1st Quarter 2011 Commentary
Ouch, What a Great Quarter
With investors focused on unsettling world events, equity markets shone brightly during the first quarter of 2011, as small-cap stocks paced the broader market higher. This was the strongest first quarter in the stock market (as measured by the S&P 500 Index) in 13 years. News on the domestic economy reflected a continuation of modest economic growth with stubbornly high unemployment. This backdrop increased the probability that monetary policy will continue to remain liquid while we wait for that liquidity to find its way more firmly into the real economy and not just into financial assets and commodities.
Global news was disconcerting, given the unrest in North Africa and the earthquake/tsunami in Japan. Fears of shortages and bottlenecks further raised the specter of inflation, with strong gains in commodity prices during the quarter, particularly food and energy. These are areas that touch all consumers, and increases could very well crimp consumer demand. We will be ever watchful for its potential impact.
The Fund delivered strong absolute returns during the quarter in besting its Russell 2000 Index benchmark by a marginal amount. All sectors of the Russell 2000 delivered positive returns, with the Energy sector leading the way with a nearly 20% gain. Sector allocation was positive, aided by an overweight to Energy and an underweight to Financials, but strong stock selection in the Industrials, Technology, Consumer Staples, and Healthcare sectors was the primary driver of relative outperformance versus the index. Five sectors increased more than 10% on an absolute basis compared with only three for the benchmark.
The top individual contributors to relative performance during the quarter were dominated by tech names. It was announced in January that IT provider and cloud computing specialist Terremark Worldwide had agreed to be acquired by Verizon for a 35% premium, highlighting a theme we discussed in our year-end 2010 commentary. Vasco Data Security and RightNow Technologies both reported strong results with an emphasis on increasing demand and recognition for the former’s security solutions and the latter’s customer service software. Elsewhere, top-10 holding Precision Drilling benefitted from an acceleration in demand for its land drilling rigs in North America, especially for unconventional oil and gas fields that require the firm's specialized rigs.
The Consumer Discretionary, Materials, and Telecommunications sectors detracted from relative performance. Consumer Discretionary was especially weak, as three of the Fund’s five biggest detractors from returns—Grand Canyon Education, Liz Claiborne, and Winnebago Industries—came from the sector. Grand Canyon and Winnebago reported weak quarterly results in the face of a still tepid economic environment for most U.S. consumers, while Liz Claiborne’s efforts to revitalize its retail brands have not gained traction. We ultimately sold Liz Claiborne during the period to fund ideas in the Energy sector.
Buys and Sells
Six stocks became full positions during the quarter either through direct purchases, market appreciation, or a combination of the two. Three of the new full positions were in the Energy space, ranging from offshore drilling rig operator Atwood Oceanics to oil and gas exploration companies Comstock Resources and Contango Oil & Gas. Contango is an innovator focused on shallow water Gulf of Mexico fields. Despite political uncertainty around the permit process in the Gulf, the company has established a track record as a low-cost operator due to specific cost advantages of drilling in the Gulf and the company’s lean business model. The firm also eschews debt and commodity hedging. The company still trades near trough multiples of book value and either a resumption of normal drilling activity in the Gulf of Mexico or an improving natural gas price could help boost the company’s earnings and cash flow growth.
Two other names that became full positions were Blue Coat Systems and Stifel Financial. Blue Coat is a market leader within two of the fastest growing segments of IT—Secure Web Gateways (SWG) and Wide Area Network Optimization Controllers (WOC)—with #1 and #3 market share, respectively. Blue Coat relied upon best-in-class technology to build its market share, but its lack of a clear marketing, sales, and distribution strategy became more apparent with the onset of the financial crisis, as sales growth lagged industry growth. A new CEO brings a history of success and the requisite experience to leverage the company’s financial and technology foundation into a strengthened position at the intersection of the high-demand, secular security and web traffic trends. Stifel Financial was founded more than 120 years ago and is known for putting clients first, supporting entrepreneurial behavior, and encouraging employee ownership. Best-in-class execution leading up to and through the recent economic and market downturn leaves the company both well capitalized and well positioned to take market share as the economy and the capital markets recover.
The Fund's exposure to REITs was reduced during the quarter with the sale of Biomed Realty Trust and Washington REIT. The proceeds were used to fund purchases in financial services companies, as well as to consolidate most of the portfolio’s exposure into apartment-focused REIT Colonial Properties. Shoe retailer DSW performed well, but was sold as its valuation became stretched. Finally, we eliminated long-term holding FactSet Research Systems from the portfolio as it reached a $5 billion market cap.
The Fund remains broadly diversified and the portfolio is driven by our bottom-up fundamental analysis. This past quarter, as noted above, we continued to reduce the Fund’s exposure to the Consumer Discretionary sector by taking profits in stocks that performed well and excising stocks not living up to expectations. We used the proceeds to fund ideas elsewhere, specifically in Energy and Industrials.
Natural gas is one of the few commodities that has not participated in the major upswing in the energy complex and we believe those companies focused on domestic exploration and production of natural gas provide attractive opportunities. The price of natural gas is well below the historic average and the spread relative to the price of oil is the widest in more than 20 years. If we could fill our cars up with either gasoline or natural gas, we would pay only $2.40 a gallon for compressed natural gas versus nearly $4.00 a gallon for gasoline as of quarter end in the Washington D.C. market. In the Energy sector, we are also investing in companies with non-U.S. oil exploration and production operations, as well as oil service firms. Global economic growth provides opportunities in water and energy infrastructure in the industrials sector. During the quarter, many companies within the sector reported strength in operations, citing firm broad-based demand for products and services.
We remain optimistic about opportunities for stocks this year. Although world events could interrupt the advance temporarily, we believe global growth will be resilient. To be sure, getting a reign on domestic government spending would improve investor sentiment. While we currently believe large-cap stocks have a valuation advantage over small-cap stocks, much innovation and execution continues in the small-cap universe.
TAMRO Capital Partners
As of March 31, 2011, Terremark Worldwide comprised 0.00% of the portfolio's assets, Vasco Data Security – 1.99%, RightNow Technologies – 2.62%, Precision Drilling – 2.32%, Grand Canyon Education – 1.32%, Liz Claiborne – 0.00%, Winnebago Industries – 1.26%, Atwood Oceanics – 1.61%, Comstock Resources –2.32%, Contango Oil & Gas – 1.49%, Blue Coat Systems – 1.55%, Stifel Financial – 1.54%, and Colonial Properties – 2.12%.
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.