3rd Quarter 2011
Equities declined sharply during the third quarter on heightened fear of a global economic slowdown resulting from the ongoing European debt crisis and a gridlocked Washington’s inability to respond with meaningful domestic policy. The decline was broad based with most sectors losing more than 20% of their value, with the stocks of economically sensitive businesses being most affected as is typical with macroeconomic related corrections. The traditionally resilient and defensive-oriented Healthcare sector performed poorly during the quarter as the overhang of potential reductions in Medicare spending starting in 2013 muted investor interest. Within the Russell Midcap Index, value slightly outperformed growth primarily as a result of its higher weighting in the better performing utility stocks.
Corporate earnings remained strong and balance sheets healthy, but visibility diminished. The housing market remained moribund as regulators and mortgage servicers failed to agree on settlement terms leaving the foreclosure backlog overhanging the market. With the significant decline in stock prices, insiders and corporations have become aggressive buyers, reinforcing our view that equity valuations remain quite attractive. While merger & acquisition activity has slowed with the decline in business confidence, we expect activity to pick up when visibility improves.
Solid Stock Selection
The Fund fared better than its Russell Midcap Value Index benchmark during the third quarter. Relative performance was driven by stock selection across most economic sectors. Picks within Financials were the largest contributor due to holdings in Capital Source, Cash America International, and agency mortgage REIT Hatteras Financial. Silgan Holdings and World Fuel Services within Materials and Energy, respectively, also aided relative returns. Packaging manufacturer Silgan declined less than the sector due to its low exposure to falling commodity prices while fuel logistics company World Fuel outperformed as it tends to benefit from volatility in energy prices.
Elsewhere, holdings in the Consumer Discretionary sector performed relatively well led by IAC/InterActive and American Eagle. Wireless systems firm InterDigital announced that it was exploring strategic alternatives as a result of the high valuation paid for Nortel’s patents, driving its stock into positive territory during the quarter. The Fund's Healthcare investments also proved more resilient than those of the benchmark as a result of less regulatory and managed care exposure. The primary detractor from relative performance was the absence of Utilities in the portfolio, which was offset by the benefit of holding residual cash in a falling market.
We focus on finding companies with solid fundamentals at opportunistic valuations, and both highlights during the quarter come from the Financials arena. Bank holding company Capital Source is transitioning its business focus to commercial lending for small and midsized companies. During the past three years management has sold non-core assets and written down and liquidated legacy loans. As a result, company debt is down more than 80% in two years and unrestricted cash is near $1 billion. Going forward, we expect legacy loans to keep declining and excess capital to grow. The bank has a growing pool of new, higher-quality and higher-margin loans funded internally by low cost deposits. The bank also originates, underwrites, manages and retains all of its loans. In the next two years, we expect that the holding company and the bank will be consolidated, achieving cost savings and increased efficiencies. The excess capital at the parent holding company is planned to be used for share repurchases and dividends. With earnings and returns on capital rising as the bank puts excess liquidity to work and as its share count declines, we believe that Capital Source’s stock price should rise meaningfully above tangible book value where it currently trades.
Cash America International is the largest pawnshop chain in the U.S. With the 2006 acquisition of CashnetUSA.com, the company also became one of the largest providers of payday loans. Conceptually, pawn loans are an attractive business as growth in locations and price levels are limited by state law. Cash profit margins of mature pawn shops near 20% and loan balances have grown steadily in the past as the low-to-middle income segment of the population
has grown. About 40% of the collateral for pawn loans is gold with the balance broadly diversified by asset type. The payday lending business is more controversial, as consumer advocates have sought to eliminate the product offering, but it represents a faster growing third of the firm's corporate profits with similar margins to pawn. Last month, Cash America announced that it was selling a controlling interest in the payday lending business through a public offering. If successful, this would significantly reduce Cash America’s payday lending exposure and should cause investors to refocus on its attractive pawn business.
Our investment outlook for the remainder of 2011 is cautious as monetary policy remains accommodative but fiscal policy and credit conditions are now headwinds, while the economy is uneven and sluggish. Equity valuations are attractive but market sentiment is poor. Investors are wary of the political process and what that will mean for tax and regulatory policy. In coming months, investors will focus on employment and growth trends to assess whether the third quarter represented simply a slowdown or something more severe. The financial forecasts driving our valuations reflect this cautious outlook. The company management teams in the portfolio remain active in redeploying their cash flow in accretive ways including acquisitions and share repurchases. We think these actions will benefit 2011 results, and also bode well for the future.
The Cardinal Capital Team
As of September 30, 2011, Capital Source comprised 2.27% of the portfolio's assets, Cash America International – 2.42%, Hatteras Financial – 1.39%, Silgan Holdings – 4.49%, World Fuel Services – 1.56%, IAC/Interactive – 4.15%, American Eagle – 1.73%, and InterDigital – 2.25%.
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.