Market Commentary as of 12/31/09
The fourth quarter saw a continuation of the stock market rally that began in early March, which has resulted in greater than 80% gains for small- and mid-cap stocks, as measured by the Russell 2000 and Russell Midcap indices. Signs that the economy has entered recovery mode have clearly heartened investors, thanks to the efforts of policy makers around the globe to flood the financial system with liquidity.
We continue to believe the recession ended around mid-year 2009. A sharp decline in the rate of business inventory liquidation and a rebound in industrial production, supported by unprecedented fiscal and monetary stimulus, continue to support the recovery. We believe that economic growth in 2010 will be modest, though likely less than expected following such a severe recession, given the ongoing deleveraging of the household and financial sectors of the economy. Sustained moderate growth should still be achievable with reduced inventory liquidation, steady personal consumption growth, and recoveries, though unspectacular, in both residential and capital spending.
Low Quality Trounces High Quality
As we highlighted in our previous quarterly letter, the smallest, cheapest, and lowest quality stocks led the way during the rally off the March 2009 lows. According to Bank of America/Merrill Lynch, stocks with a quality ranking of B or worse outperformed those stocks ranked B+ or better by more than 40 percentage points in 2009! With only a quarter of the holdings in the portfolio ranked B or lower (including those that are not ranked), that trend acted as a strong headwind against the Fund's performance. Over time, however, our experience has been that superior shareholder returns normally accrue to those companies that can sustain high returns on capital and above-average profit growth without substantial financial leverage.
With low quality trouncing high quality in 2009, we believe the stage is set for a major rotation to high-quality stocks in 2010, especially as investors start to anticipate the anticipated effort by policy makers to withdraw stimulus. This should herald the transition from phase one of the economic cycle, marked by recovery off the bottom, to a more enduring second phase, marked by sustained, albeit below trend-line, economic expansion. In the credit-constrained, low growth environment we foresee, the best performers are likely to be those companies with strong balance sheets, greater exposure to faster growing emerging markets, and increasing market share.
Technology Drag
The Fund lagged its Russell Mid Cap Growth Index benchmark during the fourth quarter and for the full year 2009. In addition to the aforementioned across the board low-quality headwind, the Technology sector proved to be the biggest drag on relative performance during the fourth quarter, while Energy delivered the biggest boost supported by rising commodity prices.
The worst performing individual holdings included Jacobs Engineering, St. Jude Medical, Lazard, Avon Products, and Kohl's. We reduced the size of the position in Avon in anticipation of a possible earnings hit from a currency devaluation and accounting change in Venezuela—a sizable market for the firm. St. Jude was also trimmed following a disappointing third quarter. With Jacobs, we viewed the share price weakness as an opportunity to increase the Fund's stake, anticipating improving order activity in 2010 from sustained strength in commodity prices and a rising flow of stimulus dollars. Individual stocks that provided the biggest lift to quarterly performance included Amphenol, Edwards LifeSciences, F5 Networks, Panera Bread, and Core Labs.
New positions initiated during the quarter included Donaldson, an industrial filtration supplier, and MSCI, a provider of equity indices and investment analytic tools. We eliminated the position in NetApp based on valuation, and sold the remaining Gamestop position on concerns about the health of the video game market. Lastly, the Fund sold C R Bard due to a disappointing 2010 outlook and a relatively full valuation.
Outlook
Last year provided some needed relief for investors after a dreadful 2008. Although we anticipate choppier action for stocks in 2010, we still expect positive returns for the year for a myriad of reasons. With a synchronized global economic recovery underway, we expect a combination of rebounding end-demand and aggressive corporate cost cutting to lead to a meaningful profit recovery over the next 12 months. With inflation low, central bankers should be slow to raise interest rates. Valuations, though less attractive than nine months ago, still appear reasonable and offer more room for upside. Within the portfolio, we continue to maintain a healthy balance of secular growers and more cyclical growth companies likely to prosper during an economic recovery. Most importantly, we believe the portfolio is well positioned to benefit from a rotation to high-quality growth stocks.
M. Scott Thompson, CFA
Andrew W. Jung, CFA
January 4, 2010
As of December 31, 2009, Jacobs Engineering comprised 1.84% of the portfolio's assets, St. Jude Medical – 1.05%, Lazard – 1.62%, Avon Products – 1.36%, Kohl's – 1.78%, Amphenol – 3.40%, Edwards LifeSciences – 0.98%, F5 Networks – 1.18%, Panera Bread – 1.58%, Core Laboratories – 2.16%, Donaldson – 1.54%, and MSCI – 1.56%.
Note: Small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by PFPC Distributors, Inc.