1st Quarter 2011 Commentary
Despite the revolutionary fervor sweeping the Middle East and the devastating Japanese earthquake, tsunami, and resulting nuclear crisis, the stock market (as measured by the S&P 500 Index) posted gains of nearly 6% during the first quarter of 2011. Fixed-income markets were generally more subdued in delivering only nominal gains. Unfortunately, the Fund underperformed its composite index benchmark comprised of 60% S&P 500 Index/40% Barclays US Government Credit Index.
During the past year, a combination of style and market-cap headwinds plus some stock selection issues have detracted from relative results. Our stock-picking process emphasizes long-term growth, valuation, quality, and near-term earnings momentum, and currently leads us toward larger names with more sustainable earnings growth—attributes that have been largely shunned in favor of smaller, more-cyclical, and lesser quality issues since the stock market bottom in March of 2009. We remain confident in our disciplines, and expect them to continue to add value over full market cycles. Despite the recent underperformance, the Fund’s five-year return remains solidly ahead of the benchmark.
Although the Fund’s Consumer Staples holdings have benefited from their global footprints over the long haul, they were adversely impacted during the quarter as many of them conduct meaningful business in Japan. The virtually unprecedented increase in commodity prices in the wake of the Federal Reserve’s launching a second round of quantitative easing (QE2) also caused unexpected margin pressure. Consequently, the forecasted improvement in the rate of earnings growth and relative momentum for these holdings was pushed out and Staples stocks as a group underperformed the broader market. The portfolio’s overweight position in Consumer Staples thus detracted from performance during the period.
The resulting underperformance of Staples has produced relative valuations that look very attractive on a historical basis, and consumer companies have begun to implement price increases which will benefit their relative earnings growth during the second half of 2011. We added to the Fund’s position in Kraft ahead of its earnings report. While commodities will put pressure on margins, we expect the company to still be able to generate earnings growth in the low-to-mid teens in 2011. Combined with a 4% dividend yield, we find the total return potential attractive.
Conversely, we trimmed PepsiCo after management lowered earnings growth guidance for 2011 primarily due to higher than expected commodity costs. Procter and Gamble was reduced as broad-based commodity inflation and disruptions in Japan are expected to temper near-term earnings growth. Although we believe Wal-Mart is heading back on the right track after some missteps in the past year or so, their core customer remains challenged from a macroeconomic standpoint, which is likely to continue to present a headwind. We thus eliminated the stock position from the portfolio.
Other consumer-related holdings negatively affected by the rise of commodity prices and the events in Japan were Carnival Cruise Lines and Coach. Carnival hurt relative performance due to the spike in oil prices caused by the turmoil in the Middle East. Energy prices are a significant input into the company’s cost structure, and because the near- and intermediate-term oil price direction is uncertain due to ongoing geopolitical risks, we sold the portfolio’s position.
The Fund purchased Coach, a leading designer and marketer of premium handbags and accessories, towards the beginning of the quarter. Following the global economic recession, the domestic handbag category appeared to be recovering and Coach’s re-pricing and rebalancing of its product mix seemed to be gaining traction, allowing the full-price U.S. business to return to positive comparisons. Coach derives about 20% of its sales from Japan, however, and we reduced the position following the devastating earthquake and tsunami that struck the country. While we view management as highly capable even when operating in an environment of considerable uncertainty, we believe Japanese demand for luxury items could be weak for a prolonged period.
Within Industrials, Fluor was up more than the sector for the quarter, but the Fund’s other holdings in the sector lagged and detracted from relative performance overall. We trimmed Fluor given its strong absolute and relative performance during the second half of 2010 and as the position size approached 4% of assets. We also reduced Emerson Electric despite the company’s solid order momentum because comparisons will get more difficult as 2011 progresses. Strong order momentum may not translate fully into upside earnings surprises given rising cost pressures. Emerson is one of the industrial companies most exposed to China, where officials are likely to attempt to slow growth over the next several years and refocus the economy on consumption over fixed asset investment. Thus, a reduction in the position seemed prudent.
Strong gains in Accenture, Apple, Oracle and Qualcomm led to positive stock selection within the Technology sector. The Fund’s underweight position in Technology contributed positively to relative performance as the sector trailed the broader benchmark. We added to Accenture after competitor IBM’s results confirmed a strengthening demand environment for information technology and consulting services. We believe that the shares of Apple are undervalued relative to the growth potential in iPhones and iPads, as well as the Mac. We expect growth to be driven by continued international expansion. We continue to see indications of improving demand at Oracle, including the strong positive reception for Exadata, evidence that an enterprise software upgrade cycle is now underway, and the fact that the firm is about to roll out a new, next-generation Fusion application suite that further complements existing new product cycles already under way in database and middleware.
An overweight position to the Energy sector aided performance as the sector posted double-digit gains within the Russell 1000 Growth Index. Halliburton was the Fund’s best performer during the quarter, though stock selection overall underperformed the benchmark owing to the absence of the index's largest position, Exxon Mobil. We continue to favor Halliburton and increased the portfolio’s position given the stock’s attractive valuation and above-average earnings growth. We added to Apache following weakness in the stock due to a cyclone in Australia and civil unrest in Egypt. Although Egypt accounts for roughly 20% of the firm's production, there had not been any reports of operations being affected in any way and the country is dependent upon Apache for its oil production.
