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Jul 19 2012

2nd Quarter 2012 Commentary - ASTON/TAMRO Small Cap Fund

2nd Quarter 2012

The Sloth Recovery

After a strong first quarter that saw double-digit stock market returns and hope for a faster growing domestic economy, reality set in during the second quarter to remind investors what a slow, atypical recovery it has been since The Great Recession ended in June 2009. Perhaps the flip side to the recession should be called The Sloth Recovery.

We have been saying that Government will likely pull the correct levers to move us forward.  Unfortunately, what one hand giveth in the form of low interest-rates and liquidity from the Federal Reserve, the other hand taketh away with more regulations and the potential for higher taxes. That is the conundrum in the markets and the economy today. Still, the United States has historically been a clever, innovative, and entrepreneurial country that has always measured up to the challenge. The U.S. remains in the lead globally in terms of the state of its economy and with some of the best stock market returns for the third year in a row.

The Fund outperformed its Russell 2000 Index benchmark in an overall down market for small-cap stocks during the quarter. Outperformance relative to the benchmark was primarily attributed to a positive interaction effect—where we had overweight positions in outperforming sectors (Consumer Discretionary and Consumer Staples) and an underweight in a lagging sector (Technology). In addition, stock selection in Energy, Healthcare, and Materials benefited the portfolio, while picks in Technology, Industrials, and Financials detracted from performance.

Consumer Winners

Three consumer-oriented holdings—MDC Holdings, Grand Canyon Education, and United Natural Foods—were among the top individual performers during the period. Homebuilder MDC reported revenues and earnings that topped expectations along with an increase in orders and backlog, signs that housing trends are improving. Results confirmed our faith in the company’s ability to execute its plan to reduce operating costs and maintain a very liquid balance sheet as a way to improve profitability amid the depressed housing market. Online, for-profit education firm Grand Canyon reported higher student starts and lower levels of bad debt due to the implementation of an improved student selection process.

Operating margins jumped at natural and organic food distributor United Natural Foods, boosting its stock. The company benefited from earlier investments in its distribution network that had depressed profitability in the recent past, reaping the rewards with the initiation of a number of newer and larger relationships. We think this new business and investment will eventually lead to higher revenues and profitability going forward in a more rapidly growing area of the Consumer Staples space.

Among the main individual detractors from performance were Colfax, Vasco Data Security International, and Acme Packet. Fluid control manufacturer Colfax was negatively affected by the macroeconomic environment despite reporting solid growth in bookings and backlog. The firm has significant exposure to emerging and developed global infrastructure projects. Execution at security firm Vasco has been spotty and its results are strongly tied to Europe, leading us to exit the position during the quarter. Telecom equipment provider Acme’s guidance came in below expectations as telecom spending has dried up owing to caution regarding the global economic environment.

Portfolio Positioning

Changes to the portfolio during the second quarter reflected profit-taking in the Industrials and Technology sectors, with the redeployment of those proceeds into the Consumer Discretionary, Consumer Staples and Healthcare sectors. Lower earnings guidance from many companies with overseas operations was the fundamental catalyst, with valuation corroborating our decision to take profits. The changes that took place were a continuation of what we started at the beginning of the year.

At quarter end, Financials, Consumer Discretionary, and Healthcare were the three largest sectors in the Fund. We think Financials still provide opportunities to invest in leading companies at attractive valuations. As consumer spending continues to improve, we believe there are opportunities for operating margins to expand for many companies in the Consumer Discretionary sector. Now that the Supreme Court has ruled on the national healthcare legislation we think there is greater clarity of operating trends for companies in that sector.

During the quarter, four stocks reached full-position status either through purchase, appreciation or a combination of the two. Medical equipment firm DexCom makes glucose monitoring devices for that helps diabetics manage their disease. The company is the only pure-play manufacturer of these devices and presently has the most durable and accurate technology on the market. The stock has underperformed the broader market over the past year due to concerns of rising out-of-pocket costs for its customers, increased FDA requirements for its next generation device, continued investment in R&D and manufacturing, and fears over future competition.  We believe investor fears are overblown given the company’s product quality, market growth opportunity, tenured management, and competitive advantages associated with its partnerships that should allow for greater uptake of its products over time.

The Fresh Market is a grocery store concept focused on providing high-quality perishable products to consumers who place an equal value on quality, time, and price. The company has more than 100 stores and store growth is based on a flexible real-estate acquisition program focused on mostly suburban areas. Gross margin (a key measure for grocery stores) has expanded into the low-30% range allowing for above-average profitability relative to its grocery peers. We believe TFM has the necessary balance sheet strength to fund its store growth program. Although it is not the only organic natural food grocery store, we think the demand for such products is likely to support more than one national chain.

Finally, Zillow is the leading provider of online real estate services. The company was founded in 2004 by the same team that dis-intermediated the travel industry with online services.  Although real estate is very different from travel, the strategy is similar: target a large market (real estate) where intermediaries capture significant value (agent commissions are estimated at $45 billion annually), develop unique data and tools to create a network effect business, and accelerate scale to accelerate profitability. Amid a challenging real estate market we believe Zillow is executing this strategy very well. And with a recent acquisition, Zillow is also poised to benefit from a rapidly improving rental market. At some point, overall economic conditions in the U.S. should improve enough to return real estate to a growing business and Zillow will likely benefit as its services increase transaction volumes for real estate agents, mortgage brokers, and other service providers to the industry.

Three full positions were sold from the portfolio during the second quarter in addition to the above mentioned Vasco. Atwood Oceanics, Seachange International, and Terex were all sold because we identified other companies that we believe represented better relative investment opportunities.

Bringing It Back Home

Although the second quarter of 2012 reflected a shift favoring more defensive sectors in the stock market, the Consumer Discretionary, Financials, and Healthcare sectors have delivered the strongest returns year-to-date. Consumers are deleveraging after a large debt build up that took years to accumulate. While the unwinding could also take years, the domestic consumer seems to be waking up after a four-year slumber. Most companies focused on the consumer have downsized, restructured, or gone away, leaving the survivors stronger and with fewer competitors. 

The American consumer is at the forefront and will be the driving force in bringing the domestic economy back from the brink. The U.S. consumer comprises two-thirds to 70% of the domestic economy, higher than any other country globally. Just as the Emerging Markets and commodities were in the vanguard during the past 10 years, the emerging trend is bringing it all back home to America. The U.S. financial system has been cleaned up and recapitalized, while consumers have paid down debt and seem to be looking to buy houses again.

A large part of the improvement in the domestic economy will rest on the housing revival. It is not rapid—again, this is a slow recovery—but at least we seem to be moving forward. Thus, we remain optimistic about the trends taking place in the domestic economy and will use volatility in the markets to add to positions or establish new investments that corroborate our thesis and investment philosophy. 

TAMRO Capital Partners
Alexandria, Virginia

As of June 30, 2012, MDC Holdings comprised 2.38% of the portfolio's assets, Grand Canyon Education – 2.41%, United Natural Foods – 2.57%, Colfax – 2.51%, Acme Packet – 0.94%, DexCom – 1.68%, The Fresh Market – 2.08%, and Zillow – 1.39%.

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.


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