4th Quarter 2010 Commentary - ASTON/TAMRO Small Cap Fund
4th Quarter 2010 Commentary
After modest relative gains during the fourth quarter, the Fund finished 2010 up more than four percentage points over its Russell 2000 Index benchmark. It was a good year for U.S. investors, as our own backyard proved the best place to invest. Domestic small-cap stocks gained nearly 27%, casting a giant shadow on most global developed and Emerging Market indices. 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 Technology was 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 Consumer Discretionary sectors also aiding returns. Three technology stocks and two restaurant stocks 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 providers 3Par and Netezza both received buyout offers during the year from large-cap companies and are no longer in the portfolio. Another firm involved in the growing field of cloud computing was communications equipment manufacturer Acme Packet (see below for more on Acme and cloud computing). The value proposition offered by both BJ's Restaurants and Domino's Pizza resonated well with cost-conscious customers in 2010.
Holdings in the Energy, Materials, and Telecommunications sectors were the primary detractors to performance for the year. Although the individual stocks that hurt performance had certain common industry characteristics, four out of the five holdings that weighed most heavily on portfolio performance suffered from company-specific miscues. For example, construction and engineering services provider Willbros Group made a major acquisition than led to a 20% dilution for shareholders. Weak fund performance and outflows at subsidiary INTECH negatively affected the stock price of Janus Capital. The exception was Hornbeck Offshore Services, which was hurt by the moratorium on offshore drilling following the disastrous oil spill in the Gulf, as well as a depressed natural gas market. All of the biggest detractors from the past year have been sold from the portfolio.
Fourth Quarter Review
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-cap stocks in the lead.
All sectors in the portfolio and the index delivered positive absolute returns, with the Fund leading the benchmark due to strong stock selection in the Consumer Discretionary and Technology sectors. Previously mentioned Acme Packet beat expectations and raised its guidance during the quarter as it continued to gain market share. The Healthcare and Energy sectors were the main detractors from relative performance. Holdings in medical device makers was a weak spot within Healthcare, specifically NuVasive and Teleflex. NuVasive lowered its guidance as a result of an industry slowdown and intensifying competition, while Teleflex reported lackluster earnings and continued sluggish revenue growth.
Other notable contributors on the upside included Harman International Industries and Texas Industries. Strong earnings at audio equipment maker Harman appeared to drive increased interest in the company, boosting its stock price. Cement producer Texas Industries beat quarterly estimates on revenues and earnings. Company management showed confidence as they publicly touted the firm's financial health and sales prospects.
Three stocks became full positions during the quarter either through direct purchases, market appreciation, or both. Two of these companies, Ixia and Terremark Worldwide, provide solutions integral to their clients' efforts to participate in cloud computing. Cloud computing is essentially delivering more services via the Internet, and is an area in which companies continue to invest aggressively in an effort to keep up with the mobility of information. We believe that cloud computing is at a nascent stage and is one of the most revolutionary changes in corporate IT in 30 years, a change that will have a long-lasting impact on how business evolves globally. We have identified a number of early beneficiaries in the enterprise market and continue to find additional innovators that should help companies increase efficiency.
Ixia is the leader in high-end Internet protocol (IP) network testing solutions. Its products and services validate functionality and reliability of complex IP networks. We believe the firm's management team's experience in IP traffic management and the company's solid financial position have enabled investments to enhance its capabilities. Recent stock weakness provided the opportunity to invest in this well-positioned innovator.
Terremark Worldwide is a leading provider of IT solutions in the cloud. The company provides IT hosting, managed services, and network connection "hubs" from three purpose-built data centers strategically focused on the Federal Government and Emerging Markets. Concerns regarding the firm's debt as well as continued investments in capacity during the downturn that affected near-term results led investors to push the stock to historic valuation lows. We believe the company is executing on its strategy, as evidenced by new partnerships formed around its cloud capabilities.
Four positions were sold from the portfolio during the quarter. Domino's Pizza's standout year in 2010 led to its sale as we had a desire to reduce the Fund's overweight to restaurants given the identification of better relative opportunities. Netezza was sold after the company received its buyout offer of $27 from IBM. After lackluster performance during much of the year, both diamond retailer Blue Nile and REIT Redwood Trust were sold to fund more compelling investment ideas.
We believe 2011 should also be a good year for domestic small-cap stocks. Although valuations are not as compelling today as they were at the start of 2010, we believe fundamental execution should continue to improve, aided by positive consumer sentiment and stronger growth in the real economy. With ample cash on corporate balance sheets, we expect merger and acquisition activity to continue on a global basis. Small-cap companies in general have been the innovators in the domestic economy and provide a supermarket for large companies to shop in order to maintain their own growth.
We also believe the uncertainty surrounding taxes and regulation will continue to dissipate with the new Congress, helping to loosen the purse strings of consumers and businesses. If there is progress in decelerating Federal spending in 2011, sentiment could approach giddiness. For the typical individual and institutional investor sentiment towards equities in general, and U.S. stocks in particular, remains guarded at best. After suffering through the third worst market ever in 2008, the comfort is still not there for stocks. In our opinion, that is an opportunity and one of the reasons why we believe domestic stocks should provide an attractive opportunity for investors. While we continue to identify attractive small-cap opportunities and believe small-caps will do well this year, 2011 could be the year that large-cap stocks take the leadership baton away from small-caps. Why? After substantially underperforming not only in 2010, but over the last 10 years, large-caps generally have better valuation support and have made progress in improving operating margins with acceleration in revenue growth.
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 Financials 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 82% of portfolio assets, while companies undergoing restructuring make up 18%.
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, 3PAR comprised 0.00% of the portfolio's assets, Netezza – 0.00%, Acme Packet – 2.62%, BJ's Restaurants – 2.31%, Domino's Pizza – 0.00%, NuVasive –1.36%, Teleflex – 1.67%, Harman International – 2.60%, Texas Industries – 2.22%, Ixia – 2.19%, and Terremark Worldwide – 2.09%.
Note: Small-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.