3rd Quarter 2011
After less than 1% real Gross Domestic Product (GDP) growth during the first half of 2011, the economy is not showing much improvement thus far in the second half of the year. The loss of economic momentum combined with only modest gains in employment and reduced consumer and business confidence are reasons for the disappointing improvement that we now forecast for the second half of 2011. Historically, recoveries following a financial crisis, such as we recently experienced, have usually been modest and bumpy. The developed world has too much debt, and it will require time, patience and sound fiscal policies to adequately reduce it in order to establish a solid foundation for future growth. In the meantime, as the private sector continues to deleverage and the public sector reduces its deficits and debt, the trend in real GDP growth is likely to be less than previously expected by economists.
The Federal Reserve achieved its desired result from the announcement of Operation Twist at its September meeting, with yields on longer-term Treasury bonds declining, while short-term Treasury notes increased slightly in yield. Current yield levels suggest investors expect the U.S. economy to enter a recession. Although we anticipate below trend growth for the next several years as debt levels are brought down at the consumer and government levels, we do not see the U.S. reentering recession. Therefore, we continue to be cautious with regard to the bond portfolio’s average duration and maintain a duration that is approximately 20% shorter than the benchmark indices.
With the anticipated second half rebound in U.S. economic activity falling short, equity investors began the process of reducing their growth outlook for both the second half of 2011 and 2012 and markets corrected accordingly. The market suffered a further blow from the festering European sovereign debt and banking crisis, plus political discord in the United States.
The Fund outperformed its composite benchmark (60% S&P 500 Index/40% Barclays US Government Credit Index) during the quarter, mostly on the back of equity performance over that of the S&P 500. The Fund benefitted from an overweight allocation to more defensive-oriented Consumer Staples stocks, as well as underweight stakes in struggling Financials, Industrials, and Materials. Materials was the worst performing sector in the S&P 500, while more cyclical Industrials names weakened with the disappointing economic news. The Fund also benefited from a meaningful cash reserve built up prior to the stock market correction. The elevated cash position was due to weak economic data, the limited availability of additional monetary and fiscal stimulus, and the fact that equity markets had rallied substantially since their March 2009 lows.
Within Consumer Staples, Colgate, Coca-Cola, Costco and Procter & Gamble all rose during a period despite the significant declines in the broader equity market. We increased the portfolio’s position in Colgate several times during the quarter as the stock traded at a compelling valuation and in the belief that its relative earnings momentum should start to improve. The company continues to manage well in a difficult environment and has boosted advertising spending back to more-normalized levels along with benefits from restructuring savings and acquisition synergies. Procter & Gamble was increased as market weakness provided an attractive valuation and our view that management may initiate a large, multi-year restructuring to help fund reinvestment and growth. These types of major restructuring programs have often been a catalyst for Consumer Staples stocks in the past.
Solid stock selection aided returns within the Consumer Discretionary sector, with McDonald’s and TJX also rising in absolute terms. Bed Bath & Beyond and Nike performed well on a relative basis, though both stocks declined modestly. McDonald’s climbed despite the company reporting disappointing same store sales comparisons for August. We trimmed back on the position thinking that its relatively high price/earnings was likely to weigh on the stock in the near-term, though it remained a top holding at quarter-end. We also reduced the position in Nike during the quarter as the stock reached an all-time high despite expected moderate first half fiscal 2012 earnings growth.
Stock selection in Healthcare positively added to relative performance as Allergan, Abbott Labs, and AmerisourceBergen all outpaced the broader Healthcare sector. Abbott generates 60% of its sales from international markets, half of which come from its increasing penetration of Emerging Markets. We think the stock is attractively valued with a hefty dividend yield, and expect the company to grow earnings in the low double-digits in 2011. AmerisourceBergen has visible earnings growth from its generic drug line and minimal regulatory and macroeconomic risk. The company’s sizeable cash position also increases its ability to return cash to shareholders through potential share buybacks and dividends.
The Fund’s equity holdings in Technology offered a mixed bag during the quarter. An underweight position in the sector detracted from relative returns, but stock selection benefited performance as Apple, Google and Visa outperformed the overall sector. Stock selection within Energy was the biggest detractor from relative performance. In particular, the portfolio did not own Exxon Mobil, one of the largest weightings in the S&P 500, which declined only 10% during the period versus the sector’s overall decline of more than 20%.
New Purchases—Monsanto and Visa
During the quarter, we established a position in Monsanto—a global provider of agricultural products and integrated solutions for farmers. We think the company stands to benefit from the increased use of genetically modified seeds, lean agricultural commodity inventories, robust demand, and the launch of a significant new product in 2012—Refuge in a Bag. We further boosted the portfolio’s position on weakness after a study by Iowa State University showed growing root worm resistance to Monsanto’s rootworm gene. The study focused on a very small sample set of fields where crop rotation and refuge compliance were sub-standard. The study has been ongoing for several years with no widespread reports of rootworm resistance reported. Monsanto is working on the next generation of its rootworm gene, with refuge and crop rotation important parts of yield improvement in preventing insect resistance to genetic traits. Monsanto is the Fund’s sole position in the Materials sector.
We also initiated a position in global payments technology company Visa. The Federal Reserve published their final rules with respect to debit fees, and the structure was more favorable than expected for the network processors. The rule should be implemented within the next few months. We think this should remove most of the regulatory uncertainty overhanging the stock.
