4th Quarter 2010 Commentary
The Fund lagged its composite S&P 500 Index/Barclays Capital US Government Credit Bond Index benchmark during the fourth quarter and for all of 2010, the latter period by a substantial margin. The year 2010 can be divided into three distinct periods. An early rally that moved equity markets sharply higher, fueled by both fiscal and monetary stimulus, followed by downward pressure beginning in late spring that lasted most of the summer—as investors feared the European debt crisis would lead to a double dip recession—concluding with another strong rally, again boosted by stimulus measures, during the fourth quarter.
It was another year where low-quality stocks beat high-quality stocks. 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 5 percentage points. There was a continuation of the move to riskier assets as investors favored smaller, lesser-quality, and generally more-cyclical names. The larger, higher-quality companies with more assured earnings prospects that we favor lagged during the year-end rally, and now look even more attractive from our perspective. Conversely, more cyclical, lower-cap names already appear fully valued and seem to be completely discounting the ongoing recovery in the economy.
Significant overweight stakes in the Healthcare and Consumer Staples sectors detracted from relative performance during the fourth quarter as both sectors lagged the broader market. Abbott Laboratories and Merck experienced negative returns as investors shunned large pharmaceutical companies. We reduced the position in Abbott twice during the period as due to the stock's lagging performance caused by analysts' concerns about the company's reliance on the drug Humira, which is subject to long-term competitive threats. Within Consumer Staples, Colgate-Palmolive suffered from diminished near-term earnings momentum and was also trimmed.
Stock selection within Financials and Consumer Discretionary hurt returns as well, in the latter case owing to some of the Fund's more defensive holdings lagging the benchmark. American Express was a notable laggard within Financials. We initially trimmed the portfolio's position following the announcement of an anti-trust suit brought by the US Department of Justice, which we thought was likely to create an overhang on the shares. The position was subsequently sold after the Federal Reserve released its initial proposal to reduce debit interchange rates. Although American Express is not directly affected, the severe reduction in debit interchange further highlights the higher cost of credit card interchange rates and could bring additional regulatory scrutiny. Visa, though considered a Technology stock by the benchmark, dropped severely on the news of the Federal Reserve's lower than expected rate limit on debit charges and was sold from the portfolio as well.
In addition, the Fund's lack of any holdings in Materials detracted from relative returns as that sector was among the strongest performing areas of the market during the quarter.
On the plus side, stock selection in the Technology and Energy sectors aided relative performance. Most of the Fund's holdings in Technology were up more than 10%, outpacing the benchmark. Occidental Petroleum and Schlumberger delivered strong gains within Energy. Mid-quarter we increased the portfolio's stake in Cameron International on the belief that deepwater spending should accelerate in 2011 and that the company is well positioned to experience growing new awards/backlog as a result. The shares rallied strongly after the addition, and we subsequently trimmed the position as the stock approached our estimate of present value. Finally, industrial firm Fluor was one of the Fund’s top performers for the quarter, positively impacting relative performance.
We initiated four new positions in the portfolio during the quarter—Accenture, Carnival, Apache, and Halliburton. Global management and IT consulting firm Accenture is experiencing accelerating growth in bookings and revenue, and should benefit from a steady improvement in discretionary IT spending. Emerging market growth and a weak US dollar may also provide an incremental boost to earnings growth as 56% of revenue is derived outside the U.S. We believe that worldwide cruise company Carnival Corporation stands to profit from expanded growth opportunities internationally as the industry continues to benefit from an improving supply situation that should lead to a better pricing environment.
New additions Apache and Halliburton brought the Fund's stake in Energy up sizably to 15% of assets. Independent exploration company Apache has grown production and reserves consistently during the last 20 years and has been a disciplined buyer of properties, providing production growth visibility for the next several years. We think services provider Halliburton is trading at a discounted price/earnings multiple. In our view, global supply and demand balances remain structurally tight and the company is working aggressively to improve returns and margins to be competitive with industry leader Schlumberger. Meanwhile, we substantially increased the portfolio's stake in Schlumberger in anticipation of accelerating earnings momentum in 2011. The recovery in international markets has been slow but steady and should continue to unfold given $80 per barrel oil.
