3rd Quarter 2012
Stocks posted decent gains overall during the third quarter despite a worsening trend in economic data. For the third summer in a row, the U.S. economy hit a soft patch. Concerns about a deepening European recession, a hard landing for the Chinese economy, and the rapidly approaching U.S. “fiscal cliff” —a huge package of tax increases and government spending cuts set to take effect next year—led businesses to reduce hiring and spending on new machines and equipment. This is evident in weaker employment data the past several months as well as falling durable goods orders and deteriorating manufacturing activity.
As a result, we estimate that growth in real gross domestic product (GDP) during the quarter just ended and the fourth quarter of 2012 will be sluggish, from 1.5% to 2.0%, after advancing just 1.7% during the first half of the year. Failure to properly deal with the fiscal cliff will increase the downside risk to our forecast and increase the chance of a downturn in economic activity during the first half of 2013. Stocks have shaken off this tepid growth, buoyed by central bank actions to supply additional liquidity to the markets in hopes of supporting risk assets and mitigating the impact of household and government deleveraging.
The broad market S&P 500 Index rallied 12% off its early June lows in anticipation of another round of quantitative easing (QE3), and the market was not disappointed when the Federal Reserve announced plans in mid-September to purchase $40 billion of mortgage-backed securities per month indefinitely. This followed announced plans by the European Central Bank to begin its own purchases of sovereign debt. The last hurdles for investors now seem to be clarity on how the fiscal cliff will be resolved and steps the Chinese government might take to support its flagging economy. How the fiscal cliff gets resolved will depend heavily on the outcome of the upcoming elections. As for China, investors must wait for the decennial government transition later this year before any new policies are put into place.
Cyclical stocks, such as those in the Energy and Materials sectors, and lesser quality “risk-on” securities aided by QE3 generally led the market during the third quarter. According to BofA/Merrill Lynch, stocks with a quality ranking of B or worse outperformed those ranked B+ or better by nearly two percentage points, continuing the trend of low-quality stocks outperforming high-quality names for the year-to-date through the end of September. This partly explains relative performance of the Fund for the quarter and the year since the portfolio tends to skew disproportionately towards what we consider higher quality names.
The Fund modestly underperformed its Russell Mid Cap Growth Index benchmark during the quarter owing equally to sector allocation and stock selection. Industrials, Materials, and Healthcare were the weakest areas for the portfolio. An overweight stake in Industrials plus mixed stock performance detracted from returns. Losses for J.B. Hunt Transport Services, Expeditors International of Washington, and Robert Half International offset strong gains by Roper Industries and Jacobs Engineering. J.B. Hunt reported disappointing revenues, but we believe that the shipping company’s intermodal (combined railway and truck shipping) business segment may be poised to reaccelerate due to rising fuel prices. Second-quarter results for Expeditors suffered from weak airfreight volumes and lower ocean yields. We trimmed the position in the portfolio. Within Materials, cleaning materials supplier Ecolab dropped after the company modestly reduced 2012 earnings guidance due to the strengthening of the US dollar, disappointing some investors.
Consumer Discretionary, Energy, and Consumer Staples were the best performing sectors for the Fund. Good stock selection offset an underweight allocation to Consumer Discretionary as Panera Bread and apparel designer/marketers Warnaco and PVH Corp (Calvin Klein, Arrow, IZOD) gained more than 20%. Cameron International and Oceaneering International boosted returns in the rebounding Energy sector, aided by the Fund’s overweight position. Despite the lackluster results among the rest of the Healthcare holdings, ResMed stood out as one of the portfolio’s big individual winners after reporting quarterly results that exceeded expectations for revenue and earnings.
Trading activity was more subdued than normal during the quarter. No positions were eliminated, and only two new positions were established—Starwood Hotels & Resorts and The Fresh Market. Starwood Hotels is a leading global hotel manager and franchiser that we think can benefit from improving pricing power from limited industry supply growth and balance sheet deleveraging, which should lead to greater cash returns for shareholders. The Fresh Market is a specialty retailer focused on selling high-quality food products with an emphasis on fresh premium perishables. The company is benefiting from the trend towards natural and organic foods and has significant unit growth potential.
Although the Federal Reserve’s monetary actions are supportive of share prices and may limit downside risk, the market may have gotten ahead of its fundamentals. It would not be surprising to us if the period ahead were more challenging. Global economic growth has weakened and corporate profit growth has slowed, while corporate profit expectations seem too high given slowing growth and profit margins near record levels. Add to that the looming uncertainty of the fiscal cliff and it is doubtful that investors have adequately discounted the weakening conditions at current market levels.
We continue to maintain what we consider a balanced portfolio of both cyclical and non-cyclical stocks to reflect the challenge of dueling market forces—weakening economic and corporate profit growth offset by additional central bank accommodation. Based on last summer’s experience with the showdown over the debt ceiling, our confidence that the fiscal cliff gets resolved gracefully is low. Regardless of the outcome, we remain convinced that the longer-term growth outlook remains subdued as household and government sector deleveraging will likely remain dominant themes for the future. In that environment, we continue to believe that high-quality growth stocks offer the greatest appeal. We view valuations for these types of businesses as attractive, while their earnings growth seems more assured due to their financial strength and geographic diversification.
M. Scott Thompson, CFA Andrew W. Jung, CFA
October 1, 2012
As of September 30, 2012, J.B. Hunt Transport Services comprised 1.11% of the portfolio’s assets, Expeditors International of Washington – 1.24%, Robert Half International – 2.32%, Roper Industries – 1.41%, Jacob Engineering – 1.23%, Ecolab – 2.60%, Panera Bread – 1.94%, Warnaco Group – 1.40%, PVH Corp – 1.87%, Cameron International – 2.50%, Oceaneering International – 2.65%, ResMed – 2.81%, Starwood Hotels & Resorts – 0.80%, and The Fresh Market – 1.38%.
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.