3rd Quarter 2011
Unnerved Equity Markets
The Fund’s MSCI EAFE Index benchmark fell sharply during the third quarter of 2011, erasing the gains international equities has made during the first half of the year. Developments during the summer unnerved most equity markets. The main issue has been the weakening economic outlook in a number of regions.
Europe has been the main problem area. The issues that have arisen there this year have not only not been resolved they have escalated and expanded. For example, the Greek government funding crisis has led to a Greek banking crisis. It has also led to a crisis for the French banks that are among the largest lenders to the Greek government. Weakness in the French banking sector may need to be stemmed by the French government, undermining that country’s AAA credit-rating. This is a concern for the French as they can see from Italy’s situation how quickly borrowing costs can rise once the confidence of the bond market is lost. This dynamic is also very apparent to the Germans, who have remained reluctant to lend their national balance sheet to the aid of the Euro zone.
The result is a very messy impasse. A coordinated response is required, yet none of the key central Euro zone countries are motivated to act. With no action forthcoming, the Euro crisis agenda is slowly being overtaken by political rather than economic considerations.
We do not know how this will end. There are many possibilities, including a Euro zone fiscal transfer union (possibly a Euro zone political union), a Greek default and exit from the Euro zone, a German exit from the Euro zone, and many others. We think the one certainty that exists is that the Euro zone will look much different in the future however this situation is resolved.
No sectors or regions in the benchmark rose in absolute terms during the quarter. Japan was the best performing region in falling only 6% followed by the UK which fell 15%. Europe ex-UK was the poorest performer down 26%, while Emerging Markets fell by 22% in underperforming the index. Consumer Staples and Healthcare were the best performing sectors in limiting losses to single digits. Materials and Financials were the worst performing areas, with Materials falling by nearly 28% during the period.
Materials and the UK
The Fund solidly outperformed the index overall during the quarter, mostly due to stock selection. Positive asset allocation by region was mostly offset by slightly negative sector allocation. The strong stock selection was largely driven by picks in the UK region and the Materials sector.
In the UK, the main factor was the acquisition of software company Autonomy Group by Hewlett Packard. The purchase price was a very attractive 79% premium to the closing price prior to the bid. The bid has gone unconditional and we look forward to reinvesting the proceeds in the coming quarter. Outperformance within Materials came on the strength of precious metals miners. Gold mining stocks continued to benefit from the negative real interest rate environment, though they struggled towards the end of the quarter possibly due to the disappointment that the US Federal Reserve did not announce a more substantial round of monetary stimulus at their September meeting.
Other contributing factors to the Fund’s relative outperformance came from stock selection in the Europe ex-UK region and the Technology, Consumer Discretionary, and Financials sectors. Returns in the tech arena were boosted by the previously mentioned Autonomy acquisition, while the strong performance of Japanese online retailer Rakuten boosted results within Consumer Discretionary. The avoidance of sagging European commercial banks led to the outperformance in Financials.
Stock selection in the Pacific ex-Japan region and the Energy sector was weak, primarily due to the poor performance of Australian uranium miner Paladin Energy. In addition, an overweight position in the battered Materials sector and an underweight stake in the more defensive-oriented Consumer Staples area detracted from relative returns.
The Fund has benefitted from its underweight position in Europe, and especially to European commercial banks, as our Strategic Policy Group remains negative on the region and the Financial sector overall. That said, many high-quality growth stocks in Europe that are less directly affected by European events have shown attractive growth at what we consider to be reasonable prices. We have been selectively adding to these ideas when we find them. One example is German pharmaceutical company Bayer. Bayer manufactures and sells its products globally and has one of the strongest new product pipelines in the pharmaceutical industry, a strong balance sheet, and now trades at a forward price/earnings ratio of not much more than seven times earnings.
The decision to selectively buy Japanese equities earlier in the year benefitted the portfolio this quarter, and our only regret was that we did not own more. Although neutral on Japan from a top-down perspective, this has not been an impediment to finding good bottom up driven growth ideas and this is likely to continue.
Overall, there were few changes made to the Fund during the quarter, with only three notable sales from the portfolio. We took profits in Spanish healthcare company Grifols and Macau gaming company SJM Holdings. SJM did not appear to be overvalued, but we had increasing doubts about the sustainability of its extremely rapid rate of growth. In addition, the tightening of credit conditions in China was the catalyst for exiting this position. Heineken was sold following a disappointing set of results that highlighted growth problems in parts of its business, most notably its African business.
We used the proceeds of the Heineken sale to purchase brewer SABMiller. SABMiller has recently acquired Australian brewer Foster’s Group. We think the deal looks sensible and should benefit from the cost savings that we believe SABMiller will extract from the combined groups. Another new purchase was Randgold Resources, which follows our belief that gold miners continue to offer an attractive investment opportunity.
In the US, economic data over the summer has been weak leading a number of economists to predict that a relapse into recession is underway. More recent economic data out of the US has been moderately better than expected though still weak. The biggest surprise in recent weeks has been the market’s sudden concern about the Chinese economy. We have commented in the past about rising inflation in China and the efforts the People’s Bank of China (PBOC) has made to keep this under control.
The recent concern has centered on the shadow banking system. A good deal of recent loan growth in China has been outside of the banking system. This has been an outgrowth of the low deposit rates offered to savers. Savers, rather than putting money in the bank, have instead made their funds available to lend to companies—primarily small- and medium-sized enterprises and small property developers. Several recent failures of smaller companies who had borrowed via the shadow banking system has led to fears of a property market collapse and other knock on effects caused by declining credit availability. If the collapse of the Chinese shadow banking system leads to less credit availability in the economy, then our investment theme related to high-end consumer spending in China is at risk.
But the weakness in the global economy and the recent renewed weakness in global equities suggest to us that more monetary stimulus will be coming, and probably soon. Fiscal stimulus measures no longer look possible. The European debt crisis and this summer’s acrimonious debt ceiling debate in the US show this to be true. Gold mining stocks look attractively valued relative to the gold price and are likely to respond well to any further monetary stimulus.
The same can be said for equities in general and especially for growth stocks. We continue to look to find companies that can grow their earnings even in a weak economic growth environment. Recent equity market weakness is disappointing but it has left more growth stocks trading at reasonable prices than we have seen in a while.
Baring Asset Management
As of September 30, 2011, Autonomy Group comprised 2.09% of the portfolio's assets, Rakuten – 1.38%, Paladin Energy – 0.64%, Bayer AG – 1.98%, Grifols – 0.40%, SJM Holdings – 0.00%, Heineken – 0.19%, SABMiller – 1.53%, Foster’s Group – 1.43%, and Rangold Resources – 1.74%.
Note: Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility.
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.