2nd Quarter 2011 Commentary
The U.S. economy continues to move ahead at a sustained but moderate pace. It is evident that even with unprecedented federal fiscal and monetary stimulus, real Gross Domestic Product (GDP) growth much above 3% has been difficult to achieve during this recovery. Unfortunately, second quarter real GDP may have increased only 1.5% due to weaker than expected consumer spending. In addition, while inflation remains generally well contained, higher energy and food prices have caused us to increase our inflation forecast for a second time this year. We now expect the Consumer Price Index (CPI) to increase 3%, versus our previous revised forecast of 2%, up from a 1% forecast at the beginning of the year.
Several factors cause us to think it is possible for economic growth to at least temporarily bounce back during the second half of this year. With a recovering Japanese economy, there should be fewer supply chain disruptions. Ongoing job and income growth, coupled with lower energy prices, should support some pickup in consumer spending, and business investment trends should be firm due to the high level of corporate profits and business tax incentives that are set to expire at year end.
This recovery continues to be frustratingly slow in view of the sharp decline in economic activity during the Great Recession, reinforcing the notion that recoveries following a financial crisis are usually modest and bumpy. The developed world simply has too much debt, and it will require time, patience, and sound fiscal policies to reduce it adequately so that a solid foundation can be established for future growth. In the meantime, as the private sector continues to deleverage and the public sector reduces its deficits and debt, trend-line real GDP growth could remain tepid.
Winners and Losers
Despite resurfaced apprehension about sovereign debt problems and continued underwhelming job growth in the U.S., bond and equity markets managed to end the quarter on a positive note. The Fund posted a marginal gain during the period, slightly trailing its composite benchmark (60% S&P 500 Index/40% Barclays US Government Credit Bond Index). The portfolio benefited from stock selection and an overweight allocation to the relatively strong Consumer Staples sector as Kraft Foods, Costco, and PepsiCo, in particular, gained more than the market. Strong performances from Nike, McDonalds, and TJX within Consumer Discretionary also aided returns. Allergan and Abbott Laboratories outperformed the overall Healthcare sector, positively affecting performance.
Technology was a mixed bag for the Fund as strong gains from Accenture and Qualcomm plus an underweight position that aided relative performance were offset by disappointing performances from Google and Broadcom. Although Google's long-term fundamentals remain attractive, we think the company's near-to-intermediate term issues warranted reduced exposure in the portfolio. Specific issues of concern include: 1) rising costs in a slowing revenue environment; 2) changes in the management structure; and 3) current antitrust investigations. The Fund sold Broadcom due to a lack of near-term catalysts and a reduction in our confidence in the company’s secular growth outlook.
Energy was the worst performing sector in the market during the period, and thus the Fund’s overweight position detracted from performance. This was mitigated somewhat by our decision early in the quarter to trim Halliburton, Occidental, Cameron International, and Schlumberger following strong absolute and relative performance over the previous six-to-eight months and our concerns that the spike in oil prices would increasingly lead to fears over demand destruction. We subsequently added back to Halliburton and Occidental, for the former on raised rig count expectations in North America related to the sustained strength in oil-related activity. We think Occidental should benefit from accelerated shale oil drilling in California and the Permian basin.
Stock selection within Industrials detracted from relative performance despite the Fund’s underweight allocation to the declining sector. One of the culprits was Fluor. Although fundamentals at the company remain sound and an energy backlog has been building, the spike in oil prices early in the quarter caused some investor anxiety regarding demand destruction. We see this development as limiting the stock's potential in the short run, warranting a reduced position.
Finally, the Fund’s sole position in the Financials sector, JP Morgan Chase, fell more than its peers during the quarter, detracting from relative and absolute returns. We reduced the position twice during the quarter as the stock has been dragged down by sector concerns (regulatory, revenue growth, etc) as well as general investor apathy towards banks and financials. Despite those results, the Fund’s underweight stake in Financials helped overall.
