1st Quarter 2011 Commentary
The Fund underperformed its Russell 2000 Growth Index benchmark during the first quarter of 2011 as small-cap growth stocks continued to advance. This was not entirely unexpected as we shifted the portfolio positioning from the fourth quarter of last year into this year. Our strategy is focused on identifying unrecognized growth potential, and many of the portfolio’s top positions from 2010 became “recognized” during the fourth quarter. Some of these companies were acquired, while other positions were trimmed or sold as they approached our price targets. Given the performance of the small-growth market the past few years, we are starting to see a number of stocks trading at higher valuations. Price target discipline prevents us from owning these companies even though they may continue to add value for the index or the Fund’s peers in the near-term after we sell them. We believe the “sweet spot” for small-growth investing lies outside of this small band of recognized names and in other areas where we think there are significant opportunities for growth that is unrecognized.
Discipline Through Price Targets
Maintaining discipline with our price targets has been a key driver of performance for our investment strategy. As part of this process, we set a price alert when a stock approaches 10% of the price target we have set for a stock. This alert triggers a re-valuation of the holding by the investment team. If we do not believe an increase in the price target is warranted we will begin to reduce the position as the risk-to-reward profile on that individual stock changes. For instance, two Healthcare stocks that were top positions in the portfolio towards the end of 2010, RehabCare Group and Hanger Orthopedic, were trimmed during the first quarter after reaching their price targets.
Acute-care rehab hospital and nursing facility operator RehabCare had been growing revenues and expanding margins, and we made it one of the top positions in the portfolio when its stock price dropped last year on erroneous regulatory concerns. Since then, the stock has increased significantly, triggering a re-valuation on our part. We could not justify a higher price target and trimmed our position. Later in the quarter, Kindred Healthcare announced it was acquiring RehabCare for a 40% premium. Hanger Orthopedic provides medical rehabilitation devices and services. During the quarter we sat down with the firm’s Chief Financial Officer to discuss a recent acquisition as well as business in general. Although we still have a positive outlook on the company and believe their fundamentals remain solid, we could not justify raising the price target further.
Many of the stocks that were detractors to the Fund’s performance were positions that we have been building during the quarter. Two such companies that fit our profile for strong fundamentals and significant upside potential were Knology and Office Depot. Regional cable and telecommunications provider Knology services tier-two and tier-three cities in the southeastern United States where it feels its service model has an advantage over the bigger industry. The stock’s price dropped during the first quarter owing to a slight promotional misstep when they increased prices at a time when competitors where running a reduced fee promotion. We viewed this as a self-inflicted wound and used it as a buying opportunity. We like the relatively fixed-cost base of cable and telecomm firms because when revenues grow, the margins naturally expand. Knology has been growing revenue with the expansion of high-speed data, VoIP (Voice over Internet Protocol) and cable in bundled offerings. The company’s management team has also been making selective accretive acquisitions and continuing to execute on its “edge out” strategy to increase the coverage area in current markets. Despite the pricing blip, our investment thesis remains intact and we believe the company has significant growth potential.
We also like the fixed-cost base of Office Depot’s business model. We view all the stores as fixed-cost boxes, and as top-line revenue grows margins naturally expand. The company is well positioned to benefit from an improving economy and increasing employment numbers, which drive more use of office products. The stock declined slightly during the quarter as it announced increases in cost inputs in Europe that have put pressure on margins. We view this as a minor event in an overall solid “return-to-growth” story. Again, our thesis remains intact and we continued to add to the portfolio’s position during the quarter.
Growth Wherever It Exists
One of the key tenets of our unrecognized growth philosophy is that we go wherever growth exists, across all sectors and economic environments. Although we certainly anticipate participating in traditional growth sectors such as Technology, Consumer Discretionary, and Healthcare when growth opportunities exist there, to the extent that we can identify companies that are growing revenues, expanding margins, and possess surprise potential in Industrials, Financials, or Telecom, we will invest there as well. One of the top contributors to performance during the first quarter was RailAmerica. The firm operates short-line railroads in North America, mainly comprising the first or last leg of the journey as goods/commodities are transported via rail. RA’s top-line revenue has benefited from an increase in the number of carloads owing to the improving economy, and further increases are expected in 2011.
Among more-traditional growth areas, information technology firm Savvis continued as a top contributor following its strong performance in 2010. The company offers a strong value proposition to enterprise customers in reducing IT infrastructure costs and is well positioned to benefit from the migration to “cloud computing” services. When we initially considered the position, one of Savvis’ business units was growing well, one was more or less flat, and one was slightly negative. After discussions with management, we felt there was strong growth potential across all three units. A key catalyst in recognizing this growth happened when management refocused the incentives of its sales team, which broadened sales efforts across all three products. Since that time the firm has continued to drive top-line revenue growth and expand margins. It generates significant cash flows and its stock price has increased significantly since the Fund purchased it at inception in November 2010. Although we are still optimistic about the fundamentals, we have been trimming the position as it approaches our price target.
Odds and Ends
More often than not we will tend to err on the side of caution given the volatile nature of small-company earnings and fundamentals. When we start to see cautionary signals to key fundamental drivers that we follow, we are likely to sell a stock. Our experience tells us to avoid big mistakes and invest where we have more conviction. Sometimes we are right and avoid a blow up, while at other times we are wrong and the stock continues to do well. During the first quarter, we sold the Fund’s position in e-commerce solutions provider GSI Commerce after management revised guidance signaling that investments in services intended to drive future growth would continue to detract from earnings for the full year 2011, putting further unexpected negative pressure on the stock price. Management’s original guidance was that these investments would turn positive within 12 months. Towards the end of the quarter Ebay announced the acquisition of GSI for a premium. Although we missed the call in this instance, over time we expect to stay clear of trouble by sticking with our discipline.
In summary, we closed 2010 on a strong note with many of the portfolio's top stocks becoming “recognized” and began transitioning the portfolio into newer positions. This quarter we have been reseeding the top holdings and building positions in companies that we believe have significant unrecognized growth potential. We remain optimistic regarding the economic recovery and the number of opportunities with which to add value for investors.
As a final note, we added an additional analyst to our Small Cap Growth team this quarter. Srinivas (Sri) Anantha, CFA joined the team in early March as a senior analyst. Sri brings 10 years of experience covering companies in the Technology, Telecommunications, Cable, and Defense Electronics/Federal IT Services industries. We are delighted to have Sri as a member of our team.
Crosswind Investments, LLC
As of March 31, 2011, RehabCare Group comprised 4.97% of the portfolio's assets, Kindred Healthcare – 0.00%, Hanger Orthopedic – 1.68%, Knology – 3.76%, Office Depot – 2.42%, RailAmerica – 2.49%, Savvis – 5.15%, and GSI Commerce – 1.88%.
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.