1st Quarter 2012
Forget About Spring, It Feels Like Summer
Stocks sizzled in the first three months of 2012, delivering the best first quarter return since 1998 (as represented by the broad market S&P 500 Index). Forgive us if we suggest that perhaps we have seen this movie before—a strong first quarter in the markets followed by a sharp correction as fundamentals weaken. Is it different this time? We are optimistic the economic expansion will follow through. We see consumers slowly waking up from their four-year slumber. Looking at retail sales growth, consumer spending has improved, while U.S. unemployment has receded to 8.2% as of March 2012. Consumer sentiment data corroborates this trend with its highest reading since the recovery began in 2009. Furthermore, the Federal Reserve’s recent bank stress test reflects improved capital ratios and the ability of major financial institutions to withstand a severe downdraft in the economy. This places U.S. banks in the lead relative to their European counterparts. In addition, the Federal Reserve and most central banks globally are providing ample liquidity to help boost economic growth. Although volatility will likely remain a factor this year, corrections should provide us opportunities to add to portfolio positions. We believe signs point to the U.S. leading global economies toward expansion.
A rising tide lifted all boats during the quarter as all sectors in the portfolio delivered positive absolute returns as the Fund slightly trailed its Russell 1000 Index benchmark. Stock selection in Healthcare and Consumer Staples, as well as underweight positions in Utilities and Telecommunications aided relative returns the most.
Apple, Athenahealth, and JPMorgan Chase were the three biggest individual contributors to performance during the period. Strong demand for the iPhone4 led to revenue and earnings results above guidance, fueling a surge in the tech/consumer products giant. Healthcare practice management and billing IT firm Athenahealth rebounded from its December correction after reporting strong top- and bottom-line growth relative to its guidance. We continue to think the company’s highly ranked software-as-a-service model is well suited for the small physician space, and that it can continue to gain market traction. JPMorgan passed the Federal Reserve stress test and reported better than expected earnings results.
The biggest drag on relative performance was stock selection within Consumer Discretionary and Technology, as well as residual cash amid the strong rally. For-profit education company DeVry saw a decline in enrollment that led to a revenue and earnings miss within Consumer Discretionary. Weak carrier spending decreased visibility for the products of telecommunications software firm Acme Packet, contributing to its earnings miss. We eventually sold the position in favor of better relative opportunities. In addition, weak natural gas prices negatively affected operating results at energy firms Range Resources and Southwestern Energy, detracting from performance.
As we like to reiterate, the portfolio is 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 further additions to the Financials sector based on attractive valuations for leading companies and an increase in Consumer Discretionary after a long hiatus. As consumer spending continues to improve, we think there is an opportunity for significant margin expansion among Consumer Discretionary companies where many could reap the benefits of multi-year cost reduction efforts. Decreases in Industrials and Technology were based on profit taking in individual positions. The three largest sectors in the Fund as a percentage of assets at the end of March were Financials, Technology, and Healthcare.
Four stocks were purchased during the quarter and reached full-position status—Amazon.com, BMC Software, Goldman Sachs, and United Natural Foods. Amazon shares have recently underperformed the broader market on concerns about management’s ramp up in investments to support future growth. Although near-term profitability will likely be challenged, we believe these investments present a near-term margin and free cash flow trough that should allow for attractive improvement in operating fundamentals as the company’s top line growth leverages incremental overhead. We view Amazon as a best-in-class, disruptive innovator led by visionary management that will continue to take share from bricks and mortar retailers.
Software and IT services company BMC Software recently refocused its strategy to accelerate growth and profitability from its software licensing and maintenance business model. The success of cloud computing is spreading to enterprise IT environments where corporations demand “private clouds” in which services, applications, and data are managed in a more secure environment than typical off-site cloud environments. With its long history of superior mainframe-to-server service, we think BMC is uniquely qualified to deliver private cloud infrastructure to companies seeking such an edge. A sluggish global economy combined with choppy execution has caused the stock to lag consumer IT high-flyers. We believe the more favorable long-term trends as well as the company’s unique expertise will likely drive renewed revenue and earnings growth acceleration.
Although Goldman is being forced to adapt to a regulatory and market environment that will limit profitability, we believe the firm’s robust capital position and talent base will enable it to outperform its peers, take market share overseas, and drive earnings higher as the economy and capital markets continue to improve. Importantly, concerns about the firm’s long-term return potential appear to be priced into the stock. United Natural Foods is the largest distributor of natural and organic foods in the United States. The company’s profitability has been depressed due to the build-out of its distribution network and the initiation of a number of new, large relationships. We believe the recently won business and significant infrastructure investment can lead to higher revenues and profitability going forward. The natural and organic foods category is growing much more rapidly than the consumer staples space overall, leaving the company well positioned to produce superior financial performance over time.
Four full positions—Dell, Resarch In Motion, Riverbed Technology, and Texas Roadhouse—were sold from the portfolio during the quarter in addition to the previously mentioned Acme Packet. The primary reason for all the sales was the identification of better relative opportunities. In the case of Research In Motion, we also believed that the continuing decline in market share for the Blackberry would make any possible recovery an uphill battle.
Opportunities in Large-Caps
Many worry the market has come too far too fast, both year-to-date and from its March 2009 bottom. We would like to point out how little the market has actually returned over a much longer period of time, despite robust growth in corporate revenues and earnings. Consider that from January 1, 2000 through December 31, 2011, the total return of the S&P 500 Index has been less than 1%. In other words, after 12 years an investor in the index would have found themselves in essentially the same spot. We think the weak relative performance of U.S. equities during that period was largely due to overenthusiasm for the asset class in 2000. In late 2000, the S&P 500 was trading north of 24 times earnings, while offering a yield of only 1.2%. What is worth noting is the financial performance of the companies in the index during this time period and its effect on valuation. From 2000 through 2011, revenues grew 56.7% from $6.5 trillion to $10.1 trillion and earnings leapt 88.4% from $453 billion to $853 billion. In turn, valuations plummeted with the S&P 500 trading at 13.6 times earnings at year-end 2011 with a yield of 2.1%. As we enter the second quarter of 2012, we continue to view U.S. equities as an under-owned asset class offering both good value and robust financial performance.
TAMRO Capital Partners
As of March 31, 2012, Apple comprised 4.76% of the portfolio's assets, Athenahealth – 2.47%, JPMorgan Chase – 2.77%, DeVry – 1.32%, Acme Packet – 0.00%, Range Resources – 1.98 %, Southwestern Energy – 1.55%, Amazon.com – 2.86%, BMC Software – 1.51%, Goldman Sachs – 1.95%, and United Natural Foods – 2.05%.
Note: Small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.