1st Quarter 2013 Commentary - ASTON/Cornerstone Large Cap Value Fund
1st Quarter 2013
The first quarter of 2013 saw a continuation of the strong market returns witnessed throughout 2012. On the heels of a 17.5% return in 2012, the Fund’s Russell 1000 Value Index benchmark gained 12.3% during the quarter. Markets pushed to an all-time high as investors showed renewed faith in the global economic recovery following a painful four-year post financial crisis period. Despite continuing concerns over the problems within the eurozone (Cypress, Italy, Greece, etc.) investors drove the U.S. markets to heights not seen since 2007. Investors appeared convinced that Federal Reserve stimulus is helping and that the slow improvement in the U.S. economy will result in Chairman Bernanke continuing to pump money into the system for the foreseeable future. This provides a good economic backdrop for a continuation of low interest rates and improved growth prospects for companies.
All 10 sectors within the Russell 1000 Value finished in positive territory for the quarter. Technology, Consumer Staples, and Healthcare were the best performing sectors, with Materials, Telecommunications, and Energy the weakest areas. Although the Fund held up well versus the broader market (as represented by the S&P 500 Index), it trailed its benchmark by a few percentage points.
Stock selection within Technology, Industrials, and Consumer Staples detracted the most from performance relative to the benchmark, as did an underweight position in Consumer Staples. Apple and Oracle were the major laggards in the tech area, with Apple the top detractor for the second quarter running as it dropped more than 16%. Investors focused on softening demand for Apple’s core products, specifically it appears that end-demand for Apple’s 10” iPad and iPhone5 has lessened, reflecting a share loss to competitors in both the tablet and smartphone markets. Recent competitive threats also seemed to hit the shares of Oracle, as investor concern over the application software space surfaced.
Other significant underperformers included Royal Dutch Shell and Capital One. Royal Dutch was the second largest detractor to relative performance after management reported disappointing fourth quarter results and the stock was penalized accordingly. Results were 10% below consensus expectations as capital expenditures continued to weigh on near-term results and the outlook into 2013 was muted. Capital One also reported a disappointing fourth quarter and gave 2013 guidance that was less robust than Wall Street was expecting. The results were primarily due to lower-than-expected asset yields and higher charge-offs associated with its credit card division.
Solid Consumer and Energy Picks
Top contributing sectors for the portfolio during the quarter included Consumer Discretionary and Energy, while the lack of exposure to the lagging Materials and Telecommunications sectors also aided relative returns. Both Materials and Telecom traded down as investors tired of defensive stocks, a sign of improving investor sentiment.
Stock selection and an underweight position drove the outperformance within Energy. Global integrated energy firm Hess was the top performing stock in the portfolio as the company announced plans to sell its U.S. oil storage terminal network as well as its refining business. The market viewed this positively as the company intends to focus on its core strength, exploration and production, going forward. In addition, an activist investor has proposed a number of initiatives that should spur management to further streamline the company, which we think would be viewed favorably by the market.
Strong performances by Mattel and Hasbro boosted returns within Consumer Discretionary. Mattel announced positive fourth quarter results as management reported market share gains in both the U.S and Europe. U.S. retail inventory was down and generally in good shape across most brands. We think lower inventory levels should position the company positively as we progress further into the year.
Other top contributors in the portfolio included Morgan Stanley and Western Digital. Western Digital delivered impressive fourth quarter results and remained committed to returning cash to shareholders. Specifically, management reiterated its commitment to a significant payout of excess cash via dividend and share repurchases. Morgan Stanley followed a strong year in 2012 with a solid first quarter as profits rebounded across all business segments and management provided an optimistic outlook into 2013. Given the strong performance and less attractive discount to our calculated valuation, we sold the position from the Fund.
Despite the market’s recent strong performance, we think valuations remain compelling by both traditional measures and Cornerstone’s proprietary valuation work. Our Fair Value Model now indicates that 68% of the stocks in our 800 stock large-cap universe are undervalued. Using normalized earnings, we calculate the price of the universe at 70.6% of fair value.
