2nd Quarter 2011 Commentary
Stock market volatility colored the second quarter landscape with the end result being a slight decline in small-cap stocks and a neutral to positive swing for large-caps. Defensive sectors of the market rose, while cyclical areas experienced profit taking. Much of the economic news during the past three months reflected weakening conditions for growth. This can be summarized by U.S. Gross Domestic Product (GDP) growth of just 1.8% during the first quarter (announced April 28th), down from 3.1% growth in the fourth quarter of 2010. Anticipated results for the second quarter of 2011 are not expected to be much better than the first.
Fiscal policy in Washington is currently focused on moving toward reducing the Federal deficit, while monetary policy is focused on maintaining liquidity and low interest-rates. With the end of quantitative easing part two, it is not evident what the next steps will be from the Federal Reserve. Historically, Federal policy has been instrumental in moving the U.S. economy from recession to recovery and there is no difference this time. As a nation, we have always been successful in addressing the major issues confronting the country, and for that reason, we are ever hopeful we will resolve them once again. We believe the levers will continue to be pulled to maintain a forward course. We are not anticipating a double dip recession due to excess liquidity and we continue to expect faster economic growth overseas. Stock market valuations are attractive based on forward earnings, and corporate balance sheets are flush with cash. Small-cap companies are often the innovators of the U.S. economy, whereas large-cap companies serve an expanding global marketplace. We remain optimistic about the long-term prospects for U.S. stocks.
The Fund declined slightly during the second quarter compared with a fall of 1.61% for its Russell 2000 Index benchmark. The outperformance relative to the benchmark can be attributed to stock selection, with the largest benefit coming from picks in the Industrials, Energy, Materials, and Consumer Discretionary sectors. The overall sector allocation effect was neutral, with the small negative impact of an overweight to Energy largely offset by an overweight in Telecommunication services.
Top individual contributors to performance included NETGEAR, BJ's Restaurants, NuVasive, and Bill Barrett. Tech networking firm NETGEAR reported strong revenue and earnings growth during the period, and management raised its guidance as contributions from new products increased to 40% of sales. Same-store sales at BJ's rose solidly within Consumer Discretionary despite an environment of lackluster consumer spending. The firm's good cost management practices also helped to boost the stock. NuVasive delivered earnings and revenues above consensus estimates, and raised guidance, as the firm continues to gain market share within the less invasive spinal procedure market. Natural gas producer Bill Barrett benefitted from the premium prices for natural gas liquids and recently received approval to drill in a potentially lucrative natural gas field.
Despite the performance of NETGEAR, overall stock selection within Technology detracted from performance, as did picks within Consumer Staples. Smith Micro Software lowered revenue and earnings guidance owing to a product transition by a major customer. Tech equipment supplier Ixia reported strong growth for their testing equipment, but uncertainty about their exposure to Japan led to profit-taking in the stock. Elsewhere, soft revenues and earnings hurt the stock of Winnebago Industries as consumer demand for recreational vehicles hit a soft patch. Stifel Financial dropped as quarterly results were shy of expectations.
Buys and Sells
Four stocks became full positions during the second quarter either through direct purchases, market appreciation, or a combination of the two. AeroVironment is the sole provider of small unmanned aerial systems (UAS) and electric vehicle charging stations to the US Department of Defense. A clean balance sheet—no debt, more than 20% of its market cap in cash—and a proven management team provide confidence in the company’s future prospects despite the typical ups and downs of being associated with being a supplier to the government. We think global engineering firm Chicago Bridge & Iron is poised for a revenue growth recovery after being hard hit, with the rest of its industry, during the recession. Recent evidence points to the continuation of energy infrastructure investment in emerging economies, and we anticipate margin expansion followed by multiple expansion as in previous economic cycles.
Rounding out the group of new full positions are two Financials stocks—IBERIABANK and UMB Financial. IBERIABANK is a multi-bank financial holding company centered in the southeastern U.S. led by a tenured management team that has grown the bank through both acquisitions and organic efforts and navigated the firm through the downturn much better than most regional banks. We expect several FDIC-assisted acquisitions and better-than-average economic conditions in the company’s key markets of Louisiana, Arkansas and Texas to support further growth in earnings and book value. UMB's high capital levels and conservative underwriting criteria are appealing attributes, but more attractive are the company’s meaningful and growing fee-based businesses, which include asset management and corporate trust services. These operations benefit from scale and we think UMB is well positioned to grow the businesses and improve profitability in the years ahead.
Two full positions were sold from the portfolio during the period, Acme Packet and Raymond James Financial. As we like to joke, Acme Packet was the “gift that kept on giving.” It delivered incredible returns for investors in the Fund since its initial purchase in June 2009. We trimmed the holding as the valuation climbed and bid a final fond farewell as its market-capitalization approached $5 billion. We took profits in Raymond James, a long-time portfolio holding, as the market-cap ascended toward $5 billion and its valuation became stretched.
Positioning and Outlook
Although we expect a continuation of modest domestic growth, TAMRO’s investment process focuses on individual, bottom-up stock selection to identify companies that we believe are best able to execute given their specific competitive advantage. Our approach to portfolio management is opportunistic and broadly diversified, with sector weights determined by where we see opportunities at the stock level rather than macroeconomic calls. At quarter-end, Industrials, Technology, and Financials were the top-three sectors in the portfolio by percentage of assets, with Industrials the only one that was overweight relative to the Russell 2000. Energy is another sector where we find more opportunities relative to the benchmark, with the portfolio ending the quarter with a 50% overweight. Financials, Materials, and Utilities are the sectors with the largest underweight positions in the Fund relative to the index. Changes from the first quarter were modest given the flattish trend of the markets. Industrials rose to become the largest sector, bypassing Technology, mainly due to relative price movements and the sale of Acme Packet.
Within certain sectors we have identified trends that have helped to focus our stock-picking efforts. Within Industrials, we see energy and water infrastructure as a major trend as emerging markets continue to develop. Efficient administration is a dominant trend in Healthcare, with the need for cost containment a priority as the demand for healthcare services continues to grow. In Technology, mobility, cloud computing, and security are the major areas where companies are investing for greater competitive efficiencies. Lastly, in the Energy sector we think we have identified companies that can unlock sources of energy that heretofore have been unreachable through the advent of new technology.
TAMRO Capital Partners
As of June 30, 2011, NETGEAR comprised 2.56% of the portfolio's assets, BJ's Restaurants – 1.98%, NuVasive – 1.53%, Bill Barrett – 2.29%, Smith Micro Software – 0.62%, Ixia – 1.60%, Winnebago Industries – 1.02%, Stifel Financial – 1.93%, AeroVironment –1.76%, Chicago Bridge & Iron – 1.98%, IBERIABANK – 2.00%, and UMB Financial – 1.63%.
Note: Small-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.