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Jul 19 2012

2nd Quarter 2012 Commentary - ASTON/TAMRO Diversified Equity 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 underperformed its Russell 1000 Index benchmark during a down quarter for equity markets. Underperformance relative to the index came from both stock selection and sector allocation. Sector performance was negatively affected by the lack of exposure to the Telecommunications and Utilities sectors. Stock selection in the Consumer Discretionary, Financials, Industrials, and Technology sectors detracted from performance, while selection within Consumer Staples, Energy, and Materials sectors benefited the portfolio.

Battered Banks

Financial giants JPMorgan Chase and Goldman Sachs were among the worst individual performers during the quarter. The stock of JPMorgan corrected sharply after management disclosed significant trading losses originating from its London office that garnered major headlines. Goldman topped expectations when it announced its quarterly results, but the firm became caught up in the general sell-off of financial stocks, especially those like Goldman with proprietary trading arms, following the JPMorgan bombshell.

Other notable detractors from performance were CarMax and Tempur-Pedic International within Consumer Discretionary. Supply disruptions continue to plague CarMax, causing weaker sales comparisons and an earnings miss at the company. Competitive pressures led the management of Tempur-Pedic to pre-announce in June a decline in second quarter sales and lower full-year guidance, causing the stock to drop significantly. In addition, Industrials firm 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.

Although stock-picking within Consumer Discretionary was a detractor overall, holdings in Toll Brothers and were notable positive contributors to performance during the quarter. A recent purchase for the Fund, Toll Brothers announced quarterly revenues and earnings that topped expectations, further signs that the housing market may be making a comeback. Revenue and earnings beat expectations at Amazon, and gross margins were improved as well.

United Natural Foods in the Consumer Staples arena was another consumer related standout on the positive side. Operating margins jumped at the natural and organic food distributor, 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 this more rapidly growing consumer area.

Portfolio Positioning

Last quarter we took profits in the Technology, Industrials, and Energy sectors and redeployed the proceeds to the Healthcare, Consumer Discretionary, and Consumer Staples areas.  Lower earnings guidance from many companies with overseas operations was the fundamental catalyst, with weak valuation support corroborating our decision to take profits in those sectors. The changes during the second quarter were a continuation of what we started at the beginning of the year.

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

In addition to the above mentioned Toll Brothers, two stocks—Macy’s and GNC Holdings—became full positions during the quarter either through direct purchases, market appreciation, or a combination of the two. Following the acquisition of The May Department Stores in 2005, Macy’s suffered from a series of management missteps and integration setbacks resulting in drags on top-line performance, profitability, and return-on-invested-capital (ROIC) that were exacerbated by the economic downturn. Three years ago, management implemented a focused strategy geared toward reinvigorating operating performance that we think has resonated with consumers and is the reason that Macy’s is now taking retail market share.

We think specialty health retailer GNC’s vertically integrated operations allow it to respond more quickly to shifts in consumer demand, as the company’s revenue is disproportionately generated from the fastest growing segments of the nutritional supplement industry. Although the firm’s stock has performed well since last year’s IPO, we continue to see strong upside from strengthening growth in its underlying markets, margin expansion opportunities from a rapidly growing web business, international expansion, and its growing mix of sales from private label products.

Five full positions were sold from the portfolio during the quarter for a variety of reasons. The world’s largest McDonald’s franchisee, Arcos Dorados Holdings, has a significant competitive advantage in the Latin America region, but was sold because of an increasingly uncertain macroeconomic operating environment. Secular changes in the for-profit education industry reduced the potential opportunity we originally saw in DeVry. We sold Johnson Controls due to management’s inability to execute, and to fund better relative opportunities. Assets from Occidental Petroleum were redeployed to consumer-oriented companies in an effort to reduce the portfolio’s exposure to the Energy sector. Finally, Cisco Systems faces a difficult competitive environment. We sold the position to fund better relative opportunities within the Technology sector, as higher-quality companies were offering attractive valuation entry points.

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, JPMorgan Chase comprised 2.40% of the portfolio's assets, Goldman Sachs – 1.90%, CarMax – 1.76%, Tempur-Pedic International – 0.72%, Colfax – 1.90%, Toll Brothers – 2.30%, – 3.28%, United Natural Foods – 2.45%, Macy’s – 2.16%, and GNC Holdings – 2.14%.

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.


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