Aside from normal additions and trims, we added four new names to the portfolio—Cummins, Emerson Electric, JPMorgan Chase, and Unum Group. Cummins is a Fortune 500 company that designs, manufactures, distributes and services diesel and natural gas engines, electric power generation systems, and engine related components. It has a strong management team, excellent balance sheet, and a diversified business mix across products and geographies. We think the company is viewed less-cyclically now given the growth in their power generation segment and its expansion within the engine components segment. The valuation was attractive based on our fair value calculation.
Emerson Electric is a standout engineering services firm with one of the most respected management teams in the Industrials sector. David Farr is only the third CEO in the 56-year history of the company. He has focused the company on Emerging Markets, which should lead to higher growth relative to its peers. Global macroeconomic concerns and the integration of two recent acquisitions have weighed on the stock, resulting in an attractive valuation. Coupled with strong fundamentals, a solid balance sheet, strong free cash flow and a healthy yield, the stock is a strong addition to the portfolio.
Fundamental improvement since the financial crisis and modest underperformance relative to its peers led to an attractive valuation at JPMorgan. Its recent underperformance was due in no small part to the so-called “London Whale” trading issue, which had a negative impact on both the company’s stock price and its otherwise exemplary reputation. Highly regarded CEO Jamie Dimon led the firm out of the financial crisis looking better than most peers, and financially the company has healthy looking capital reserves. In short, we see an excellent opportunity in an attractively valued, high-quality company with a strong strategic and financial position.
In addition to Morgan Stanley, Apache, Teva Pharmacueticals, and Merck were sold during the quarter to make room for the new holdings. Independent energy firm Apache showed modest fundamental deterioration, making it no longer one of our 30 best stocks. A 2010/2011 spending spree was probably well timed and entirely consistent with the core competency of the company, but it increased the firm’s debt position and affected cash flows. Although possibly manageable, it put pressure on organic growth, which has not been a core competency of the company in the past. This coupled with the ever-present geopolitical risk from the company’s significant production in Egypt, as well as compelling opportunities elsewhere, caused us to exit the position.
Teva was another stock sold owing to deteriorating fundamentals, as the company’s core competency in traditional generic drugs appears to be eroding due to increased competition and a lack of focus. The extent of future opportunities in biosimilar drugs is vague and difficult to predict. In addition, a new CEO has had difficulty articulating this strategy and a significant driver of current earnings, Copaxone, remains at risk from competing drugs and generic completion.
We significantly trimmed Merck toward the end of the quarter for valuation reasons after a solid run-up in the stock. Merck had outperformed the S&P 500 the last two years despite some meaningful setbacks and a notable decline in sales. Previously the stock had no embedded expectations for its pipeline drugs, but this seems to be no longer the case at its current valuation. Given the strong performance and less attractive valuation it is no longer among our 30 best ideas.
We continue to find considerable value in the market. We are enthusiastic about the portfolio’s positioning and our ability to improve the quality of the holdings while owning market leading, cash flow rich, and attractively priced companies in the process. We endeavor not to be swayed by the “noise” in the market, however, which appears to be changing quarter to quarter. While, there may continue to be periods of strength and weakness, we will not stray from our process which we think is time tested.
Cornerstone Investment Partners
As of March 31, 2013, Apple comprised 3.48% of the portfolio’s assets, Oracle – 3.36%, Royal Dutch Shell – 3.67%, Capital One Financial – 3.29%, Hess – 3.77%, Mattel –3.97%, Hasbro – 2.87%, Western Digital – 3.43%, Cummins – 1.47%, Emerson Electric – 2.42%, JPMorgan Chase – 2.33%, Unum Group – 2.17%, and Merck – 1.02%.
Note: Value investing often involves buying the stocks of companies that are currently out of favor that may decline further.
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.