3rd Quarter 2011
You Can Lead a Horse to Water …
What a disappointing quarter for stock investors, particularly in small-caps. Whatever stimulus the Federal Government provides, the follow through of growth into the private economy has been ephemeral. The consumer, who represents at least two-thirds of the economy, is still de-leveraging—which will take years to unwind—despite a lot of liquidity in the financial system. Corporate balance sheets are bulging with cash and the 30-year US Treasury yield is less than 3%. The catalysts for growth are there—it's just that consumer and business confidence remains subdued. You can lead a horse to water …
So, what’s the problem? Is it the European sovereign debt issue? Is it the slowdown in growth in emerging economies? Economic growth globally and domestically has slowed. The latest Federal Reserve initiative to spur growth is Operation Twist, which follows its second round of quantitative easing that began in August 2010 and ended in June. That initiative jump started a rally in stocks and boosted consumer confidence. Will the new Operation Twist have the same impact? Operation Twist is a policy to sell short-dated fixed income securities and buy long-duration bonds. The intent is to lower long-term interest rates and also to steer more investable funds to other sources of long-duration assets like common stocks. Rising stock prices have lifted consumer and business sentiment and led to a stronger economy at times in the past.
Whether or not this is the correct lever for the Government to pull, the important point for long-term investors is that stocks are once again attractively priced. We could cite a lot of statistics to convey the facts, but one significant action to note is that legendary investor Warren Buffett, CEO of Berkshire Hathaway, believes its stock is undervalued and announced that it may begin to buy back some of its shares. This is only the second time in the firm's history that it has made such an announcement. The last time was March 2000.
At TAMRO our mantra has always been to buy the best when they’re depressed. When the entire market swoons, we look for companies that fit our Leader investment category and tend to sell undervalued, lower-confidence holdings and redeploy to equally undervalued, higher-conviction stocks. Our philosophy is to focus on companies that we believe have a sustainable competitive advantage and opportunistically buy them when the valuation is attractive—where we calculate an upside potential to be at least three times greater than the downside risk. In times of uncertainty we stay with what we know best.
Positive Health, Sagging Tech
During the third quarter, the Fund declined sharply with the rest of the equity market and roughly in-line with its Russell 2000 Index benchmark. Positive stock selection overall relative to the benchmark was largely offset by a negative allocation effect. Stock selection was quite strong in the Healthcare, Materials and Consumer Staples sectors, with the picks in the latter category actually able to eke out a positive gain during the period. Healthcare IT firms Athenahealth and Quality Systems both reported solid quarterly earnings results that exceeded expectations. In addition, Athenahealth benefitted from strong cross-selling opportunities as a result of a recent acquisition and Quality Systems' pipeline for new deals remains robust.
Another top individual contributor was Advisory Board, a research firm that provides best-practices analysis to client companies—most of which are in the Healthcare industry. Strong results across all measures and raised guidance drove the stock higher as the firm continues to benefit from upcoming reimbursement changes for hospitals and growth in its analytical tools business. Finally, mining stock Royal Gold within Materials appreciated as the price of gold continued to increase.
An underweight stake in the defensive Utilities sector and an overweight position in the battered Energy sector led to the negative allocation effect. Natural gas commodity prices declined 15% and crude oil 17%, creating uncertainty about energy demand going forward and negatively affecting holdings such as Comstock Resources and Precision Drilling.
In addition, stock selection within Technology, Financials, and Telecommunications detracted from relative performance. Tech stocks Vasco Data Security and NETGEAR were among the largest individual detractors from performance during the quarter, one on company concerns and the other from macroeconomic worries. Vasco suffered a black eye from a security breach at a recently acquired subsidiary while NETGEAR declined on fears an economic slowdown that might negatively affect consumer spending on technology. Another notable detractor was telecomm provider Cbeyond, which reported light net customer additions that prompted fears that small businesses were under more pressure.
Outlook and Positioning
We still believe the economy will avoid re-entering a period of recession. Although we are not top-down investors, we do not ignore the macroeconomic backdrop. The domestic consumer is still deleveraging, a process that has been ongoing for the past three years. As we stated last quarter, corporate balance sheets are flush with cash, interest-rates are at historic lows, domestic Gross Domestic Product (GDP) growth has been positive for four quarters and, outside of housing, there are no other major excesses that have built up in the economy.
At quarter end, the Fund’s largest sector weightings in absolute terms were in Industrials, Financials, and Technology. Relative outperformance also boosted the stake in Healthcare (which would be even greater if you consider Advisory Board as a Healthcare stock, which we do internally, instead of an Industrials name as it is officially classified). Efficient administration continues to be a dominant trend in Healthcare, with the need for cost containment as important as ever as demand for healthcare services continues to grow. In our opinion, that is a long-term trend that resonated with several stocks in the portfolio this quarter. Within Financials we believe that leading companies will consolidate and gain market share, while several companies in the Industrials sector continue to be beneficiaries of global growth as emerging economies invest in water and energy infrastructure.
High-capacity wireless network equipment-maker Ceragon Networks became a full position during the quarter. The company’s Wi-Fi backhaul solutions enable global wireless carriers to offload data traffic onto “secondary” Wi-Fi networks in their efforts to manage the mobile data explosion. Firm growth was pressured by India’s strategic security review of its telecomm network that slowed carrier capital expenditures. With the security review complete, firms have resumed spending on wireless infrastructures in what had been Ceragon’s most important region. The company’s financial strength enabled the acquisition of Nera, a complementary firm, which provides the strategic heft necessary to capitalize on the emerging mobility trend.
Three full positions were sold from the portfolio during the period—Blackboard, Lumber Liquidators, and NuVasive. Blackboard performed well since its purchase back in early 2009, and was sold as a source of funds as it traded near its takeover price of $45/share from an investor group led by affiliates of Providence Equity Partners. Lumber Liquidators reported earnings in line with reduced guidance, but inventories jumped sizably from the prior year causing us concern. NuVasive was sold due to a patent lawsuit filed against it by Medtronic. Although the company will appeal the loss verdict, we think it is a significant distraction for management.
TAMRO Capital Partners
As of September 30, 2011, Athenahealth comprised 3.35% of the portfolio's assets, Quality Systems – 2.24%, Advisory Board – 3.76%, Royal Gold – 0.99%, Comstock Resources – 1.78%, Precision Drilling – 1.48%, Vasco Data Security – 1.05%, NETGEAR – 1.94%, Cbeyond – 0.99%, and Ceragon Networks – 1.47%.
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.