1st Quarter 2012
It would be an understatement to say the market got off to a good start in 2012. Indeed, it was the strongest first quarter in more than a decade, with major market indices moving to new recovery highs. We think the origins of the rally can be traced back to several events that occurred during the final months of 2011. First, investor macroeconomic perceptions clearly shifted during the fourth quarter of last year into early 2012. Following the U.S. debt downgrade in August and ongoing saga of the EU sovereign debt crisis, fears of recession were pervasive late last year. As fall turned to winter, however, macroeconomic data pointed toward stability which, in turn, helped assuage investor anxieties about global economic growth. Second, and perhaps as important, the European Central Bank (ECB) and European policy makers tackled banking system liquidity fears with the introduction of their own version of quantitative easing, the Long Term Refinancing Operation (LTRO), in December. LTRO provided needed funding to banks across Europe that were facing increased borrowing costs and funding pressures as concerns continued to mount over the Continent’s debt crisis. Rising confidence and ample liquidity provided the elixir the market needed to produce a strong rally to start 2012.
Consistent with past liquidity-fueled rallies, higher-beta (volatility), low absolute share price, lower-quality stocks led the way. According to Bank of America/Merrill Lynch Quantitative Strategy research analyst Subramanian Savita, stocks ranked B or worse in their quality rankings handily outperformed those stocks ranked B+ or better by a margin of more than three percentage points during the quarter. Against that backdrop, the Fund fully participated in the rally without compromising its focus on quality.
Although quality was a headwind during the period, our experience has been that investing in high-quality stocks has served investors well over time. Companies that can sustain high returns and above-average earnings growth without substantial financial leverage are likely to eventually be rewarded by investors, especially when economic growth remains below trend.
The Fund lagged its Russell Mid Cap Growth Index benchmark by a little more than a percentage point in delivering absolute gains of more than 13% during the quarter. This modest underperformance relative to the benchmark was roughly split between sector allocation and stock selection. Stock selection within the Materials, Industrials and Healthcare sectors served as the main drag on relative performance, along with a roughly 5% stake in cash. Holdings in Jacobs Engineering, Donaldson, and Robert Half were the primary individual detractors within Industrials.
Varian Medical Systems and Edward Lifesciences lagged the strong gains of the broader Healthcare sector. We increased the portfolio’s stake in Varian as the stock pulled back towards the bottom of its historical range on lackluster fourth quarter results and investor concerns regarding the impact of austerity measures on hospital capital spending in Europe. Total orders were still up a solid 6%, and management reiterated its confidence in delivering solid double-digit earnings growth.
Energy was the biggest positive contributor to relative performance, resulting mostly from stock selection on the back of strong gains in Core Laboratories and Oceaneering. Performance also benefited from strong stock-picking in the Consumer Discretionary sector, which was one of the best performing areas of the market during the quarter. Chipotle Mexican Grill has been one of the Fund’s best performers the last several years. We sold the position during the period as our investment process dictates that once a stock reaches a 20% premium to our estimate of intrinsic value, we take action to meaningfully reduce or eliminate the position. Although fundamental trends at Chipotle are strong, the good news appeared to be fully priced into the stock, leaving the shares vulnerable to a meaningful correction should fundamental trends moderate even slightly. Tractor Supply and TJX Companies were other notable contributors within the sector that were reduced as they approached or exceeded our estimated fair value and traded at the upper end of their historical price/earnings ranges.
Trading activity during the quarter was moderate. We sold two other holdings in the portfolio in addition to the aforementioned Chipotle—investment banking boutique Lazard and publishing company John Wiley & Sons. Lazard reported disappointing fourth quarter results as economic and market uncertainty dampened the company’s merger and acquisition (M&A) and asset management businesses. At the same time, the company has struggled with compensation levels. The result has been a significant deterioration in relative earnings momentum. Earnings momentum similarly deteriorated at John Wiley, leading us to exit the entire position.
New positions in SM Energy and Warnaco Group were added to the portfolio during the quarter. For oil/gas exploration and production company SM we expect growth in coming years to be driven by two of the most attractive shale oil plays in the continental U.S., Eagle Ford and Bakken. Warnaco is an apparel design and manufacturing concern with key brands such as Calvin Klein, Speedo, and Chaps. The Calvin Klein brand should be a cornerstone of growth the next few years as the company expands its international distribution.
We continue to believe U.S. economic growth is sustainable but likely to remain sluggish for an extended period of time given the ongoing de-leveraging of household, financial, and public sector finances, along with increased regulation and potentially higher taxes in 2013. We also expect overall corporate profit growth to slow in 2012, as peak profit margins combine with below trend economic growth to cause a broad deceleration in earnings growth. We think high-quality companies with a proven ability to generate strong profits across the economic and profit cycle will be rewarded in the period ahead.
M. Scott Thompson, CFA Andrew W. Jung, CFA
April 5, 2012
As of March 31, 2012, Jacobs Engineering comprised 2.25% of the portfolio’s assets, Donaldson – 1.87%, Robert Half – 2.54%, Varian Medical Systems – 2.03%, Edwards Lifesciences – 1.48%, Core Laboratories – 2.23%, Oceaneering International – 2.08%, Tractor Supply – 1.11%, TJX Companies – 1.01%, SM Energy – 1.12%, and Warnaco Group – 1.00%.
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.