1st Quarter 2011 Commentary
The first quarter of 2011 proved to be an eventful one for financial markets, with strong gains for the quarter being accompanied by a small dose of intra-quarter volatility. The year started off quietly enough, as stocks building on 2010’s strength marched steadily higher in a low-volatility uptrend to new 52-week highs by mid-February. Investor complacency was snapped, however, by a wave of political unrest, uprisings and violence across the Middle East and North Africa, contributing to even further increases in oil prices. As investors were trying to make sense of those events, the massive earthquake and subsequent nuclear power plant disaster that hit Japan added to investor anxiety. These issues drove a bout of profit taking, with the S&P 500 Index falling 7% from its mid-February closing high to mid-March low. This was the first pullback of at least 5% since September.
While the events that trigger a correction are usually unknowable in advance, we felt strongly toward the end of 2010 that the preconditions were in place. The events in Japan and the Middle East proved to be merely the catalyst for a mid-quarter correction. We used the weakness in the market to deploy the cash reserves the Fund had previously established to add to existing portfolio holdings and initiate several new positions. The market subsequently surged the last two weeks of the quarter, allowing the major market indices to finish the quarter close to their highs. The first quarter advance was once again led by small- and mid-cap stocks, a trend that has been firmly entrenched since the bear market bottom in March 2009. For the quarter, growth slightly beat out value among the components of the Russell MidCap Index.
The Fund bested its Russell Midcap Growth Index benchmark during the quarter, adding to its substantial outperformance for the trailing 12-months through March 31, 2011. Stock selection drove the outperformance with holdings in Technology being the most notable performers, followed by stock-picking in Consumer Discretionary and Health Care. Communication equipment supplier Polycom was the Fund’s best performer as the company showed good order momentum and continuing margin improvement. Another standout in Technology was semiconductor firm Altera, which continued to gain market share. The company is operating at peak margins, and we trimmed the position as it traded in excess of our estimated present value.
Chipotle Mexican Grill, Panera Bread, and Tractor Supply delivered strong gains in the Consumer Discretionary sector. The big winner in Healthcare was St. Jude Medical which gained more than 20% during the period. We think the stock is still attractively valued after the company reported a solid fourth quarter, and believe the company will continue to gain market share and benefit from continued traction in new end markets.
Stock selection within Financials and Materials weighed on relative performance during the quarter. Risk management and benchmark index provider MSCI declined as the company indicated that increased hiring and investment plans would prevent margin expansion for the next few quarters. We believe that the company will continue to deliver above-average earnings growth.
Other individual laggards included Expeditors International and NVIDIA. Expeditors fell short of Wall Street analysts’ December estimates. We believe a moderation in volumes will be offset by an improvement in yields, allowing the company to continue to deliver mid-teens earnings growth this year, and took advantage of the weakness in the stock to add to the Fund’s position. Graphic chip designer NVIDIA is an emerging market leader in the fastest growing portion of consumer technology today—smart phones and tablets. We took advantage of a price drop in the stock to initiate and subsequently build the portfolio’s position. We have high conviction in the company’s prospects as changes in the competitive landscape within the traditional server, PC, and notebook markets should enable the company to gain additional market share.
Buys and Sells
Two positions were sold during the quarter, Juniper Networks and Kohl’s Corporation. Juniper traded above our estimated present value and we were concerned about the firm’s end market after networking company F5 missed earnings in part to weakness in the Telecommunications sector, Juniper's largest customer segment. Kohl’s was sold to make room for several new names which we think possess better intermediate-term growth opportunities.
Along with the previously mentioned NVIDIA, the new names were baby-formula manufacturer Mead Johnson Nutrition, audio equipment maker Harman International, and F5 Networks. The Fund had sold F5 on valuation concerns during the third quarter of 2010. Following its missed earnings report and subsequent sell-off during the first quarter, we were able to revisit the stock at a more attractive discount than when the Fund exited the position. We think the firm’s underlying fundamentals remain strong while investor expectations, which we felt had become too ebullient, have been rationalized. Mead Johnson’s significant exposure to Emerging Markets, where per-capita consumption remains very low, is providing a tailwind for growth. Harman is benefitting from the proliferation of high-end audio and navigation systems being installed across the price spectrum of motor vehicles.
Looking to the second quarter and remainder of the year, we think the market can grind higher from current levels, driven by sustained economic growth both here and abroad. We do caution, however, that the road ahead for the market may get choppier as comparisons get more difficult and monetary stimulus is withdrawn. When the Federal Reserve finished its first round of quantitative easing (QE) in April 2010, money supply growth flatlined and the market fell. It wasn’t until the Fed signaled its intent to initiate another round (QE2) in late August 2010 that the market got back on track. Come June, QE2 will wind down, and what the effect will be on the market is unclear. At the same time, we expect corporate profit growth will downshift as companies face increasingly difficult comparisons and the impact on margins begins to be felt from the rapid rise in commodities. It is under this framework that we believe the period immediately ahead continues to favor the higher quality growth stocks that comprise the holdings in the portfolio.
M. Scott Thompson, CFA
Andrew W. Jung, CFA
April 1, 2011
As of March 31, 2011, Polycom comprised 3.21% of the portfolio's assets, Altera – 1.72%, Chipotle Mexican Grill – 0.83%, Panera Bread – 1.47%, Tractor Supply – 1.83%, St. Jude Medical – 2.32%, MSCI – 1.60%, Expeditors International – 2.30%, NVIDIA – 1.67%, Mead Johnson – 1.19%, Harman International – 1.16%, and F5 Networks – 0.78%.
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.