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 underperformed its Russell 1000 Index benchmark. The underperformance relative to the benchmark was primarily due to stock selection in the Technology and Consumer Discretionary sectors. Tech firm Vasco Data Security suffered a black eye from a security breach at a recently acquired subsidiary. The setback at the previously untainted firm, and its depressed stock, eventually led us to sell the position to fund higher conviction names. Auto parts supplier Johnson Controls within Consumer Discretionary underperformed on margin weakness in its non-auto business segments as well as macroeconomic fears of a global recession.
Stock selection within Utilities and Financials, along with underweight positions in the more defensive Utilities and Consumer Staples sectors also hindered performance relative to the benchmark. Life-insurance giant MetLife continued to correct on concerns that a low absolute interest-rate environment would pressure the firm’s profitability.
Stock selection in Healthcare, Materials, and Energy were strong on a relative basis, with the portfolio’s Healthcare holdings actually posting a positive absolute return for the quarter. Healthcare IT firms Athenahealth and Cerner both reported solid quarterly earnings results and raised guidance. In addition, Athenahealth benefitted from strong cross-selling opportunities as a result of a recent acquisition and Cerner showed robust booking and order backlog growth.
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.
Mining stock Royal Gold was another top contributor within Materials as the price of gold continued to increase. Despite a drop in natural gas and oil commodity prices, shares of energy firm Range Resources rose on speculation regarding the company’s attractiveness as a potential acquisition target. Finally, though the overall sector allocation effect for the portfolio was negative during the period, it was more than offset by a positive interaction effect—where the portfolio was overweight outperforming sectors and underweight underperforming sectors.
Outlook and Positioning
Although our expectations call for a continuation of modest domestic economic growth, TAMRO’s investment process focuses on individual, bottom-up stock selection to identify companies that we believe are best able to execute given their specific competitive advantage. Our approach to portfolio management is opportunistic and broadly diversified, with sector weights determined by where we see opportunities at the stock level rather than macroeconomic calls.
At quarter end, the Fund’s largest sector weightings in absolute terms were in Healthcare, Financials, and Industrials, with Financials entering the top-three sectors mainly owing to purchases. We decisively added to Financials during the quarter as we identified more high-quality companies that represented attractive opportunities within the sector. We believe domestic economic growth is only sustainable with a strong financial sector and we think we have identified clear leaders that have executed throughout the financial crisis. We believe there are only a handful of “thrivers”—companies with a competitive advantage that differentiates them from their peers that are attractively priced due to current investor disinterest.
Relative outperformance pulled Healthcare into the top three, pushing Technology out of the top tier. 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. We have identified Healthcare IT companies that we think are major beneficiaries of this trend and have been able to hold the investments as business execution has continued.
Seven stocks became full positions within the portfolio during the quarter either through direct purchases, market appreciation, or a combination of the two. Notable among them were Berkshire Hathaway, Cisco Systems, and Raymond James Financial. Warren Buffett uses Berkshire’s enormous float, produced by its successful insurance operations, to opportunistically invest in attractively-priced assets. The summer 2011 market selloff drove the company’s share price to a multi-year low on a price-to-book basis. The attractive valuation, improved pricing in the insurance market, and the announced company share buyback program were all catalysts for the re-introduction of Berkshire into the portfolio.
Cisco’s aggressive acquisition campaign over the past decade led to the company overreaching and creating confusion with its customer base. The experienced management team is beginning to undertake the changes needed to refocus on customer needs, however, which we believe should reinvigorate revenue growth and stock performance. We find regional brokerage firm Raymond James attractive because of its management team and strong historical track record. The company gets a majority of its revenues and significant profits from its traditional brokerage/private client operations, but also has an important capital markets operation, asset management group, and bank. Although the firm will likely be affected by overall market conditions and concerns about the outlook for financial services firms in general, we expect management to continue successfully charting the company’s course.
Five full positions were sold during the quarter in addition to the previously mentioned Vasco, including Royal Gold, EMC, and United Technologies. As investors fled to the safety of gold and commodity prices rose, we gradually took profits in Royal Gold and used it as a source of funds for other opportunities. Long-term holdings United Technologies and EMC performed well for the portfolio since their purchase, but operating margins for United Technology are at historic highs and a pending acquisition raises near-term uncertainty about integration. EMC was sold to fund better relative opportunities within the Technology sector.
TAMRO Capital Partners
As of September 30, 2011, Vasco Data Security comprised 0.00% of the portfolio's assets, Johnson Controls – 1.97%, MetLife – 1.86%, Athenahealth – 3.40%, Cerner – 3.52%, Advisory Board – 3.21%, Royal Gold – 0.00%, Range Resources – 2.69%, Berkshire Hathaway – 1.84%, Cisco – 1.63%, and Raymond James Financial – 2.14%.
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.