3rd Quarter 2011
The best thing we can say about the third quarter is that it is over. In our second quarter letter we warned that a downshifting in economic growth, the ongoing European sovereign debt crisis, the conclusion of the Federal Reserve’s second round of quantitative easing bond purchases (QE2) and uncertainty about the outcome of this summer’s political showdown regarding the U.S. debt ceiling could result in choppier markets in the period ahead. Unfortunately, we were right. The third quarter rout in stocks marked the worst quarterly performance by the broader US market (as measure by the S&P 500 Index) since the 2008-2009 bear market and the worst September quarter for mid-cap stocks (Russell Midcap Index) since the third quarter of 1990. Fortunately, our prediction that high-quality, mid-cap growth stocks would perform better in such an environment was also correct.
Consumer Picks Hang Tough
The Fund declined sharply during the third quarter in this harsh environment for stocks, but did manage to best its Russell Mid Cap Growth Index benchmark by a healthy margin. Relative returns benefitted from both sector allocation and stock selection, with stock selection in Consumer Discretionary, an underweight position in Materials, and stock selection in Energy the most positive influences. Off-price retailer TJX and auto parts/services provider O’Reilly Automotive were among the top contributors within Consumer Discretionary. Both businesses tend to do well during more challenging economic periods given their strong value proposition. The Materials and Energy sectors were among the worst performing areas of the benchmark, and the Fund’s holdings in each held up better than the broader sector—significantly so in Energy.
Stock selection in the Consumer Staples and Healthcare sectors also provided modest boosts.
Despite the broad downdraft in share prices, the Fund did have a few stocks produce positive absolute returns. Consumer Staples companies Church & Dwight and Mead Johnson Nutrition both posted gains as investors sought out businesses believed to be relatively immune to the weakening macroeconomic trends. Within Healthcare, Quality Systems was up strongly during the quarter. The company is seen as a beneficiary of growth both in electronic medical records as well as revenue cycle management products. Finally, the Fund’s moderately higher than normal cash position buffered returns somewhat.
Stock selection within the Financials and Technology sectors negatively affected relative performance the most. The hardest hit stocks were, not surprisingly, those companies that investors perceived to be most vulnerable to weak growth. Merger & Acquisition boutique Lazard fell sharply during the quarter, significantly underperforming the broader Financials sector. Underperforming tech stocks included F5 Networks, Polycom, FLIR Systems, and Sapient, all noticeably lagged the broader sector. We actually increased the Fund’s stake in F5 Networks given what we viewed as an attractive valuation and recent reports from sell-side firms that meetings with company management affirm strong near-term business trends and a promising new product cycle for 2012. Polycom had been one of the Fund’s top performing stocks over the last year, and thus was likely subject to some profit taking. Sapient was weak due to a lack of upside in second quarter results and third quarter guidance. We added to the position based on still strong earnings momentum and a compelling valuation.
Trading activity during the quarter was moderate. We added just one new position to the portfolio, re-establishing a position in network equipment producer Juniper Networks. We previously owned Juniper until January of this year when the stock reached 120% of our intrinsic value calculation, and sold it in accordance with our sell discipline that require us to take action to eliminate or reduce positions when they achieve such valuation levels. We like Juniper’s intermediate-term growth opportunities driven by a new product cycle beginning in 2012, and saw the significant share price correction as a chance to re-enter the position at a bigger discount.
Two positions were sold during the quarter—semiconductor manufacturer Microchip and infrared equipment maker FLIR. Microchip was eliminated after the company negatively preannounced for the June quarter. Although part of the miss was related to a significant drop-off in orders to auto manufacturers following parts hoarding in the immediate aftermath of the Japan earthquake that, in hindsight, appears to have resulted in a pull-forward of demand into March and April. The company also cited broad-based weakness across its entire customer base—which is one of the broadest in the industry, covering autos, industrial, aerospace, consumer and computing. Microchip guided cautiously for the September quarter and warned that it expects similar downward revisions from others in the industry over the next quarter or two. We exited FLIR because roughly 50% of its revenues come from the federal government, and the U.S. fiscal condition dictates a weaker outlook. In addition, the outlook for its commercial business, which has been strong, now has to be called into question due to the deteriorating economic environment.
We see a number of cross currents that could affect market performance the remainder of the year. First and foremost, investor, consumer and business confidence, and therefore the pace of global economic growth, remains highly dependent upon the path policy makers in Europe take in dealing with the continent’s debt situation. Here in the U.S., our policy makers also face difficult decisions as the deficit “Super-Committee” convenes in November to make additional headway on our budget deficits.
On the positive side, the Federal Reserve continues to reinforce the notion they stand ready to provide ample liquidity to jittery markets. The decline in share prices in recent months has resulted in more compelling valuations, while investor sentiment is similar to levels last seen when Bear Stearns failed in 2008. Liquidity, valuation and negative investor sentiment have historically served as important market backstops and/or pre-conditions for stock market rallies. Regardless of the near-term outcomes, however, we continue to believe that a major rotation toward higher-quality issues is underway. We think the companies that comprise the portfolio offer superior growth, a higher degree of earnings predictability, higher return potential, and healthier balance sheets than those of the broader mid-cap universe. We believe these characteristics make the portfolio better prepared for the more uncertain environment we expect to prevail in the months and quarters ahead.
M. Scott Thompson, CFA Andrew W. Jung, CFA
October 13, 2011
As of September 30, 2011, TJX Companies comprised 1.89% of the portfolio’s assets, O’Reilly Automotive – 2.76%, Church & Dwight – 2.45%, Mead Johnson Nutrition – 2.18%, Quality Systems – 2.59%, Lazard – 0.76%, F5 Networks – 1.82%, Polycom – 2.23%, FLIR Systems – 0.00%, Sapient – 1.66%, and Juniper Networks – 1.11%.
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.