3rd Quarter 2013 Commentary - ASTON/Cornerstone Large Cap Value Fund
3rd Quarter 2013
U.S. equities continued the strong performance run that began at the start of 2012, with the Fund’s Russell 1000 Value Index benchmark gaining 3.9% during the third quarter. Despite the stellar market returns, we think that equities continue to look attractive. Corporate balance sheets are in their best shape in the 25 years, earnings growth continued to easily outpace any returns one could achieve in the bond market, while dividends remain healthy and continue to grow. This is an environment where active management steps to the forefront, as not all boats will rise with the rising tide. We believe fundamentals will continue to determine value. Now more than ever is the time to focus on companies with strong and improving fundamentals that trade at attractive valuations.
Eight of 10 sectors within the index were in positive territory during the quarter, led by Materials, Industrials, and Consumer Discretionary. Telecommunications, Utilities, and Consumer Staples were the three weakest sectors. The Fund outperformed the benchmark during the period.
The Fund’s relative performance benefitted from an overweight position and stock selection in Industrials, a rebound by integrated energy company Hess, and an underweight stake and stock selection in Financials. In addition, for the third consecutive quarter, the absence of holdings in struggling Telecommunications and Utilities aided relative returns.
Industrial stocks Cummins, Emerson Electric, and Parker-Hannifin were three of the top performing holdings in the portfolio. Engine and power system provider Cummins’ performance came on the heels of it being one of the portfolio’s biggest detractors during the second quarter. The market shrugged off worries over high inventories in China and focused on the company’s overall growth prospects within Emerging Markets.
During Emerson’s quarterly earnings update call management called out positive order growth in July across most business divisions and stated that it’s European business had stabilized with the potential for modest growth next year. Given the overall drag of Europe recently, investors were encouraged with this news. Parker-Hannifin’s management also cited improving markets in Europe as well as a focus on an overall restructuring within its international segment targeted to improve both top-line revenue growth and overall profit margins.
Finally, Apple rebounded from disappointing returns during the first half of the year to become the top-performing holding within Technology and the second-best performer overall. The market rewarded the stock following the much-better-than-expected rollout of the newest iPhone releases (5s and 5c).
Stock selection within Consumer Discretionary and Healthcare was the primary detractor from returns, while the lack of exposure to the Materials sector acted as a drag on relative performance. Toy company Mattel was the biggest detractor to performance after the company reported disappointing earnings in July that were below street expectations. It cited weak revenues in the Barbie division and weaker margins across the company as the reasons for the shortfall. Historically, the second quarter is not a seasonally important period for toys, and we believe these concerns are short-term in nature.
French pharmaceutical company Sanofi also delivered a weak earnings report and lower guidance for the third quarter. Several of the company’s growth platforms did not produce expected results, with the market penalizing the stock accordingly. We had already begun trimming the portfolio’s position in Sanofi before the start of the quarter, and actually sold it completely during the period. It was a long-term outperformer, but was no longer a top-30 opportunity within our investment universe.
Elsewhere, Microsoft and Google detracted from returns in Technology. A top-performer during the second quarter, the market punished Microsoft following its announced acquisition of Nokia’s phone business. Longer-term, we believe that the market will reward Microsoft for its dominance within its Windows division. Google reported earnings in line with expectations, but the stock sold off as investors remain concerned about the competitive environment in search advertising.
EMC and Exxon
Aside from the normal additions and trims to current positions, we added two new names to the portfolio—EMC Corporation and Exxon Mobil—and exited two others (Hess and Sanofi). Enterprise storage leader EMC has a strong balance sheet and its cash flow generation is impressive. Its fundamentals have been improving since 2011, yet the performance of the stock has been flat. Given the underperformance the past two years, the stock was as attractively valued as ever according to our Fair Value Model. Oil giant Exxon Mobil had been weak due to a recent quarterly earnings shortfall, declining production volumes, and the company’s exposure to US natural gas. Given its unparalleled scale and 10% cash flow return, however, its valuation appeared attractive.
Hess had been one of the top-performing stocks in the portfolio during the first three quarters of the year. Investors rewarded the stock given recent events associated with an activist investor who is acting as an agent of change. The company’s Board of Directors was restructured, and the company announced the disposal of its downstream businesses and other non-core assets. In addition, the valuation on the stock had deteriorated based on our proprietary energy work causing us to exit the position.
Despite the market’s strong performance during the third quarter and throughout 2013, valuations remained attractive per both traditional measures and our proprietary valuation work. Our Fair Value Model now indicates that 55% of the stocks in the 800 stock universe are undervalued relative to our assessment of their fair value. Using normalized earnings, we now calculate the price of our universe at 82% of fair value. The current equity risk premium for the Model, the projected excess return for equities over a risk free rate, is now at 5.7%, versus an historical average of 3%.
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 by owning what we think are market-leading, cash flow-rich, and attractively-priced companies. We strive not to be swayed by the “noise” in the market, which appears to be changing quarter to quarter. In the meantime, while there may continue to be periods of strength and weakness, we will stick to the process that we believe is sensible and tested by time.
Cornerstone Investment Partners
As of September 30, 2013, Hess comprised 0.00% of the portfolio’s assets, Cummins – 3.13%, Emerson Electric –3.07%, Parker-Hannifin – 3.32%, Apple – 3.01%, Mattel – 3.55%, Sanofi – 0.00%, Google – 3.90%, Microsoft – 3.93%, EMC – 1.89%, and Exxon Mobil – 1.92%.
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.