We increased the portfolio's stake in Procter & Gamble after the company reported fiscal first quarter 2011 results that were in-line with revenue expectations and slightly beat earnings estimates. We boosted the size of the position further following the company's analyst day at which it reiterated its above-average earnings growth estimates for 2011.
Within Technology, we added to Oracle and Qualcomm as the both companies continue to deliver solid earnings growth. Early in the quarter, we trimmed Google given the position size and a recent 20% recovery in the share price. Later, however, the stock pulled back on rumors of a proposed $6 billion acquisition of deal-a-day site Groupon. Given a strong fourth quarter earnings outlook, compelling valuation, and Groupon's confirmation of its plans to stay independent, we took advantage of the stock weakness to increase the portfolio's position.
Less Cereal and Post-It Notes
Both Kellogg and 3M were sold during the quarter. Kellogg was initially trimmed due to lingering execution issues and weak overall category trends. We ultimately exited the position following the company's third quarter earnings release. Although results were in-line with the company's previous pre-announcement, guidance was worse than anticipated. Thus, the expected acceleration in earnings momentum had been further deferred. 3M was sold due to reduced earnings visibility as the U.S. economy has moved past the early stage of the recovery.
Wal-Mart Stores was trimmed following the company's analyst day as the company remains focused on growth versus returns. While this may prove to be effective in the long run, near-term visibility on strengthening earnings momentum is dim.
After 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. The market is technically overbought and investor enthusiasm has reached elevated levels. We do, however, expect share prices to ultimately grind higher along with the sustained economic growth that is being further supported by the ongoing Federal fiscal and monetary stimulus.
The bond market is likely to be range-bound during the first quarter of 2011. Improved economic growth due to additional fiscal and monetary stimulus has put upward pressure on interest-rates, but further increases are likely to be mitigated by the Federal Reserve's purchase of Treasury securities in their quantitative easing program. Subdued inflation resulting from high unemployment and low capacity utilization should also allow interest-rates to remain near their current low levels. We are wary of the effects of quantitative easing on long-term interest-rates, however, and continue to view the risk/reward trade-off unfavorably given the current low level of interest rates overall.
Thus, we are maintaining a defensive duration position in the bond sleeve of the portfolio, with the average duration (a measure of interest-rate sensitivity) approximately 15% shorter than that of the Fund's bond benchmark. We believe that the yield differential, or spread, between corporate and Treasury bonds will continue to narrow. This should be driven by solid fundamentals, with corporations enjoying strong profits, and by investors continuing to seek out incremental yield in a low interest-rate environment. Accordingly, we continue to favor high-quality intermediate maturity corporate bonds.
We believe that the Fund is well positioned with its emphasis on high-quality growth stocks. The shares of these companies are attractively valued and their earnings growth rates are more assured due to their financial strength and global diversification, particularly in their exposure to the faster growing Emerging Markets. The Fund's Energy and Technology holdings should benefit from the growth of Emerging Markets and recent cyclical improvement in the U.S. economy, and its multinational holdings with strong global brands should benefit from the robust growth in consumer spending in developing markets overseas as well. This will likely be reinforced by the eventual and inevitable shift in the mix of the Chinese economy toward consumption and away from fixed asset investment. Emerging Market consumer spending now represents about 35% of global consumer spending, in-line with those countries' contribution to global Gross Domestic Product. Finally, we continue to highlight the unusually attractive dividend yields and dividend growth prospects of these leading global growth companies in an environment of low interest-rates for both short- and long-term fixed-income investments.
Montag & Caldwell Investment Counsel
As of December 31, 2010, Abbott Laboratories comprised 1.81% of the portfolio's assets, Merck – 2.86%, Colgate-Palmolive – 0.62%, American Express – 0.00%, Visa – 0.00%, Occidental Petroleum – 2.50%, Schlumberger – 2.61%, Cameron International – 1.69%, Fluor – 2.62%, Accenture – 1.85%, Carnival Corp. – 1.35%, Apache – 1.15%, Halliburton – 0.88%, Procter & Gamble – 2.55%, Oracle – 1.48%, Qualcomm – 2.61%, Google – 2.75%, and Wal-Mart Stores – 0.58%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its dividends.
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.