4th Quarter 2011 Commentary - ASTON/Herndon Large Cap Value
4th Quarter 2011
In 1986, legendary R&B singer Luther Vandross won a Grammy Award for the album The Night I Fell in Love in the category of Best R&B Vocal Performance for a Male singer. One of the memorable songs on that album was It’s Over Now. As the market finished 2011, I echoed that sentiment. After a thoroughly lackluster fourth quarter, the Fund ended the year essentially flat (-0.54%; N shares) on an absolute return basis in underperforming its Russell 1000 Value Index benchmark (+0.39%) by less than a percentage point.
The market clearly maintained a strongly defensive bias for much of the year. Utilities performed like a gem with a 19% return during the year as investors embraced not only the defensive characteristics but also the attractive yields in that area of the market. The Fund had little exposure to Utilities due to the lack of what we consider value creating opportunities due to valuation concerns despite their yields. We are not of the mind that a prudent investor would purchase any of the companies at the levels current valuations suggest. Industrials and Materials were the two other sectors that hurt performance the most owing to economic growth concerns on a global basis related primarily to the European crisis.
The three sectors with the highest contribution for the year were Consumer Discretionary, Financials, and Consumer Staples. Consumer Discretionary holdings were predominantly focused on discount retailers such as TJX Companies and Ross Stores. A large underweight position in struggling Financials aided returns overall, while Consumer Staples held up well due to the defensive orientation of the sector.
Overall stock selection was negative, with Lazard, Federated Investors, and HollyFrontier among the biggest detractors. Financial firm Lazard was penalized for its exposure to Europe, about a third of its business mix, in addition to general exposure to market-related areas. Asset manager Federated has struggled with the low interest-rate impact on money market funds, where the firm is a dominant provider. Energy company HollyFrontier has seen spreads collapse on refining margins with the narrowing of the price differential between Brent and West Texas Intermediate crude. With the exception of Lazard, all remain portfolio holdings as we perceive the issues perplexing the companies as being temporary in nature.
The three top individual stock contributors were TJX Companies, Kinetic Concepts, and Marathon Oil. Previously mentioned TJX benefited from being a discount branded retailer able to offer lower prices to cost-conscious consumers. Medical technology firm Kinetic Concepts rose on a buyout offer, causing us to sell the position as the all-cash deal offered little additional upside. Marathon Oil benefited from a rise in oil prices during the fourth quarter. We continue to view both TJX and Marathon as value creating opportunities, and each remains a portfolio holding.
"You Treated Me So Bad"
Luther Vandross’ It’s Over Now also resonated as the Fund ended a run of five consecutive quarters of benchmark-beating performance in the recently concluded fourth quarter of 2011. During the period, we identified with one of the key parts of the chorus which was “You treated me so bad.” Although the Fund delivered its highest quarterly absolute return for the year, it was clearly behind the benchmark in finishing with the worst relative quarterly performance since inception.
Eight out of 10 sectors in the portfolio underperformed their respective sectors in the Russell 1000 Value, and/or the benchmark overall. The two sectors in the Fund that outperformed were Materials and Consumer Discretionary. Performance for the benchmark was fairly broad, with five sectors—Energy, Industrials, Materials, Consumer Discretionary, and Technology—outperforming. All of these sectors are typically thought of as having a pro-cyclical growth tilt. Eight out of 10 sectors yielded a double-digit absolute return with only Utilities and Telecom, bastions for yield-hungry investors, not hitting that mark as the market rebounded strongly.
Sector allocation for the Fund was positive, but stock selection was decidedly negative. Interestingly, the portfolio had positive sector contributions in all but two sectors—Consumer Staples and Industrials. Thus, for this quarter, the portfolio was in the right places in terms of sectors but at the wrong time in terms of the individual stocks.
The poor or untimely stock selection endemic across the portfolio particularly affected results within Industrials, Financials, and Consumer Staples. The Fund’s holdings were not well correlated to the risk-off, risk-on type of environment that dominated the market, primarily after October. Europe took center stage as the market progressed approximately 1.5% overall from November through December, while the portfolio declined slightly more than 3%. In our view, nothing much changed except market perception.
The biggest individual detractors included Avon Products, Warner Chilcott, and the previously noted Federated Investors. Execution issues plagued Consumer Staples stock Avon and specialty pharmaceutical company Warner Chilcott. Although we view many of these issues as temporary, the period of rectification has been extended. Avon has responded with the removal of its CEO. We have responded with the removal of both stocks from the portfolio, though we will continue to monitor them to see if they are worth revisiting later.
The three top contributing sectors during the fourth quarter were Utilities, Materials, and Telecom. Both Utilities and Telecom were well positioned from a sector standpoint with underweight positions, while an overweight stake in outperforming Materials was the best performing sector for the period. Marathon Oil, TJX, and Exxon Mobil were the top individual contributors, and all three remain portfolio holdings.