We established five new positions in the portfolio during the quarter. We think leading U.S. drugstore operator Walgreen stands to benefit from an aging population and a significant amount of branded drugs going off-patent over the next few years, as pharmacies make much higher gross profit dollars on generics relative to branded drugs. In addition, the company has what we believe to be superior freestanding real estate locations, and has refocused toward improving the existing store base through its Customer Centric Retailing initiative.
The Fund’s Healthcare stake increased as we added pharmaceutical and specialty care products distributor AmerisourceBergen, and pharmacy benefit manager Medco Health Solutions to the portfolio. Both companies are attractively priced according to our valuation work, and their earnings could potentially benefit from a significant number of generic drugs coming to market over the next several quarters.
In addition to the previously mentioned sale of Broadcom, the Fund trimmed several positions during the quarter. Disney was reduced significantly following an earnings report that missed expectations. Earnings for the company are likely to be uneven over the next couple of quarters related to some unusual items such as the Tokyo Disney shut-down and ESPN affiliate fee recognition, difficult advertising comparisons, and the uncertain economic environment.
Other trims in position size within the portfolio included Costco, UPS, and Apache. Costco traded at our estimated present value and was pared back as a source of funds for other ideas. We trimmed UPS based on concerns that the global economic slowdown is likely to result in softer than expected volume. Apache was reduced as fall elections in Egypt and renewed tensions in the Middle East (Syria, most recently) may hamper the stock in the very near term.
We believe the stock market could be challenging in the months ahead. The economy is showing less than expected growth, and earnings momentum is fading as annual comparisons become more difficult and cost containment and productivity benefits begin to subside. Earnings expectations for the second half of 2011 are probably too high given the downshift in economic growth that has developed during the first half of the year. It is unclear what impact the end of the Fed’s second quantitative easing program (QE2) on June 30 will have on the market, but many investors believe QE2 has boosted the price of commodities and more risky stocks. These assets could come under selling pressure and contribute to greater stock market volatility.
We also think the fixed-income market will be volatile within a narrow range over the coming months. Yields will be pressured higher by elevated commodity costs, continued economic growth and the end of QE2, which will deprive bonds of a strong source of demand that it has enjoyed over the last several months. This will be offset to some degree by continued deleveraging by consumers and governmental entities, which implies weaker economic growth and periodic bouts of flight-to-quality caused by adverse developments with the European debt crisis. Given the low absolute level of yields, we continue to maintain a short duration position in the portfolio. We favor high-quality, intermediate-maturity Corporate bonds as we believe that strong company fundamentals and the search for incremental yield should continue to benefit this sector of the bond market.
With QE2 ending and earnings momentum fading, we believe there will be a change in the nature of the market from one that is momentum driven and led by riskier cyclical stocks, to one that is supported by sustained but moderate economic growth and led by higher-quality cyclical and secular growth issues such as those held in the portfolio. We believe the shares of these companies are attractively valued and their earnings growth rates are more assured due to their financial strength and global diversification. We think that the Fund’s multinational holdings with strong global franchises are particularly well positioned for the sustained but moderate growth period ahead.
Montag & Caldwell Investment Counsel
As of June 30, 2011, Kraft comprised 1.95% of the portfolio's assets, Costco – 1.37%, PepsiCo – 2.74%, Nike – 1.84 %, McDonald’s – 2.80%, TJX – 1.54%, Allergan – 2.39%, Abbott Laboratories – 2.04%, Accenture – 2.31%, Qualcomm – 3.00%, Google – 2.18%, Halliburton – 1.86%, Occidental Petroleum – 2.24%, Cameron International – 0.81%, Schlumberger – 2.13%, Fluor – 1.82%, JPMorgan Chase – 1.17%, Walgreen – 1.48%, AmerisourceBergen – 0.64%, Medco Health Solutions – 0.91%,Walt Disney Co. – 1.31%, UPS – 2.14%, and Apache – 1.39%.
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.