3rd Quarter 2012
Sluggish Recovery Continues
The U.S. economy continued to record modest growth during the third quarter of 2012, with employment and housing strengthening. The Federal Reserve initiated a third round of quantitative easing by announcing that it would buy up to $40 billion in mortgage-backed securities per month until signs of a substantial recovery is underway in the U.S. Although the euro zone seems to be moving toward a more unified fiscal structure, each pronouncement by an individual country or officials in Brussels threatens to take that movement off its current path.
Against this backdrop, U.S. equities posted solid gains during the period, rebounding from their second quarter lows. The Fund’s S&P MidCap 400 Index benchmark rose more than 5%, slightly behind the broad-market large-cap oriented S&P 500 Index. The Fund outperformed both during the quarter and closed to roughly in-line with its benchmark for the year-to-date through the end of September.
New York Times Company was the top contributor to performance for the second consecutive quarter. Investors reacted positively to the appointment of a new CEO and the sale of About.com, an underperforming asset. Mark Thompson, formerly with the British Broadcasting Corporation (BBC), was named as the new President and Chief Executive Officer and will join the firm in November. In addition, it reported an 8% increase in circulation revenues for the second quarter and a double-digit rise in digital subscriptions. We think the company is on the right track in monetizing its valuable content by offering paid access to its news and other content, while enhancing its user experience with upgraded digital interfaces.
Other significant contributors to performance were Akamai Technologies, Gannett, and FMC Technologies. Akamai reported better-than-expected results and gave guidance for a strong second half of the year. As the leader in accelerating delivery of Internet content, we think the company is uniquely positioned to benefit from the demand for greater speed on the web. Media holding company Gannett reported increased digital subscribers and revenues, and continued to make progress in monetizing its content delivery through digital and print mediums. Second half results are likely to get a boost from advertising revenues related to the Summer Olympics and the fall elections. We modestly reduced the size of the portfolio’s positions in all three stocks after they had appreciated substantially.
On the negative side, transportation stocks were among the biggest detractors, while Hospira and Lexmark suffered from near-term setbacks. Southwest Airlines, Werner Enterprises, and Con-way were among the best performers during the second quarter but declined due in part to higher fuel costs. Hospira, the world’s largest producer of injectable drugs and infusion technologies, received new warning letters from the FDA concerning manufacturing issues. The company is addressing these problems and we expect profits to recover once these issues have been resolved.
Lexmark reported second quarter results below expectations. The company subsequently announced a significant share repurchase program and a major restructuring plan (including exiting the low-margin inkjet printer business). With its stock currently trading at book value with an attractive yield, we’re maintaining the position as the restructuring plays out.
Short-term Concerns, Long-term Opportunities
The portfolio is structured and managed to participate in the long-term growth of the companies in which we invest across a variety of market environments. Concerns about the current economic problems in the U.S. and abroad have provided us with the opportunity to initiate or add to positions with strong secular growth that are under pressure due to the weak economic environment. We look for companies that have the ability to weather the current storms and report strong results once conditions improve. Cost cutting, operational restructuring, and balance sheet strengthening are actions that company management teams can implement to improve long-term profitability. Due to the difficult times, the stock prices of many companies have fallen to levels that present long-term investors with great opportunities. We think that three new holdings added to the portfolio during the quarter — DeVry, Staples, and Lear—are examples of such opportunities.
College enrollments are down in the U.S. due to slow economic growth and prolonged high unemployment, negatively affecting for-profit education firms like DeVry. Management has taken steps to align costs with enrollment levels, and it continues to expand into international markets (Brazil) where enrollments are stronger and profit margins higher. The company has a strong balance sheet with no debt, and pays a modest dividend. The stock was trading near the low end of its historic valuation range at the time of purchase. We think the long-term prospects for the company are quite positive as DeVry is recognized for its strong brand and reputation, and stands to benefit from improved economic conditions.
Staples is the world’s largest office products company and second largest internet retailer behind Amazon.com. The company is profitable with a large revenue base, but a recent decline in earnings has prompted management to reorganize operations. Our analysis shows that the stock is trading at all-time low valuations. We think that the ongoing restructuring will lead to an increase in firm profits that will eventually benefit the stock.
Lear produces fully assembled seat systems tied to new car production. The stock was trading at depressed levels given the economic problems in Europe, including weak new car sales. Since emerging from bankruptcy roughly three years ago, Lear has rationalized operations and moved manufacturing to lower cost locations. We expect revenues and profits to improve in the coming years as worldwide demand for automobiles and light trucks increases.
The only position sold outright from the portfolio was home healthcare provider Lincare Holdings after it announced that it agreed to be acquired by German company Linde AG at a substantial premium. Lincare had been a holding in the portfolio for six years, highlighting the benefits of our long-term perspective on owning proven companies. Acquisition targets tend to involve companies perceived as solid businesses trading at attractive prices. Since 1999, the Fund has experienced takeover offers in 26 holdings, a substantial number for a relatively low-turnover portfolio that typically numbers only 40 to 45 holdings. The bursting of the credit bubble has put a damper on merger and acquisition activity in recent years, however. Only two of the takeovers in the Fund, including Lincare, have occurred since the credit crisis in 2008. We view the takeover of Lincare as a sign that the market may once again be recognizing that there are companies with strong, focused business models trading at sizeable discounts.
Economic growth in the U.S. continues to be sluggish, but some important sectors are showing signs of strength—employment and auto sales are increasing and the housing market is improving. The national elections in November may have some impact on tax policies, healthcare reforms, and government spending, however, and the looming “fiscal cliff” may result in government spending cuts beginning in January if Congress does not act before then.
We remain aware of macroeconomic uncertainties and are prepared to take advantage of significant moves in the market if they occur. We will add to holdings with competitive advantages, good management teams, and strong balance sheets when valuations are attractive. Similarly, we will sell stocks when they become fully valued. Overall, we view the portfolio as attractively valued on a price/earnings (P/E) and P/E to growth (PEG ratio) basis as of the end of September, more so than that of the Fund’s S&P 400 benchmark.
Thyra E. Zerhusen, Chief Investment Officer
Marie L. Lorden, Portfolio Manager
Mary L. Pierson, Portfolio Manager
As of September 30, 2012, New York Times Company comprised 3.80% of the portfolio’s assets, Akamai Technologies – 3.19%, Gannett – 3.78%, FMC Technologies – 2.40%, Hospira – 2.87%, Lexmark International – 2.82%, Southwest Airlines – 2.76%, Werner Enterprises – 2.42%, Con-way – 2.08%, Devry – 1.74%, Staples – 2.01%, and Lear – 1.55%.
Note: 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.