1st Quarter 2012
The first quarter of 2012 was generally a low-quality, “risk-on” quarter where smaller, riskier stocks led the charge amid a broad rally that saw most major indices post double-digit gains. As profiled by Steven DeSanctis of Bank of America/Merrill Lynch, within the Russell 2000 Value Index the largest market-cap quintile of stocks underperformed the smallest quintile by eight percentage points, companies in the highest quintile for return-on-equity (ROE—a measure of earnings quality) lagged the lowest quintile by six percentage points, and high-beta (volatility) stocks in the first quintile gained 17% versus only 5% for the lowest quintile. Moreover, stocks priced at less than $5 (typically considered lower quality) gained 23%, companies with no earnings 15%, and those with no dividend outperformed dividend-payers by four percentage points.
Aside from the defensive-oriented Utilities sector, all sectors within the Fund’s Russell 2000 Value Index benchmark were positive—with six posting double-digit gains. The rally was led by the Consumer Discretionary, Materials, and Healthcare sectors, while Utilities, Energy, and Consumer Staples lagged the overall index. All in all, it was not a good relative environment for the higher-quality names that comprise the bulk of the Fund’s portfolio, which lagged its benchmark by more than two percentage points. Some of these lower-quality trends did ebb in March, however, and the Fund gained considerable ground during the month against the index.
Lagging Consumer Picks
Sector allocation was modestly negative during the quarter, with an underweight position in Consumer Discretionary and an overweight stake in the poor performing Consumer Staples sector serving as the biggest drags. Stock selection detracted from performance within the consumer sectors as a number of the portfolio’s holdings were hit by higher costs and we have struggled to find palatable specialty-retail exposure within the Consumer Discretionary sector. Lancaster Colony, which we continue to think is a wonderful company, struggled with high commodity costs within Staples. Matthews International was the weakest holding in the Discretionary, as company earnings faced pressure from higher raw material costs. The portfolio also performed relatively poorly in solid performing Materials where an overweight position wasn’t enough to overcome lagging stock picks. Schnitzer Steel has put up disappointing results of late, with weaker than expected volumes and margins in its core recycling segment.
Stock selection in Technology and Financials was the primary positive contributor to relative returns during the quarter. Electronic payment software developer ACI Worldwide reported earnings above expectations and also completed its acquisition of competitor S1 during the quarter. Fuse manufacturer, and top-10 holding, Littelfuse notched impressive gains on continued solid results. Despite being underweight Financials in general, and strong performing REITs in particular, holdings led by insurance provider Protective Life’s helped the group to modestly outperform the benchmark sector as well as the overall Index.
During the quarter we initiated positions in five stocks, most notably MKS Instruments, Thermon Group, and Innophos Holdings. MKS is a company we have followed and admired for several years as a leading sub-systems supplier to the semiconductor and other advanced process industries (solar, LED, flat panel display, medical, environmental). At the time of purchase the company had a high return-on-invested-capital (ROIC) with sizeable net cash on its balance sheet. The company has been a consistent free cash flow generator, with positive free cash flow in 15 of the past 16 years.
Texas-based Thermon is a global provider of highly engineered thermal solutions, known as heat tracing, for process industries. The company’s products provide an external heat source to pipes, vessels, and instruments for the purposes of freeze protection, temperature maintenance, environmental monitoring, and surface snow and ice melting. The company generates solid free cash flow and appears attractively valued on expected earnings growth near 20% over the next few years. Innophos is a leading producer of specialty grade phosphates used in food, pharmaceutical, and industrial markets. The company has a clean balance sheet with low net debt. The business is relatively slow growth, but stable, with emerging market strength and has the potential for capital deployment through its strong cash flow and unlevered balance sheet. We think earnings can grow at around a 10% rate, with possibilities for more robust growth through acquisitions.
Four holdings were sold during the quarter, including Highwoods Properties, Standard Microsystems, Cantel Medical, and Brady. Highwoods was a small position that we decided to eliminate to focus on other REIT holdings. We sold Standard Micro and Cantel as they appeared to be fairly overvalued. We have been increasingly frustrated with the results at Brady over the past few years and decided to deploy the funds elsewhere where we had greater conviction.
Given the headwinds caused by the strength in the lower-quality segment of the small-cap market and the dramatic rebound of many of 2011’s poorer performers, we were generally pleased with the relative performance of the portfolio during the first quarter. In recent meetings with company management teams, we detect a greater sense of optimism over U.S. business trends. We continue to hear references to increased merger and acquisition activity in the small-cap pipeline, from which we think the Fund could benefit. Although concerns over slower economic growth in China, still tenuous sovereign debt issues in Europe, and a potentially nasty election circus in the U.S., we believe small-caps can build on the gains realized during the period. We are cognizant, however, that given the robust performance of the past six months we may be in for a digestive pause. Still, we see long-term potential given the reasonable valuation of the portfolio, solid free cash flow generation, and generally healthy balance sheets.
Silvercrest Asset Management Group
New York, NY
As of March 31, 2012, Lancaster Colony comprised 2.03% of the portfolio's assets, Matthews International – 1.66%, Schnitzer Steel – 1.51%, ACI Worldwide – 2.53%, LittleFuse – 2.64%, Protective Life’s – 2.85%, MKS Instruments – 1.81%, Thermon Group – 1.72%, and Innophos Holdings – 2.01%.
Note: Small-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.