1st Quarter 2011 Commentary
The market continued to rise during the first quarter of 2011 on the back of modest improvement in the economy and a pickup in mergers and acquisitions activity. The U.S. economy showed further signs of recovery as employment growth picked up, though it remained modest despite a tick up in consumer expectations. The Federal Reserve’s quantitative easing program is likely to continue through June as policymakers consider the economic recovery fragile and not yet self-sustaining. A brief, mid-quarter correction in reaction to the political turmoil in the Middle East that caused a spike in oil prices and the potential economic disruption associated with the earthquake and tsunami in Japan reversed itself once investors quickly concluded that these events were unlikely to derail the global recovery. Overall, money flows into equities from fixed-income continued as US equities remain attractively valued on a relative basis, while long-term government bonds posted losses during the quarter.
The value component of the Russell Midcap Index slightly trailed its growth counterpart owing once again to its higher weighting in financial services stocks (banks in particular) that lagged the overall index as well as better performing Consumer Staples stocks on the growth side. High-quality stocks, larger market-cap stocks along with those with higher volatility (beta), were the best performers—which is not completely unexpected as the economy begins to normalize.
The Fund delivered solid absolute and relative performance during the quarter. Stock selection within Industrials, Consumer Discretionary, and Financials plus an underweight position in the poorly performing Financials sector were key contributors. Industrials were one of the largest weightings in the portfolio, and those holdings produced double-digit returns led by standout performances by Atlas Air Worldwide and Teledyne Technologies. International airfreight services provider Atlas has seen robust volumes and firm pricing due to strong secular trends and supply constraints. Teledyne, an electronic and communication systems provider for space, defense and industrial applications announced the sale of its legacy piston airplane engine business for a healthy price and the acquisition of a higher margin and growing niche electronics business. The two deals are accretive to earnings and facilitate the company’s shift toward higher margin commercial businesses.
Six Flags Entertainment and Stanley Black & Decker boosted returns within Consumer Discretionary. Six Flags, which emerged from bankruptcy last summer, announced better than expected results and reacted positively to insider buying and its first investor day following the reorganization. Tool-maker Stanley Black & Decker announced better than expected earnings and increased its guidance for 2011.
Stock selection in Healthcare and an underweight stake in surging Energy stocks modestly detracted from relative performance. In addition, holding residual cash amid a strong equity market served as a minor headwind.
At Cardinal, we focus on finding companies with solid fundamentals at opportunistic valuations. Two examples of such situations are IAC/Interactive and KAR Auction Services. IAC operates more than 35 online brands in a well-positioned portfolio following Barry Diller’s 2008 spin-off of Ticketmaster, Home Shopping Network, LendingTree, and Interval. The company’s largest business segments are search (Ask.com, toolbars and applications) and personals (Match.com). Last year, Ask.com was restructured to improve profitability and reinvigorate growth while Match.com is the dominant player in a fragmented industry with many opportunities for growth. The company generates significant free cash flow, which management has used to aggressively repurchase its shares. The stock’s current valuation suffers from both its conglomerate history and the nominal earnings on its large cash hoard, so as the management team continues to narrow its business focus and reduce its cash balance we think the discount should dissipate.
KAR Auction Services is a leader in the vehicle redistribution business in the U.S. and Canada. Company operations include whole car auctions, salvage auto auctions and a used car dealer floor-plan finance operation. The company also provides value added services that add to profits. As the businesses are oligopolies with pricing power, KAR generates substantial free cash flow. In 2007, the company went private in a leveraged buyout which permitted it to make needed management, operational, and structural changes. A poorly handled IPO in late 2009 provided the Fund an opportunity to invest at an attractive price in a business we have followed for a long time. We think management’s current focus on reducing debt should benefit shareholders in the next few years as they are able to focus on growth opportunities and whole car industry volumes turn up.
We remain constructive on the economy and equity market as fiscal and monetary policy continues to be accommodative and economic and credit conditions continue to improve. Equity valuations remain attractive and mergers and acquisition activity is increasing. The cyclical rotation of fund flows from fixed-income into equities is only likely to gain momentum if the positive relative return trend for equities persists. Cardinal’s lower weighting in bank stocks, which has been a major contributor to the Fund’s strong relative performance remains in place. With recent adverse regulatory changes like the Dodd-Frank bill, we believe that the banking business is not as attractive as it once was, with the result that historical valuation metrics are no longer relevant. Assuming a normal economic recovery, we find very few banks which offer us the high rates of return or visibility that we seek in an investment opportunity. Our approach of opportunistically buying sound free cash-flow producing businesses at inexpensive valuations has generated attractive long-term returns, and we believe that it will continue do so. The management teams of the companies in the portfolio have become much more active in redeploying their cash flow in accretive ways, including acquisitions and share repurchases. We think these actions bode well for the future.
The Cardinal Capital Team
As of March 31, 2011, Atlas Air Worldwide comprised 3.19% of the portfolio's assets, Teledyne Technologies – 2.75%, Six Flags Entertainment – 1.68%, Stanley Black & Decker – 3.73%, IAC/Interactive – 2.38%, and KAR Auction Services – 2.18%.
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.