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. It seems that many of the same issues that the market has dealt with during 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 after an abnormally mild winter evidently pulled forward demand. In addition, new concerns about slowing Emerging Market economies, peak corporate profitability, and the looming U.S. “Fiscal Cliff” have emerged. (“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.) As a result of both new and ongoing issues, we believe stock market volatility will remain high in the near term until investors gain more clarity about both fiscal and monetary policy throughout the world.
The Fund declined roughly half a percentage point during the quarter, in-line with its composite 60% S&P 500 Index/40% Barclays US Government Credit Index benchmark. The equity portion of the portfolio outperformed the S&P 500, as our quality-growth bias aided performance amid the turbulent market environment. The fixed-income portion lagged as an overweight stake in Corporate bonds suffered as investors flocked to the safety of US Treasuries.
Solid Staples and Healthcare
Overweight positions in Consumer Staples and Healthcare, plus stock selection and an underweight stake in Technology—one of the worst performing sectors of the market—boosted relative performance among equities. Pharmaceutical company Allergan performed well leading us to trim the position as it approached our estimate of present value. Within Technology, Apple and Visa did well on a relative basis, and first quarter purchase eBay delivered solid returns after reporting excellent results that led us to increase the portfolio’s position.
Elsewhere, the Fund’s holdings in Industrials and Materials performed better than their respective sectors powered by General Electric and Monsanto. We continue to have a positive view of GE based on late-cycle acceleration in its industrial business, ongoing operating margin expansion, and the shrinking of GE Capital leading to the possibility of excess cash flowing upstream to the parent company to fund dividend increases and/or share repurchases. Monsanto rose during the quarter as the Materials sector fell and we continue to like the stock’s attractive valuation and the company’s strong earnings momentum.
Holdings in the Energy and Consumer Discretionary sectors were mixed, while the lack of holdings in Telecommunications, the best performing sector during the quarter, detracted modestly from relative returns. Energy was among the worst performing sectors of the market and while the Fund’s underweight position helped, this was offset by weakness in holdings such as Cameron International and Occidental Petroleum.
Within Consumer Discretionary, strong gains from TJX and Amazon were offset by the poor performance of Las Vegas Sands, McDonald’s, and Nike. Las Vegas Sands reported first quarter results that fell short of elevated expectations on the part of some investors. Although a slow start to company’s Cotai Central Macau resort is disappointing, we think the fundamental trajectory of the business remains solid. The company stands to benefit from market share gains in Macau and solid underlying growth in both the Macau and Singapore gaming markets.
We established three new positions in the Fund during the quarter—Juniper, Wells Fargo, and Starbuck’s. We expect networking company Juniper to deliver strong secular revenue and earnings growth driven by: (1) continued rapid data traffic growth fueled by cloud adoption, the mobile internet, and online video; (2) market share gains in routers from new and refreshed product cycles; and (3) a dramatic expansion of the company’s addressable market with the introduction of a broader portfolio of enterprise-class solutions. We also think the ramp up of four major new products should boost near-term momentum for 2012.
Wells Fargo became the sole holding in Financials during the quarter. The company is focused on sales and revenue growth, implements a consistent strategy, and should benefit from a robust mortgage pipeline. We think the bank has managed to grow without increased risk, and earnings have surpassed prior peak levels. We believe Starbuck’s is poised to resume growing units in the U.S., with the growth opportunity presented by its packed goods division with Via and K-Cups, and has the ability to use the free cash flow generated to increase its dividend or repurchase shares.
Two stocks, Cisco and Haliburton, were eliminated from the portfolio and a number of others trimmed amid the volatility during the quarter. Cisco was sold after the company lowered guidance for its fiscal fourth quarter. The CEO noted that while many customers have told him they are planning for increased second half spending, they have cautioned that it is dependent on what happens in Europe and government fiscal policy. Halliburton continued to experience margin pressure in North America caused by a shift from gas-directed drilling towards oil drilling.
