2nd Quarter 2011 Commentary - ASTON/TAMRO Diversified Equity Fund
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.
Weakness in Technology
The Fund declined during the second quarter in trailing the roughly flat returns of its Russell 1000 Index benchmark. The underformance relative to the benchmark can be attributed to stock selection in Technology, with company-specific issues affecting three stocks that detracted the most from performance during the period. Stock selection within the Utilities and Consumer Discretionary sectors also hurt relative performance. The overall sector allocation effect was slightly negative due to an underweight position in Consumer Staples during a time when investors sought relative safety in the defensive-oriented sector.
The three tech holdings that disappointed were Research in Motion, Smith Micro Software, and Ixia. Softened demand for Research in Motion’s high end offerings combined with a delay in the launch of new products led to a reduction in guidance by the company that has weakened the stock considerably. Smith Micro Software lowered revenue and earnings guidance owing to a product transition by a major customer, and is no longer in the portfolio. 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. In addition, Google declined during the period as uncertainty rose in regards to its capital allocation plans as founder Larry Page assumed the position of CEO. We see the change by the company as a move to refocus on innovation.
Stock selection in the Financials and Healthcare benefitted performance during the quarter, with health-related firms Allergan, Cerner, and Advisory Board among the top contributors. Allergan received 12 approvals from the FDA for new products even as revenue growth at the company continues to be robust. Cerner continues to benefit from the strong spending trend in health care IT as the industry becomes more digitized. Finally, research firm Advisory Board saw improved demand from its hospital client base that resulted in strong contract growth.
Buys and Sells
Six stocks became full positions during the second quarter, notably American Express, Fluor, and Teva Pharmaceutical. We think American Express is well positioned to benefit from the transition to a “cashless” society and the ongoing rebound in discretionary spending by its affluent customer base. Additionally, the company’s iconic brand should support further expansion into key Emerging Markets. Global engineering firm Fluor is rebounding quickly along with the boom-bust energy and raw materials industry that it supports. If historical patterns hold, the growth in the firm’s order backlog will presage revenue and earnings growth while also boosting profitability, thereby, we think, boosting its stock price.
Teva is the leading manufacturer and marketer of generic drugs worldwide. The company also operates a branded specialty pharmaceutical business primarily focused on central nervous system therapies led by Copaxone, the number one treatment for multiple sclerosis. Despite its dominant position, international market share expansion, and industry catalysts that should favor Teva near-term, investor concerns over potential Copaxone deterioration from new oral drugs entering the market and potential generic competition combined with a shift in strategy have led to skepticism over management’s long-term outlook, causing its stock to underperform. In our view, Teva continues to possess a competitive advantage in generics, has diversified the Copaxone risk, and enhanced its branded portfolio and innovation capabilities with its recent acquisition of Cephalon. We think it generates sufficient cash flow to successfully execute future acquisitions and return cash to shareholders via dividends and share repurchases. We believe the risks are largely priced into the stock and view current price levels as an opportunity to own an excellent business at a near-trough valuation.
Seven full positions were sold during the period, including Goldman Sachs, Microsoft, NVIDIA, and Washington Post Company. Goldman offered an attractive valuation, but the wildcard remains its potential level of profitability in a post-financial crisis world of heightened regulation. We sold Microsoft to fund other tech opportunities in which we have greater conviction. We trimmed the portfolio’s stake in NVIDIA when it spiked earlier this year, and took the remaining profits during the second quarter to fund ideas we think have better upside/downside ratios. Washington Post, with its Kaplan Education Division, was sold to fund a more pure play in the education space.
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, Healthcare, and Technology were the top-three sectors in the portfolio by percentage of assets, with Technology the only one that was underweight relative to the Russell 1000. We have added to the Fund’s stake in Healthcare since the end of the first quarter, propelling it into the top-three, and took profits in Energy, which dropped from the top-three. We also decreased exposure to Financials due to reduced expectations within the banking industry.
Within certain sectors we have identified trends that have helped to focus our stock-picking efforts. Within Industrials, the major trend is rising global demand from Emerging Markets for capital equipment. 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. We have also recognized that growing demand for a better diet in emerging countries has affected grain and protein pricing. We think this situation bodes well for both seed and agricultural nutrients companies.
TAMRO Capital Partners
As of June 30, 2011, Research in Motion comprised 1.44% of the portfolio's assets, Smith Micro Software – 0.00%, Ixia – 1.85%, Google – 2.13%, Allergan – 2.35%, Cerner – 2.99%, Advisory Board Company – 2.38%, American Express – 1.68%, Fluor – 2.18%, and Teva Pharmaceutical – 1.94%.
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.