2nd Quarter 2012
After consecutive double-digit quarterly increases that had investors collectively breathing a sigh of relief, equities took a step backward during the second quarter of 2012. In what may be described as déjà vu, many of the same issues that the market has dealt with the past couple of years came back into the headlines: gasoline prices crept up toward the psychologically important $4 level; liquidity injections from the European Central Bank gave way to ongoing structural concerns about sovereign solvency and the European monetary union; and U.S. economic activity showed signs of slowing as it became evident that an abnormally mild winter pulled forward demand. In addition, new concerns about slowing Emerging Market economies, peak corporate profitability, and the looming U.S. “fiscal cliff” have emerged. (The “fiscal cliff” refers to the simultaneous tax increases and spending cuts that will go into effect at the beginning of 2013 unless Congress acts to prevent them—something that we can no longer take for granted considering that the polarization in Congress is now at record levels.) As a result of these new and ongoing issues, we believe stock market volatility will remain high in the near term until investors get more clarity on both fiscal and monetary policy throughout the world.
The Fund underperformed its Russell Mid Cap Growth Index benchmark during the quarter. At its nadir, the benchmark was down 13% from its highs for the year before rebounding into quarter end. The portfolio outperformed during the market weakness, as we would expect considering its bias toward what we consider higher-quality companies. It underperformed, however, during the subsequent market rally. Worth noting is that according to Steven DeSanctis of Bank of America Merrill Lynch, both the most expensive stocks by price/earnings quintile and the companies with the lowest return-on-equity (ROE) outperformed during the period, shedding further light on relative underperformance owing to the portfolio’s sensitivity to valuation and quality.
The Fund’s underperformance came mainly from stock selection as strong performances by holdings in the Consumer Staples and Materials sectors were not enough to offset weakness in Technology, Healthcare and Consumer Discretionary. Ecolab, within Materials, actually rose during the quarter while the overall sector fell. Baking soda producer Church & Dwight lifted the Staples group with strong returns. That prompted us to trim back the Fund’s position as the stock approached our estimate of fair value and with the company facing more difficult earnings comparisons in the second half of 2012. Despite weakness elsewhere within Healthcare, Edwards Lifesciences was the portfolio’s top performing stock.
Technology was one of the weakest areas of the market during the quarter, and several of the Fund’s holdings declined more than the overall sector. Communications equipment provider Polycom reported preliminary first quarter results that fell significantly short of expectations. The weakness was due to disruption related to its North American sales reorganization and a slowdown in Asia Pacific revenue. Sapient also posted disappointing first quarter results as it experienced broadening sales weakness and gave disappointing guidance. Both stocks were sold after their announcements. Healthcare IT firm Quality Systems pre-announced slowing growth and weaker earnings just a day after providing an optimistic outlook at an investor conference, significantly damaging investor confidence in the management team. It too was sold from the portfolio.
Several of the Fund’s Consumer Discretionary holdings experienced significant declines as well, as economic data weakened and some companies missed revenue targets. We added to several of these laggards—Borg Warner, Panera Bread and Warnaco—as we think their longer-term fundamentals remain intact. O’Reilly Automotive was reduced, however, after the company pre-announced weaker than expected second quarter results. The mild winter pulled forward demand from the second quarter, resulting in a sharp deceleration in same store sales comparisons.
Buys and Sells
Trading activity during the quarter was slightly elevated from the first quarter as six holdings in the portfolio were eliminated and four new positions added. In addition to the three stocks mentioned above, we eliminated Harman International, Air Products, and TJX Companies. Harman International was sold after Apple announced at its Worldwide Developer Conference an agreement with eight auto makers to integrate its Siri voice control software into vehicles. Although we believe this announcement validates Harman’s vision about the electrification of automobiles, we became increasingly concerned that the level of competition was ratcheting up and that technological risk was becoming much more significant. Air Products experienced broadening sales weakness throughout the organization and TJX was eliminated as the stock appreciated beyond the maximum market-cap of the benchmark and no longer met our criteria for a mid-cap company.
The four new positions purchased during the quarter were Perrigo, IDEXX Laboratories, ResMed, and Ross Stores. Perrigo is a leading global supplier of over-the-counter and prescription pharmaceuticals, nutritional products, and consumer products that we believe will benefit from the current and ongoing patent expiration wave of branded drugs. IDEXX is a leader in diagnostics and information technology solutions for animal health as well as water and milk quality. The company has a history of robust growth and consistent execution in a fragmented market. ResMed develops medical equipment for diagnosing and treating sleep disordered breathing along with a variety of other respiratory conditions. We expect the company to benefit from the combination of expanded Medicare/Medicaid coverage beyond sleep laboratories to home diagnosis as well as growing awareness about sleep disorders among the large undiagnosed population. Finally, we initiated a position in Ross Stores, which is an off-price retailer and competitor to TJX. The company has significant store growth potential and should continue to benefit from consumers’ increased frugality following the severe 2008/2009 recession.
The U.S. economy continues to grow, albeit at what seems like a glacial pace. Inflation has subsided due to the recent decline in commodity prices and residential investment looks poised to add to growth for the first time since 2005. With more than 70% of the U.S. economy derived from consumer spending, both falling inflation and the apparent stabilization in housing represent two very important developments. On the other hand, it remains to be seen how businesses and consumers alike will deal with the uncertainty of government fiscal policy as well as how much of an impact a recession in the Eurozone and slowing growth in emerging economies will have domestically. It’s unlikely that the economy will grow in real terms any faster than 2%, as the private sector continues to deleverage and the public sector attacks its deficit problems. Still, we optimistically believe this continues to be a favorable economic backdrop for growth companies given the scarcity of growth throughout the world.
Despite another turbulent quarter, the view that the U.S. expansion is intact keeps us constructive on the outlook for equities in general and quality mid-cap growth stocks in particular. Even though we fully expect volatility to remain high for the near-term as politicians are forced by markets to make difficult decisions, the current combination of subdued inflation, low interest rates, and easing from global central banks should combine to help mitigate negative volatility. As noted previously, it is our contention that high-quality companies with a proven ability to generate strong profits across the full economic and profit cycle should become increasingly attractive to investors in the period ahead.
M. Scott Thompson, CFA Andrew W. Jung, CFA
July 5, 2012
As of June 30, 2012, Ecolab comprised 2.85% of the portfolio’s assets, Church & Dwight – 2.06%, Edwards Lifesciences – 1.79%, Borg Warner – 1.72%, Panera Bread – 1.65%, Warnaco Group – 1.20%, O’Reilly Automotive – 1.57%, Perrigo – 1.95%, IDEXX Laboratories – 1.68%, ResMed – 1.44%, and Ross Stores – 1.01%.
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.