2nd Quarter 2011 Commentary - ASTON/Cardinal Mid-Cap Value Fund
The optimism prevalent in the equity market earlier in the year waned during the second quarter. Concern that the economy would slip back into recession was exacerbated by credit market fears raised by the European sovereign debt crisis and politics being played with the U.S. government debt ceiling. Economic data showed a marked deceleration with employment growth in particular much lower than forecast and housing data weak as flawed foreclosure processes at loan servicers and regulatory delays have created a shadow inventory that overhangs the market. Although economic growth estimates for the second quarter were positive, they have been falling due to the impact of severe storms and floods in the U.S., lower consumer spending as a result of much higher gasoline prices, and business disruption caused by the events in Japan.
Most economists do expect a stronger second half to the year, however, as gas prices have come off their highs and the Japanese economy is bouncing back rapidly. As expected, monetary policy remained supportive as the Federal Reserve reiterated their intention to keep interest rates low for an extended period even as the second round of quantitative easing ended. Despite heightened economic uncertainty, merger and acquisition activity remained robust as valuations are attractive and credit is available at low rates for most publicly traded companies. With the markets already assuming that Congress will raise the U.S. debt ceiling prior to a default, equity markets rallied in relief at quarter end after the passage of Greece’s $41 billion austerity program.
Value Lags Growth
The value component of the Russell Midcap Index trailed its growth counterpart by more than two percentage points during the quarter. The value index lagged as a result of its lower weighting in better performing Consumer Discretionary stocks and its higher weighting in poorer performing names in the Financials and Energy sectors. Overall, more defensive Healthcare, Consumer Staples, and Utility stocks led the market while more cyclical Energy, Industrials and Technology shares lagged.
The Fund outperformed its Russell Midcap Value Index benchmark in posting a slight loss for the period. Relative performance was driven primarily by stock selection within the Financials, Materials, Industrials, and Consumer Discretionary sectors. Among Financials, shares of Cash America rose sharply after the threat of adverse payday lending legislation in Texas ended. Silgan Holdings, a processor of metal cans, plastic containers and closures outperformed its peers due to its negligible exposure to falling commodity prices. Gains in KAR Auction Services (strong used car prices) and R.R. Donnelley (significant share repurchase) within Industrials more than offset declines in Equifax (weaker than expected mortgage-related activity) and Atlas Air Worldwide (concerns that international freight trends may weaken). IAC/Interactive was the best performer in the Consumer Discretionary sector due to strong results in its Internet search and match.com businesses as well as the successful renegotiation of its relationship with Google. In addition, Virgin Media rose on continued strong operating results. The primary detractors from performance were an overweight stake in poorly performing Technology stocks and the absence of better performing Utility stocks.
Among the companies with solid fundamentals trading at opportunistic valuations in which we seek to invest, we highlight Six Flags and InterDigital this quarter. Six Flags is the largest regional theme park operator in the U.S., attracting 25 million visitors to 19 parks annually. Laden with billions in debt following a failed effort to diversify, Six Flags filed for bankruptcy in 2009. Emerging last year with substantially less debt and significant tax assets, the company hired new management to focus on improving park operations. A key change is that management will spread capital spending across all parks to keep them fresh instead of building a few blockbuster attractions each year which leaves most parks with nothing new to attract visitors. Management also has plans to reduce costs, boost sales, and monetize non-core assets. With a proven management team, we believe that Six Flags will successfully execute its operating plans and redeploy its free cash flow wisely to enhance shareholder value.
Founded during the 1960s, InterDigital designs and develops advanced digital wireless technologies and has more than 18,000 patents essential to virtually every wireless device. The firm is second only to Qualcomm in terms of non-carrier based intellectual property used in wireless cellular devices, and we expect that its IP network will eventually be licensed by everyone. The mobile phone market is growing rapidly and about half of the InterDigital’s licensees, including Apple, pay fixed fees based on far fewer units than they are selling today. The firm is focusing its efforts on expanding capacity for wireless data as existing infrastructure and technology are inadequate to meet the demand for high speed and quality data. Despite the quality and value of its assets, InterDigital has no real research coverage, and we expect that Google and other vendors who missed out on previously available Nortel patents to take a hard look at possibly acquiring the company to remain relevant and cost competitive in the wireless market.
We are cautiously optimistic on the remainder of the year as fiscal and monetary policy remain accommodative and credit conditions improve despite the sluggish economy. Equity valuations continue to be attractive despite poor market sentiment. Investors expect the U.S. debt limit to be raised but remain skeptical that government spending can be brought under control. In coming months, investors will focus on employment and growth trends to assess whether the first half’s soft patch was temporary. Mergers and acquisition activity has remained strong and is important to our positive stance on equities.
We think Cardinal’s approach of opportunistically buying sound, free cash-flow producing businesses at inexpensive valuations has served investors well. One key reason is that the investment opportunities that we seek arise from systemic structural inefficiencies which are not dependent on market conditions. The company management teams of holdings in the portfolio have continued to be active in redeploying their cash flow in accretive ways, including acquisitions and share repurchases. For example, Stanley Black & Decker completed the acquisition of Niscayah, a Swedish security services firm and R.R.Donnelley bought back $1 billion of outstanding stock. These actions have benefited results thus far, and we think also bode well for the future.
The Cardinal Capital Team
As of June 30, 2011, Cash America comprised 3.25% of the portfolio's assets, Silgan Holdings – 4.14%, KAR Auction Services – 2.74%, R.R. Donnelley & Sons -3.35 %, Equifax – 1.88%, Atlas Air Worldwide – 3.35%, IAC/Interactive – 3.31%, Google – 0.00%, Virgin Media – 1.82%, Six Flags Entertainment – 2.14%, InterDigital – 1.86%, and Stanley Black & Decker – 3.44%.
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.