As we reiterate as often as we can, we cannot predict the timing, duration or magnitude of outperformance. All we can do is try to position ourselves to achieve it. For three out of four quarters in 2011, we did just that. Although the streak of five consecutive quarters of outperformance has ended, we still believe that the portfolio is positioned to outperform over the long haul. Please note that nothing has changed with our process. One quarter of underperformance, regardless of the magnitude, does not justify undoing a process that we have employed professionally for more than a decade.
Stocks not previously mentioned that were eliminated due to sector adjustments and/or valuation or fundamental issues were Pepsico, Abbott Laboratories, Owens-Illinois, Joy Global, and 3M Corporation. These changes were primarily driven by the dynamic interrelationships of the sectors as we seek to position the portfolio to exploit value creating opportunities. As we like to share regarding our investment philosophy, “We have a core process but no core holdings.”
The relatively high number of stocks eliminated allowed for positions to be initiated in Express Scripts, Campbell Soup, Halliburton, and Eli Lilly among others. Each stock was purchased after first being identified as a value creating opportunity followed by our in-depth fundamental analysis of their potential as a portfolio holding.
The result of this and related activity during the quarter was that exposure to Energy, Healthcare, Materials, and Consumer Staples was increased. Exposure to Technology, Industrials, and Consumer Discretionary decreased, while all other sectors essentially remained the same given market appreciation or depreciation.
As a reminder, sector allocation decisions are made on the basis of the value creating opportunities that we find in the market rather than top-down, macroeconomic decisions. Due to this approach, the portfolio may look out of step with conventional thinking. Then again, we are not seeking conventional results. We expect our different approach to yield different, value-added results.
Returning to the theme of Luther Vandross’ Grammy Award-winning album, I'm reminded of another song, Wait for Love, which begins with the lyrics:
Knowing love the way I do
I can say for certain that it’s true
There’s a chance for me and you
I surely feel like the time is near
The picture in my mind is very clear
I think love has brought us here
Looking ahead, it is clear that a confluence of issues is coming to a head. The economy, though wildly debated, appears to be headed in an upwardly sloping direction. Funny thing how we often forget that the economy is cyclical, as we become bogged down in believing that it can only move the same way infinitely. The economy appears to have rebounded from its lows with data suggesting that the environment is getting better at an accelerating pace. Thus, despite the negative spin that gives contrary market pundits popularity, I know that it is true that there is a chance for me and you to see the upside of the economic cycle.
Europe, however, has become the issue of the day as all wait to see if the European Union will become the European Dis-Union. Europeans suggest no, but it has become convenient and expedient for commentators to suggest otherwise. Nothing keeps the eyeballs on television than a controversial counterargument.
The presidential election could be one of historic proportions. The economy could be peaking just in time for President Obama to begin his victory lap. Or, if it falters, the Republican Party will have final confirmation for repudiating his tenure and legacy.
What is the constant theme in all of this? Time. Within a matter of months we should have better information to remove the knowledge vacuum that has allowed for a vortex of volatility that makes short-term investment decisions look idiotic or brilliant.
As Luther Vandross poetically sang, “The picture in my mind is very clear”. At Herndon Capital Management, what is clear is that we will continue to look through the noise and short-term issues to seek out value creating opportunities. This last quarter was gut-wrenching from the slow bleeding nature of the underperformance that began in November and ended in December. After being almost even with the Russell 1000 Value in October, it was a painful experience to watch the portfolio lose 10 to 30 basis points daily in a way that we are not accustomed. We persevered because we continue to believe that purchasing companies at a discount to what the fundamentals bear is the only true way investing is supposed to be undertaken.
The picture clearly in my mind is that the Fund has a portfolio of attractively valued, solid fundamental companies in an economic environment that is improving with interest rates still at historic lows. The confluence of these variables could make 2012 a surprising market to the upside for investors. While love has not brought us here, consistency of process has. After the end of five consecutive quarters of outperformance, what did we learn from the turmoil in the fourth quarter? While we may pursue perfection in terms of outperformance, we will never achieve it. But, pursue it we will.
Randell A. Cain, CFA
Principal and Portfolio Manager
Herndon Capital Management
January 5, 2012
As of December 31, 2011, TJX Companies comprised 4.41% of the portfolio's assets, Ross Stores – 1.30%, Lazard – 0.00%, Federated Investors – 1.42%, HollyFrontier – 0.82%, Kinetic Concepts – 0.00%, Marathon Oil – 2.43%, Avon Products – 0.00%, Warner Chilcott – 0.00%, Exxon Mobil – 3.98%, Express Scripts – 2.23%, Campbell Soup – 2.11%, Halliburton – 1.90%, and Eli Lilly – 1.11%.
Note: Value investing involves buying the stocks of companies that are out of favor or are undervalued. This may adversely affect the Fund's value and return.
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 BNY Mellon Distributors Inc.