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 in 13 years, as measured by the S&P 500 Index. 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 solid absolute returns during the quarter, but lagged its Russell 1000 Index benchmark. All sectors of the Fund and the benchmark delivered positive absolute returns. On a relative basis, the underperformance versus the index came from weak stock selection in the Consumer Discretionary, Financials, and Materials sectors, while sector allocation was neutral overall. Long-term profitable holding Dollar Tree dropped on concerns about peak margins and increased competition. We had been taking profits in the position owing to its rich valuation and ultimately exited it for better relative opportunities. Within Financials, Goldman Sachs detracted from relative returns as concerns about the revenue outlook at the firm weighed on the stock.
Holdings in Technology made a positive contribution to relative return, but it was a bit of a round trip with strong gains in January and February largely offset by weakness in March. NVIDIA rose on optimism for its new mobile products, while ARM Holdings reported revenue and earnings that exceeded expectations. We decided to sell the position due to the increased valuation on the stock. Stock selection and an overweight to the Industrials sector benefitted the portfolio as well.
Energy a Mixed Bag
Although the Energy sector was by far the best performing area on an absolute basis, it was a mixed bag for the Fund in relative terms. Strong returns from top-10 holdings Range Resources and National Oilwell Varco were offset somewhat by a disappointing position in Weatherford International. Improving near-term sentiment for natural gas commodity prices, based on increasing electricity demand and the potential for global exports, drove Range Resources higher. NOV benefitted from increased demand for the company’s support equipment for deep-water rigs from rig operators winning contracts for the increasing off-shore development off of Brazil.
We initiated a position in Weatherford in the portfolio during the fourth quarter because we believed that the management team of this oil service firm had made good progress in the past few years in expanding its offerings to increase its global footprint and increase its presence in the more lucrative foreign markets. We further added to the holding during the first quarter. When the company announced that accounting issues caused the delay of their SEC filings, however, we sold the stock—realizing the accounting issues that we thought had been sufficiently corrected are still a problem.
The Fund remains broadly diversified and continues to be driven by our bottom-up fundamental analysis. This past quarter, we reduced the portfolio’s emphasis on Consumer Discretionary, mainly due to valuation and opportunities we identified in the Energy sector. Many leading energy companies were trading at what we consider depressed valuations as those with a focus on natural gas have been ignored by investors.
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.
Of the three stocks that became full positions during the quarter were two energy companies focused on natural gas exploration and production—EOG Resources and Southwestern Energy.
Concerns about EOG’s natural gas weighting and its ability to fund its capital spending budget have caused the stock price to underperform its peers. Given its history of funding new development ideas—such as unconventional liquid plays in oil and condensate—with the most efficient sources of capital available, we view this as an opportunity to buy a leading energy producer at a low valuation. Southwestern’s management team has a history of shrewd capital allocation, with a preference for adding reserves organically. This disciplined approach has led to positive returns on capital throughout the energy cycle. Still, returns are currently at trough levels reflecting lower natural gas prices. Trading at a price-to-book value near its historic lows, the stock has plenty of room to rise with any kind of appreciation in natural gas prices.
Overall, 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, Goldman Sachs comprised 1.72% of the portfolio's assets, NVIDIA – 1.92%, ARM Holdings – 0.00%, Range Resources – 2.70%, National Oilwell Varco -2.60%, EOG Resources – 1.61%, and Southwestern Energy – 2.11%.
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.