Notable additions to current holdings during the quarter included Kraft Foods, Emerson Electric, and Stryker. We believe Kraft’s announced plan to divide the company into a global snacks business and North American grocery business will garner a higher valuation for the stock. We boosted the position in Emerson on market weakness that provided a more attractive valuation. The company continues to be optimistic about the outlook for Emerging Markets next year, which is expected to approach 40% of the firm’s sales. In addition, its Industrial Automation & Process Management division backlog orders are at or near record levels. Finally, we increased medical device-maker Stryker owing to an attractive valuation and our belief that management execution and a diversified business model will allow the firm to continue to deliver double-digit earnings growth in a more challenging profit environment.
The Fund eliminated five positions during the quarter—Walgreen’s, Apache, General Electric, Walt Disney, and Coach. We sold Walgreen’s due to management’s apparently entrenched negotiating position with pharmacy benefit manager Express Scripts. Although management is convinced it would be able to retain customers even if Express Scripts drops Walgreen’s from its plans, most observers believe Walgreen’s position will weaken over time as consumers may accept and become accustomed to a new pharmacy. Energy firm Apache was cut in favor of adding to Cameron International, which has exposure to both surface shale oil/gas and deep-water/offshore end markets that should garner investor attention in a recovery. Apache may also be hampered by the ongoing political transition in Egypt.
Despite General Electric’s attractive valuation, we sold the stock as it was not as defensive as we had expected. This likely reflected investor concerns about a new round of credit losses at its GE Capital financial division and/or the likelihood that decelerating economic growth may push out its recovery to the later-cycle industrial businesses. Consumer Discretionary holdings Disney and Coach were eliminated on the expectation of future headwinds—upcoming tough comparisons, slowing economic growth, deleveraging consumers, and heightened capital expenditures for Disney and likely reduced earnings growth from its focus on the high-end consumer for Coach.
The largest reductions to current positions from the previous quarter came from the Fund’s Energy holdings. Occidental Petroleum was trimmed as a source of funds. Oil prices had moved back up toward the higher end of our anticipated price range during the quarter, resulting in the potential for profit-taking in the sector—particularly after a weak June employment report. We further reduced the position, along with a holding in Schlumberger, in order to raise cash in anticipation of stock market weakness following lackluster economic reports.
Elsewhere, Oracle, Qualcomm, and Accenture were all trimmed within the Technology sector. We reduced the portfolio’s stake in Oracle and Qualcomm following a negative pre-announcement from leading microcontroller supplier Microchip. Given Microchip's broad industry, customer, and geographic diversity, its warning is noteworthy and may indicate widespread weakness in the technology sector. We subsequently added back to Qualcomm after its price significantly corrected, however, given that we continue to be optimistic about the company’s long-term earnings growth prospects. Accenture was reduced after the stock moved up nicely following the company’s strong third quarter earnings report and its addition to the S&P 500 Index. Index buying helped push the stock to new highs and the price approached our estimated present value.
U.S. Treasury bonds benefited from a flight-to-quality as headlines around the European debt crisis continue to spark fear among investors. We anticipate that volatility will continue in the bond market within a fairly narrow range. Yield levels are not compelling and thus a favorable resolution to the debt crisis would likely cause a reversal in bond market gains. On the other hand, increases in yield are likely to be limited due to continued weak economic growth. With respect to other sectors of the bond market, yields did not fall as much as Treasury bonds, resulting in attractive yields relative to Treasuries. We believe that high-quality corporate bonds will perform better than Treasuries as investors seek incremental yield in a low interest rate environment. Mortgage-backed securities should also perform better than Treasuries following the Fed’s announcement that it will reinvest mortgage maturities from its portfolio back into mortgage securities instead of into Treasuries as has been its practice over the last several months.
Over the next several months we expect a continuation of the challenging stock market environment as well as the ongoing rotation to higher-quality growth stocks such as those held in the Fund. In our opinion, the stock market correction during the third quarter was caused by investors realizing that the developed world had too much debt and that economic and profit growth would be slower than anticipated as these countries de-leverage. In addition, due to the bruising battle over raising the U.S. debt ceiling and subsequent decision by Standard and Poor’s to cut the United States’ AAA credit rating, it became evident that U.S. policymakers had limited stimulus options for dealing with a slower economic growth environment. Although relief rallies are likely to develop along the way, this more challenging and volatile stock market environment may persist into 2012 as investors further reduce their economic growth and valuation assumptions.
We believe the investment trends favoring higher-quality growth stocks that developed during the third quarter are likely to continue in the period ahead. The shares of these companies are attractively valued and their earnings growth rates are more assured due to their financial strength and global diversification. The Fund’s more defensive growth holdings, ones that offer attractive dividend yields and dividend growth prospects, are particularly attractive in this low bond-yield environment that is expected to last for a considerable time.
Montag & Caldwell Investment Counsel
As of September 30, 2011, Colgate-Palmolive comprised 1.81% of the portfolio's assets, Coca-Cola – 3.02%, Costco – 1.47%, Procter & Gamble – 2.65%, McDonald’s – 2.64%, TJX – 1.72%, Bed Bath & Beyond – 1.34%, Nike – 1.49%, Allergan – 2.51%, Abbott Laboratories – 2.69%, AmerisourceBergen – 0.95%, Apple – 2.63%, Google – 2.10%, Visa – 1.24%, Exxon Mobil – 0.00%, Monsanto – 0.99%, Kraft Foods – 2.53%, Emerson Electric – 1.13%, Cameron International – 0.96%, Stryker – 2.36%, Occidental Petroleum – 1.17%, Schlumberger – 1.03%, Oracle – 1.82%, Qualcomm – 2.31%, and Accenture – 1.79%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its dividends.
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.