Elsewhere, individual standouts included Disney, Stryker, and JP Morgan Chase. Disney was up strongly during the quarter. We had increased the position following robust December quarter results that demonstrated strong momentum across all business units. Disney is currently benefitting from a strong ad cycle, a renewed creative cycle, and a recovery at its theme parks. Stryker enjoyed strong gains due to good momentum in its orthopedics business. The Fund’s sole financial firm, JP Morgan Chase, increased more than the sector during the period modestly contributing to relative performance. We increased the position as we believed that dividend payments were likely to be implemented by the end of the first quarter, which subsequently occurred. In addition, the stock was attractively valued on both current and normalized earnings, the yield curve is steeper, and the macro environment has improved—which helps both credit-quality and loan demand.
Equity Buys and Sells
During the quarter, the Fund established one new position in Omnicom Group, a global leader in advertising, marketing and corporate communications services. We believe a cyclical recovery in demand for advertising and marketing services is driving accelerating organic revenue growth. The company should improve margins over the next two years and is a beneficiary of the secular shift from traditional advertising to digital and other non-traditional marketing services.
We added to positions in UPS, Nike, and Google. UPS offered a compelling combination of attractive valuation and above average earnings growth. In addition, we believe two issues are probably not well-known or understood by analysts and could contribute to upward earnings revisions during the second quarter: (1) the change in the surcharge structure that reduces the incentive for the "trade down" effect in the face of rising oil prices and better protects UPS to the extent it does occur; and (2) the easier second quarter earnings comparison created by the incurrence of charges for retraining/relocation as part of the North American reorganization last year that will not be present this year.
Nike was increased after weakness in the stock due to the company missing analyst expectations for their fiscal third quarter earnings. Although the company faces near-term margin pressures, we believe that strong demand for the company’s products will permit it to successfully raise prices in the period ahead. Google was increased on weakness due to our confidence in the company’s relative earnings strength.
Along with the previously mentioned Wal-Mart and Carnival, Merck and Juniper Networks were sold during the quarter. Merck suffered from the failure of one of their pipeline products and fears that an arbitration case involving Remicade may go against the company. An accumulation of factors has changed the long-term growth profile of the company, including the health care reform fee/excise tax, a 7% excise tax in Puerto Rico, and continued high unemployment having led to depressed prescription utilization and growth. 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.
Broadcom was trimmed following an earnings report that revealed greater than expected increases in operating expenses related to legal expenses, employee merit pay, and acquisitions. We continue to be optimistic about the company’s long-term prospects because of its exposure to the wireless, broadband, and networking markets, but the reduction in near-term earnings momentum warranted a smaller position. Costco was also trimmed as the stock traded at a relatively high P/E ratio and approached our estimated present value.
We believe the stock market will continue to grind higher along with sustained economic and profit growth. The market is still in what stock market commentators often refer to as its “sweet spot” with a growing economy, generally well-contained inflation and the Federal Reserve providing ample liquidity to support share prices.
After unusually strong gains in corporate profitability since the end of the recession, corporate profit growth should moderate as cost containment and productivity benefits begin to subside. We expect this downshift in corporate profit growth during the second half of 2011, to coincide with a rotation from lesser quality, more-speculative stocks to the shares of higher quality issues such as those held in the Fund. The shares of the latter are attractively valued and their earnings growth rates are more assured owing to their financial strength and global diversification.
The Fund’s Energy and Technology holdings should benefit from the growth of Emerging Markets and the improvement in the U.S. economy. Multinational holdings with strong global brands that the Fund owns also stand to gain from robust growth in consumer spending in Emerging Markets. This will be reinforced by the eventual and inevitable shift in the mix of the Chinese economy toward consumption and away from fixed asset investment. Emerging Market consumer spending now represents about 35% of global consumer spending, in-line with the developing world’s contribution to global GDP. We continue to highlight the unusually attractive dividend yields and dividend growth prospects of these leading global growth issues in an environment of low interest rates for both short- and long-term fixed-income investments.
On the fixed-income side, we believe US Treasury yields are likely to rise in the period ahead as economic growth continues and we approach the end of QE2. Higher commodity costs have led to an increase in inflation expectations, which should pressure yields higher. The other sectors of the bond market are likely to perform better than Treasuries as investors continue to seek out incremental income in a low interest-rate environment. In addition, continuing corporate profits and reduced supply from the mortgage and asset-backed sectors provide a solid fundamental and technical backdrop for the bond market outside of US Treasuries. Given this outlook, we continue to maintain a duration in the bond portfolio that is shorter than the benchmark in order to mitigate the negative effect rising interest-rates have on bond prices. We are also maintaining an overweight position in high-quality intermediate corporate bonds in anticipation of that sector’s continued outperformance.
Overall, we think that we are very close to an inflection point similar to that during the second half of 2007 when the market’s focus shifted from momentum to fundamentals, and high-quality growth stocks came into favor.
Montag & Caldwell Investment Counsel
As of March 31, 2011, equity positions in Kraft comprised 1.72% of the portfolio's assets, Pepsi – 1.87%, Procter & Gamble – 1.99%, Wal-Mart – 0.00%, Carnival Corp. – 0.00%, Coach – 0.46%, Fluor – 2.40%, Emerson Electric – 1.21%, Accenture – 2.61%, Apple – 2.09%, Oracle – 2.45%, Qualcomm – 3.00%, Halliburton – 1.59%, Apache – 2.09%, Walt Disney Co. – 2.50%, Stryker – 3.02%, JPMorgan Chase – 2.53%, Omnicom Group – 0.14%, UPS – 2.86%, Nike – 1.93%, Google – 2.98%, Broadcom – 1.12%, and Costco – 2.04%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its dividends.
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.