4th Quarter 2011
Stocks rebounded nicely off their early October lows as more encouraging economic data in the U.S. put to rest fears of a double-dip recession. European leaders also successfully bought themselves more time to deal with their systemic debt issues with a program allowing the European Central Bank to supply additional liquidity.
The fourth quarter capped a volatile year for stocks that saw a variety of exogenous events, including the tragic earthquake and tsunami in Japan, the Arab Spring revolts, the Washington debt ceiling stand-off and subsequent U.S. credit downgrade by S&P, an unfolding European sovereign debt crisis, and severe flooding in Thailand. In retrospect, it is quite remarkable that despite all these events that the broader stock market (as represented by the S&P 500 Index) eked out a small gain for the year. Through it all the U.S. economy continued to expand, albeit modestly, and corporate profits registered solid gains in helping to underpin stocks.
The heightened uncertainty these events created, however led investors to seek out safety and quality. Defensive groups such as Consumer Staples and Utilities typically did well, while more cyclical sectors such as Financials and Materials did not. Fundamental factors such as low beta (volatility), high return-on-equity (ROE), and high dividend yield also tended to lead to superior share gains. According to Bank of America/Merrill Lynch, stocks rate B+ or better outperformed those rated B or worse by more than 11 percentage points in 2011, after lagging significantly the prior two years.
Among the Russell indices, mid-cap stocks outperformed large-caps but lagged small-caps during the quarter. For the year, it was the reverse as mid-caps performed better than small-caps but not large-caps. In terms of style, the Fund’s Russell Midcap Growth Index benchmark slightly lagged its Russell Midcap Value Index counterpart for both the quarter and the year, not altogether surprising given the quality bias in the market. Fortunately, the portfolio was well positioned for the shift to quality this year, resulting in a year of strong outperformance for the Fund relative to the benchmark.
The portfolio delivered double-digit gains in besting the index during the quarter. For the year, the Fund managed to deliver positive returns while the benchmark lost ground. For both the quarter and full year, strong stock selection superseded sector allocation as the biggest contributor to performance versus the index. In particular, strong selection within Consumer Discretionary, Technology and Industrials led the way. Among the biggest individual contributors to relative performance were Industrial firms Robert Half International and Donaldson, Internet networking specialist F5 Networks in Technology, and Energy companies Oceaneering International and Core Labs.
An overweight stake further added to the outperformance within Industrials during the quarter with Jacobs Engineering and Joy Global contributing. Jacobs reported a solid September quarter that marked a further acceleration in bookings, revenue, and earnings growth, leading us to increase the portfolio’s position in the stock. We think Joy Global can continue to deliver above-average earnings growth, and increased the position amid periods of market weakness during the quarter when there were opportunities to add at an attractive valuation.
Underweight stakes in Energy and Materials—among the best performing areas of the index during the quarter— detracted from relative returns, while the performance of the Fund’s Healthcare holdings were mixed. Varian Medical Systems and Dentsply outpaced its sector peers, but Quality Systems, Waters, and St. Jude Medical lagged. Quality Systems corrected following strong year-to-date gains after the company indicated that market growth had transitioned primarily toward replacement activity versus organic growth. St. Jude announced that a promising new product, CardioMEMS, failed to win FDA Advisory Panel approval, diminishing future growth prospects. We sold the portfolio’s position following the news.
Notable individual detractors from performance included Newfield Exploration, Polycom, and Mead Johnson Nutrition. Oil and gas producer Newfield suffered, and was sold, after an earnings disappointment and significant downward revision to 2012 production forecasts undermined our original investment thesis. An earnings disappointment caused videoconferencing equipment maker Polycom to significantly underperform. We believe the setback to be transitory, presenting an opportunity for us to add to the position at more attractive prices.
Mead Johnson declined sharply late in the quarter as a bacteria scare involving the death of an infant in Missouri led Wal-Mart and other retailers to remove Mead Johnson’s Enfamil infant formula from store shelves while an investigation took place. We immediately trimmed the Fund’s position due to uncertainty regarding the source of the contamination and the length of the investigation. Fortunately, subsequent tests by both Mead Johnson and the FDA exonerated the company, meaning product sales could resume. We expect the financial impact of this incident will prove to be relatively minor and expect the shares to fully recover in time.
Positioning and Outlook
The Fund established one new position during the quarter in leading data warehousing vendor Teradata. We think the company is well positioned to capitalize on rapid growth in data collection and rising corporate adoption of business intelligence analytics.
Conversely, three positions were sold from the portfolio. In addition to Newfield Exploration and St. Jude Medical, asset manager Eaton Vance was eliminated. Eaton Vance reported an earnings disappointment that suggested to us that both cyclical and structural forces were at work against the company. We redeployed the proceeds from the sale into other financial firms such as Intercontinental Exchange and MSCI. We think Intercontinental stands to benefit from the migration of derivative/futures trading to exchanges, and MSCI continues to benefit from the trend towards passive investing and flows to ETF products.
Looking ahead, we expect the challenging and volatile stock market environment to continue until the middle of this year. Although recent data on U.S. employment and housing activity are encouraging, fears about the fallout from a potentially severe European recession, coupled with the possibility of hard landing in China, will likely keep investor risk aversion at elevated levels. By mid-year we are hopeful that investors will start to have a better sense of the likely outcomes of the fall elections and the implications for policy that will lead to necessary deficit and debt reduction, and ultimately, a pathway to healthy sustainable growth. In the meantime, we believe that we are in the early stages of a rotation towards higher-quality growth stocks such as those we seek for the portfolio. The valuations for these stocks remain attractive based on our work, and we think their earnings growth is more assured due to their financial strength, geographic diversification, and unique product cycles.
M. Scott Thompson, CFA Andrew W. Jung, CFA
January 3, 2012
As of December 31, 2011, Robert Half comprised 2.74% of the portfolio’s assets, Donaldson – 2.88%, F5 Networks – 2.42%, Oceaneering International – 2.04%, Core Laboratories – 2.23%, Jacobs Engineering – 2.37%, Joy Global – 1.63%, Varian Medical Systems – 1.73%, Dentsply – 2.22%, Quality Systems – 1.75%, Waters – 1.85%, Polycom – 2.22%, Mead Johnson Nutrition – 0.97%, Teradata – 1.36%, Intercontinental Exchange – 1.99, and MSCI – 1.99%.
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.