1st Quarter 2011 Commentary
International equity markets delivered positive returns during the first quarter of 2011, as the Fund's MSCI EAFE Index benchmark rose 3.4%. This was an amazing result considering the tumultuous events of the past several months. To recap, we saw protests that led to the fall of governments in Tunisia and Egypt, the outbreak of civil war in Libya, civil unrest in Bahrain, and a nascent protest movement in Saudi Arabia. A 9.0 Richter scale earthquake struck Japan (the fourth most powerful earthquake ever recorded) causing a tsunami, which in turn led to an ongoing nuclear incident at the Fukushima nuclear power plant. Finally, there was the slow, grinding, relentless escalation of the European debt crisis.
If that weren't enough, we began the year with a number of risks and imbalances already, which we highlighted in last quarter's commentary. Among them, the risk of an over tightening of credit in China and the possibility of a double-dip recession in the West. For good measure, the first quarter also saw the price of oil increase to more than $100 per barrel. And yet, with only a few wobbles, the international equity market absorbed all of these events and moved higher during the period.
Europe ex-UK was the best performing region during the quarter, rising nearly 8%, followed by the UK itself which gained less than half that amount. Not surprisingly, the worst performing region was Japan which fell nearly 5%. Emerging Markets on the whole gained ground, but underperformed the developed countries of the MSCI EAFE Index. Energy was the best performing sector followed by Telecommunications. The Technology sector was the worst performing area, declining marginally and only slightly more than than Consumer Discretionary.
The Fund underperformed the benchmark during the quarter mostly due to weak stock selection. Allocation by region was moderately negative owing to an underweight to Europe and weak performance from Canadian-listed, Indian gas producer Niko Resources. Allocation by sector was neutral overall—a positive contribution from an overweight to Energy offset small negative contributions from overweight positions in Technology and Materials, and underweight stakes in Telecomm and Industrials.
Stock selection was a detractor on both a regional and sector basis. Poor results in the Pacific ex-Japan region, primarily due to the decline in uranium producer Paladin Energy after the Japan nuclear incident, served as a drag on regional results. Although this was offset to some extent by good stock selection in Japan, including an underweight position to troubled nuclear plant operator Tokyo Electric. None of the portfolio's other Japanese holdings stood out individually, though the Fund's Japanese stocks were less affected by the earthquake than was the overall Japanese market.
Stock selection was weak in the Materials, Energy, Industrials and Telecommunications sectors. The poor performance within Materials came mostly from the turmoil in Egypt. While gold-miner Centamin Egypt has not had its operations in disrupted by recent events in the country, sentiment weighed against the share price on fears of operational disruptions. On a positive note, good performances from Healthcare stocks Grifols and Shire aided returns, as did a new holding in Russian gas producer Gazprom.
When our Strategic Policy Group upgraded our top-down score on Japan to neutral near the end of last year we had been looking to add any interesting Japanese growth stocks that our analysts could identify. That work was still in progress when the earthquake struck, thus the portfolio was underweight to Japan—which was fortunate. Now, the question is whether the sell-off in Japanese equities has created a buying opportunity. The answer is not clear cut. Some companies have seen their business models severely disrupted by the earthquake and it will be some time before normal service resumes, while a number of companies are still finding out the extent of the disruption they will face.
Still, other companies have emerged relatively unscathed with their growth plans intact. Where we can find these types of companies on attractive valuations we may make purchases for the portfolio. What is clear in the current circumstance is that the disorder caused to the Japanese economy by the disaster has made historical correlations less useful than before. The result is that Japan has become a much more bottom-up market than it once was—at least for now. Two names that did make it into the portfolio during the quarter were factory automation specialist Keyence and technology company Kyocera.
Elsewhere on a regional basis, we added two new names from Europe. Norwegian salmon farming company Marine Harvest appealed to us as farmed fish looks to be a long-term growth industry given its ability to sustainably supply the growing global demand for fish protein. In the UK, we added global advertising agency WPP, as we expect that company to benefit from the ongoing economic recovery.
We continue to favor the Energy sector from a top-down perspective. We think the economic recovery will be good for demand more so than because of geopolitical considerations. During the quarter, we increased the Fund's stake in that area by adding Singaporean offshore drilling rig manufacturer Keppel and the previously mentioned Gazprom.
The Fund sold four stocks during the quarter for a variety of reasons. We further reduced the portfolio's weighting to the Consumer Staples sector by selling Reckitt Benckiser. Following a profit warning late last year we found an opportunity to sell the holding in UK banknote printer De La Rue. Downgrades from our analysts led to the sale of Japanese technology firm Fujitsu. Finally, after a strong performance we sold out the Fund's holding in Bank of China Hong Kong.
Despite the positive start to the year, the recent turmoil across the globe is a source of concern looking ahead. The unrest in North Africa and the Middle East has had little direct impact on the global economy because these economies remain relatively small. The indirect impact, however, has been the rise in the price of a barrel of oil as investors contemplate disrupted oil shipping lanes in the Straits of Hormuz.
The compound disaster that is the Japan earthquake-tsunami-nuclear accident is having a much greater impact on the global economy. First of all it is has created tremendous human and physical loss to the world's third largest economy which will lead to lower economic output in the short-term. Second, it has led to supply chain chaos in the technology and automotive industries as the production of key components has been disrupted.
The last point to note about the Japan situation is that the nuclear crisis at Fukushima has thrown a dense fog over the future growth of nuclear energy. In past commentaries we have mentioned looking for growth ideas that played into the nuclear energy theme. The one holding that the Fund did purchase, uranium miner Paladin Energy, sold off heavily as the crisis unfolded. We are reviewing this holding, as well as the entire industry, in deciding a course of action.
The future growth of nuclear energy is not clear. The Europeans seem likely to react the most severely, and their cancelling of new nuclear power plants would not be a surprise. Roughly half of the nuclear power plants planned globally by 2020 are for the Chinese, however. Although the Chinese have ordered a safety review of their planned nuclear projects, given their lack of oil resources and their over-reliance on coal it would seem that they have little alternative but to increase the share of power that they generate from nuclear. Similar arguments apply to India and to other developing markets. Notwithstanding this, liquefied natural gas (LNG) is a clear beneficiary of the Japan nuclear incident, and the portfolio has a strong position in this area.
Lost amongst all of the events in the first quarter was the slow and relentless escalation of the European debt crisis. How events here will unfold is unclear because the decisive factors will have as much to do with political choice as economic factors. Therefore, we are comfortable continuing to avoid owning European banks.
Also overlooked amongst the events of the first quarter was sufficient appreciation of the coming end to US Federal Reserve's second round of quantitative easing (QE2). The end of QE1 saw the US economy with insufficient momentum to sustain growth. Barring further disasters, investors are likely to pay much more attention to this during the second quarter. We think there is a good chance that the end of QE2 could reveal the weakness of the underlying growth in the US economy. It is for this reason that our focus remains on finding growth stocks for the portfolio. When economic growth is scarce, growth stocks tend to rise to a premium to the market.
Baring Asset Management
As of March 31, 2011, Niko Resources comprised 1.58% of the portfolio's assets, Tokyo Electric – 0.00%, Centamin Egypt – 1.54%, Grifols – 1.48%, Shire – 1.99%, Gazprom – 1.89%, Keyence – 1.43%, Kyocera – 1.37%, Marine Harvest – 1.50%, WPP – 1.48%, and Keppel – 1.70%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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.