We trimmed Procter & Gamble after the company reduced fiscal fourth quarter guidance. Recent market share performance and the apparent need to roll back pricing in selective categories underscore the point that the company hasn't hit its inflection point yet, with reported confirmation unlikely for another couple of quarters. The holding was further reduced after the company lowered guidance for the 2012 fiscal fourth quarter and for fiscal 2013. There was a notable change in management’s tone—talking about the lack of breakthrough, taking too much pricing in too few categories, not getting enough cost savings, and poor execution. Tangible improvements will take time to play out. Thus, a smaller position seemed prudent.
Other notable trims to current positions included Accenture, Bed Bath & Beyond, and McDonald’s. Accenture derives approximately 40% of its revenue from Europe, and we are increasingly concerned about Europe and enterprise IT demand broadly in the second half of 2012. A smaller position seemed warranted in Bed, Bath & Beyond after the stock performed relatively well despite recent weak economic data and the company’s status as the portfolio's least-value-oriented retailer with a largely-discretionary product mix. Finally, McDonald’s was trimmed after the company reported same store sales comparisons that missed estimates. We think ongoing global economic volatility, austerity measures in Europe, and increased general and administrative expenses are likely to significantly pressure second quarter results.
With the global economy slowing and the future of the eurozone uncertain, investors pushed the yield on the 10-Year US Treasury bond to a new low intra-quarter. Headline risks are likely to continue to drive yields, and we expect that interest rates will be range-bound at low levels during the third quarter. Economic growth is slowing and yield levels are already near historic lows. Thus, the potential for further decreases in yields are minimal. On the other hand, it is clear that there are few high-quality alternatives for investors seeking safety, with any increase in interest rates limited given ongoing uncertainty. Similarly, while the yield differential, or spread, between corporate and Treasury bonds may widen modestly if corporate profits disappoint as we expect, the extent of the widening is likely to be restrained as investors continue to seek incremental yield in a low interest-rate environment. Accordingly, we are maintaining a short duration position in the bond portfolio favoring high-quality intermediate corporate bonds.
Although the markets have been paying attention to European debt and U.S. unemployment for much of the past few years, they now have the added concern of a weaker global economic backdrop. We think the decline in U.S. stock market indices during the second quarter was primarily due to this weakening global economic outlook. We doubt that investors have fully discounted the global slowdown and expect the stock market to remain challenging until the economic and earnings outlook stabilizes. With global growth slowing and corporate profit margins at record levels, we believe investors will be disappointed to find that corporate profit expectations for both the intermediate and long-term periods are generally too high. Investors also still have to contend with significant political uncertainty until U.S. voters determine which candidates are most capable of addressing the large budget deficit, high national debt, and elevated unemployment in the U.S.
Ultimately, amid this slowing economic environment we think that investors are likely to rotate back to the higher quality growth stocks that led the market during the second half of 2011. The Fund held up better than the market during the second quarter because of its emphasis on high-quality growth. We believe that these types of stocks are better able to withstand the challenging market environment that we expect to continue in the months ahead, as their valuations remain attractive and their earnings growth is more assured. Due to their financial strength and global diversification, these companies appear to be positioned to provide sustained growth over the long-term and in some cases offer attractive dividend yields in an environment where both growth and income will be scarce.
Montag & Caldwell Investment Counsel
As of June 30, 2012, Allergan comprised 1.79% of the portfolio's assets, Apple – 2.69%, Visa – 1.93%, eBay – 1.36%, General Electric – 2.16%, Monsanto – 2.11%, Cameron International – 1.29%, Occidental Petroleum – 1.89%, TJX Companies – 1.16%, Amazon.com – 1.11%, Las Vegas Sands -0.89 %, McDonald’s – 1.49%, Nike – 0.71%, Juniper – 0.77%, Wells Fargo – 0.85%, Starbuck’s – 0.60%, Procter & Gamble – 0.90%, Accenture – 0.87%, and Bed, Bath & Beyond – 1.24%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its dividends.
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.