4th Quarter 2011
U.S. Stocks—Time For a Close Up
Uncertainty about growth in the global economy made 2011 a year of volatility in the stock market. All year, headlines questioned whether there would be a double-dip recession in the U.S. The fourth quarter saw the upside to that query as markets rallied globally. Small-cap stocks (Russell 2000 Index) led during that period, though large-cap stocks represented by the Fund’s Russell 1000 Index benchmark led for the year. The year-end strength came mostly during October, reflecting encouraging news on corporate earnings. This belied arguments for a double-dip. In addition, a pick-up in Gross Domestic Product growth and less hostile employment results corroborated views on a more constructive market outcome.
Last year we postulated that large-caps could be big in 2011 and that U.S. domestic stocks would be recognized and preferred by investors because of sentiment, valuation, and improving fundamentals. Well, the U.S. stock market (as defined by the large-cap oriented S&P 500 Index) was the best performing equity market for the year, and one of only two markets across the globe to post positive gains. This was the second year in a row where U.S. stocks in general provided superior returns on the global equity stage. It’s time for their close up! We think a trend seems to be developing that warrants further attention from investors.
Overall, though, it was a mixed year for investors. Large-cap stocks, particularly large-growth stocks, registered positive returns for the year, superseding small- and mid-caps among the respective Russell Indexes. But those returns were inconsequential from an absolute return perspective. Still, with an estimated 16% increase in corporate profits in 2011, (based on S&P 500 earnings) and a flat market, we continue to view valuations as compelling, particularly for large-caps. The factors that led us to be sanguine about large-caps heading into 2011 remain in place as we move into 2012. We think sentiment is positive as U.S. large-caps represent an under-owned asset class. Valuations and fundamentals both remain compelling according to our bottom-up analysis, with corporate balance sheets showing U.S. companies flush with cash that can provide necessary liquidity for flexibility.
It was a challenging year for the Fund, which lagged its benchmark substantially in posting a negative return. Poor stock selection in the Technology and Consumer Discretionary sectors was not offset by strength in other sectors. A deceleration in the economy created much of that weakness, but there were also company specific miscues. Specifically, product transitions are never easy and with Research In Motion the only thing in motion was its stock price on a downward path. We believed the company’s superiority in the enterprise space due to its secure network together with its overseas market share lead would provide a cushion. Unfortunately, competition from Google’s Android operating system and Apple’s iPhone and iPad caused the company to lose market share during the year. Yes, it is still part of the portfolio, as profitability and cash flow remain robust along with overall customer growth. A much delayed product transition should begin to take hold later this year and we think the transition should reawaken investor interest as the current valuation is discounting no improvement whatsoever in operating fundamentals. Stock selection in the Utilities and Financials sectors was also weak, but the Fund’s underweight position in Financials muted the impact.
On a positive note, stock selection in the Healthcare, Materials, and Industrials added to relative performance. Stock selection was strong in the Consumer Staples sector, but this benefit was largely offset by an underweight allocation to the sector.
Fourth Quarter Rally
The market rally that began in October led to strong absolute returns, with all sectors of the Russell 1000 and the Fund delivering positive returns. On a relative basis, the Fund was essentially flat in trailing the benchmark by roughly half a percentage point. Stock selection in the Consumer Discretionary, Consumer Staples, and Industrials sectors, as well as an overweight position to Industrials benefitted the portfolio.
Home Depot and Philip Morris International led the way in Consumer Discretionary and Staples, respectively. Home Depot reported solid quarterly results driven by continued strong sales comparisons, a dividend increase, and enhanced share repurchase activity. Favorable pricing and volume led to better than expected results for Philip Morris. Elsewhere, Google beat expectations and showed a reassuring focus on project expenses, boosting its stock. Energy firm EOG Resources was the top individual contributor to relative performance as earnings growth at the firm accelerated as crude oil and natural gas production rose more rapidly than anticipated.
The biggest drag on relative performance was an overweight stake and weak stock selection within Healthcare. Physician services firm Athenahealth issued 2012 guidance below expectations driven by reinvestment in the business. Healthcare IT firm Cerner fell on concerns about future booking trends and a shift toward lower margin businesses. Cerner had been a strong contributor to the portfolio since its initial purchase in 2008, with its forward-looking culture and significant investment in research and development that enabled it to remain at the forefront of automating (and in some cases transforming) healthcare operations for hospitals and other health care providers. We sold the portfolio’s position in November based on valuation.
The portfolio remains broadly diversified, with sector allocations resulting from opportunities we identify at the stock level through our bottom-up fundamental analysis and valuation work. The most notable shifts during the quarter were a decline in the Healthcare sector weighting due to sales/profit-taking based on valuation and an increase in Technology. The major trend that has resonated within Technology is the move by corporations toward cloud computing to increase flexibility and efficiency. Those companies that facilitate that shift came into our valuation target range and provided the incremental opportunities. Technology ended the year with the largest sector allocation in the portfolio, followed by Financials and Industrials.
Although the Financial sector was the worst performing sector in the market in 2011, we began increasing the Fund’s exposure during the third quarter having identified what we believe to be clear leaders with compelling valuations. Importantly, while European banks need to raise additional capital, U.S. banks met their requirements a few years ago, thus placing them in a more competitive position. The exposure to Industrials is based on high-quality global leaders where economic uncertainty has depressed valuation.
During the quarter, four stocks reached full-position status either through purchase, appreciation, or a combination of the two. Apple has a unique ability to anticipate users’ wants, meet those wants with simple, easy-to-use functionality, and leverage marketing to create a buzz and level of cache to command a premium price. Now dominant in the mobile landscape, the firm has global trends at its back and a head start against rivals looking to crack the space. We believe that the company’s large cash position should enable premium pricing and high levels of profitability.
Dialysis services provider DaVita provides care to approximately 131,000 kidney failure and end-stage renal disease patients nationwide through nearly 1,700 outpatient centers. In our view, the company possesses competitive advantages given the stability of its business model, predictability of demand for its services, scale within the industry, strong track record of providing quality care, and a payment model that provides the company relative protection from draconian reimbursement pressure. In addition, we see longer-term opportunities for DaVita to gain market share from smaller operators that lack the clinical expertise to effectively operate in a healthcare environment that emphasizes risk management as opposed to fee for service.
Four full positions, in addition to the previously mentioned Cerner, were sold from the portfolio during the fourth quarter. Amgen, Atwood Oceanics, and Corporate Executive Board were sold to fund purchases in other companies that we view as better relative investment opportunities. After a steep third quarter decline, we took advantage of a sharp rebound in mining equipment maker Joy Global to sell the position and use the proceeds to add to stocks with greater potential.
We believe that U.S. stocks can potentially provide investors good-to-average returns for the upcoming year. We think that large-caps should have an edge over small- and mid-cap stocks due to superior valuation and improving fundamentals. The domestic economy will likely register continued subpar economic growth, and global markets will likely remain subdued due to credit issues in Europe and softness in export markets—a key driver for emerging economies. As this is an election year, we believe there will continue to be volatility in the U.S. market. We hope to take advantage of any near term downward volatility to add to best-in-class companies at more compelling prices.
TAMRO Capital Partners
As of December 31, 2011, Research In Motion comprised 1.04% of the portfolio's assets, Google – 3.03%, Apple – 2.12%, Home Depot – 2.17%, Philip Morris International – 2.50%, EOG Resources – 3.20%, Athenahealth – 2.20%, Cerner – 0.00%, and DaVita – 2.33%.
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.