit returns for the quarter and full year, with the Fund's Russell Midcap Value Index benchmark gaining 12.2% during the final quarter. The value component of the Russell Midcap lagged its growth counterpart due to its higher weighting in utilities, insurance companies and banks, which were negatively affected by the weak bond market. Consistent with previous economic recoveries, small- and mid-cap returns were led by low-quality stocks for the full year of 2010, with economically sensitive sectors posting the largest gains. Although the economy grew only modestly during the fourth quarter, prospects for 2011 brightened.
Quarter and Year-End Review
The Fund outperformed the benchmark during the quarter owing to a favorable industry mix within Financials (more diversified financials and fewer REITs and insurance companies), better stock selection in the Healthcare and Energy sectors, and the absence of poorly performing Utility stocks. Beckman Coulter, a supplier of clinical laboratory equipment and tests, put itself up for sale causing the stock to rise more than 50%. Oil-focused exploration and production company, Concho Resources, benefitted from an accretive acquisition, higher oil prices, and continued high organic growth. The two main detractors from performance during the quarter were nominal losses in Alliant Tech Systems and L-3 Communications reflecting investor concern over the impact from cuts in the defense budget.
Although the Fund delivered solid absolute returns for the full year, it trailed the index. The primary factors were stock selection in the Industrials and Healthcare sectors. Commercial printing company R.R. Donnelly and two defense contractors were the main detractors within Industrials. R.R. Donnelly's stock price was depressed due to a lack of earnings leverage in 2010 and a prolonged regulatory review of its Bowne acquisition. Within Healthcare, an investment in Quest Diagnostics suffered from weak volumes and Beckman Coulter lagged from regulatory issues early in the year. Mitigating these performance headwinds was the absence of poorly performing Utilities in the portfolio and also excellent stock selection in the Technology sector. In particular, Intuit and Progress Software rose sharply on improving fundamentals and Hewitt Associates was acquired by Aon at a significant premium.
Two examples of companies that exemplify what we look for—solid fundamentals at opportunistic valuations—are World Fuel Services and Teledyne Technologies. World Fuel is a global marketing and logistics provider that has expanded from its historical role as a fuel broker for the marine shipping market into the aviation and land fuel markets. Management has used its risk management, fuel hedging, and relationship network as a sophisticated logistics platform, to develop scale within fragmented markets. It has grown both organically and through acquisitions as the major oil companies abandoned downstream markets to focus on exploration. Our interest in World Fuel was triggered by the attractive and evolving nature of its business model, which is not well understood by many investors. Management targets risk adjusted return on capital and focuses on gross profit dollars through tailored credit and payment terms for each customer. Although this approach has led to short-term price and volume volatility, it has also resulted in significant revenue growth over time. World Fuel management has proven to be sound operators and prudent business leaders who have used the company's pristine balance sheet to make several strategic and accretive acquisitions.
Teledyne provides highly engineered technology products and systems to heavily regulated end markets with significant barriers to entry. Founded by the legendary Henry Singleton in 1960, the company has a long legacy as a valued provider of solutions to complex problems. Recently, Teledyne announced the sale of its legacy piston airplane engine business for a healthy price and the acquisition of a higher margin and growing niche electronics business. The two deals are accretive to earnings and facilitate the company's shift toward higher margin commercial businesses that we think warrants a higher valuation. With defensible and growing niche end markets, solid free cash flow metrics, and a top-notch management team we think a reacceleration in earnings growth should improve Teledyne's valuation.
Strategy and Outlook
Our investment outlook for 2011 is upbeat as fiscal and monetary policy are accommodative and economic and credit conditions continue to improve, albeit unevenly. Corporate earnings growth is forecast to grow in excess of 10% and equity valuations remain attractive. Importantly, economists expect that unemployment will improve as hiring surveys show corporations poised to add jobs. An additional underpinning of our upbeat view for equities is increased mergers and acquisition activity. As management confidence has improved, companies are becoming much more active in redeploying their cash flow and debt capacity to make accretive acquisitions. Equity funds flows have also turned positive, as investors’ aversion to equities following the 2008 correction may have come to an end.
The Cardinal Capital Team
As of December 31, 2010, Beckman Coulter comprised 0.97% of the portfolio's assets, Concho Resources – 2.26%, Alliant Techsystems – 1.49%, L-3 Communications – 1.93%, R.R. Donnelly & Sons – 3.15%, Quest Diagnostics – 1.08%, Intuit – 3.75%, Progress Software – 2.87%, Hewitt Associates – 0.00%, Aon – 0.00%, World Fuel Services – 1.40%, and Teledyne Technologies – 2.58%.
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.