When Will the Elephant Leave?
Six months ago we wrote about " the Elephant in the Room,” the coordinated actions by central banks to enforce low or negative real interest rates by purchasing enormous quantities of long-term government and mortgage debt. Well, the elephant is still around and keeps changing its mind about leaving. We know this process, generally known as Quantitative Easing, cannot continue indefinitely – a central bank cannot simply print money and buy government and mortgage debt forever – but until markets rebel, there is nothing to stop the process. In the meantime, it complicates how portfolio managers determine fair value for securities. Low interest rates make it easy for highly indebted companies to stay in business and even prosper. Estimating the value of a security by discounting a stream of cash flows becomes a challenge with an artificially controlled interest (discount) rate. This conundrum clearly vexes our portfolio managers and in the sections below each of them tries to make sense of what are for all of us truly unique circumstances.
Stuart D. Bilton, CFA
Chairman and Chief Executive Officer
Aston Asset Management
Montag & Caldwell
Our long term outlook for the market is favorable given that recession risk is low, sentiment is not euphoric, the market is not extremely overvalued, and the Federal Reserve is very accommodative. The short term outlook is less clear however, given that asset prices continue to move ahead of fundamentals due to the Fed's Quantitative Easing (QE) program. As a result, expectations for earnings remain high despite earnings estimates for the S&P 500 dropping this year from $120 to $110, and in our opinion, remaining unrealistically high for 2014. These high expectations have distorted valuations and when the Fed does decide to taper we may be left with inflated stock prices and unattainable earnings, particularly for the lower quality, smaller capitalization companies that have been favored in the current market. The market may then begin to anticipate a move from a manipulated market towards a free market, which could result in downside volatility, in which case high quality consistent growth stocks should hold up better. These companies could also catch up to the market given their relative attractiveness and more assured growth and income profile. Regardless of how it plays out, our portfolios are well positioned to take advantage of a rotation towards high quality large cap growth stocks.
Ronald E. Canakaris, CFA
Chairman and Chief Investment Officer
ASTON/Montag & Caldwell Growth Fund · ASTON/Montag & Caldwell Mid Cap Growth Fund
ASTON/Montag & Caldwell Balanced Fund
Cornerstone Investment Partners
While there continues to be macro induced volatility, the S&P 500 continues its positive advance from the market lows of March 2009. We believe that the U.S. remains an attractive place to invest. Even though the rate of economic growth is slow, industrial production, manufacturing and housing has improved, the jobless rate is trending down, interest rates are at historical lows, consumer prices are falling, energy independence is on the horizon and we are seeing improved economic data from China and Japan. While there are negatives, Cornerstone’s proprietary Fair Value Model, which gauges the attractiveness of stocks, suggests that U.S. stocks are attractive, as we find over half of our 800 stock universe of large cap stocks are trading at some level of discount to fair value. The average stock trades at 80-85% of our calculation of fair value. That said, the attractiveness of valuations is widely varied. We see a mix of highly over-valued stocks, while many remain significantly under-valued. It suggests a market where stock selection is critical and where you cannot hope to stumble upon valuation. Stocks must be carefully evaluated to determine whether they offer a prudent investment opportunity.
Rick van Nostrand, CFA
Senior Portfolio Manager
ASTON/Cornerstone Large Cap Value Fund
Herndon Capital Management
2013 is shaping up to be just as frantic in securities markets as 2012. However, in the second half of this year, enthusiasm is being tempered slightly by the increased probability of tapering by the Federal Reserve and the potential for higher interest rates. Notwithstanding this possibility, the market continued to surge ahead, overcoming geopolitical issues in the Middle East, weakness in emerging markets, and modestly positive economic news to achieve new highs. This run-up has compressed valuations in some sectors while inflating them in others. Herndon believes that there will be opportunities in 2014 and our focus continues to be on picking value creating opportunities, which are stocks trading at significant discounts to their fundamentals. We continue to maintain our pro-cyclical growth tilt by being overweight the Energy, Materials, Information Technology, Industrials and Consumer Discretionary sectors coupled with multi-national Consumer Staples.
Randell A. Cain, Jr., CFA
Principal and Portfolio Manager
ASTON/Herndon Large Cap Value Fund
TAMRO Capital Partners
Our perspective on the equity markets remains constructive. We believe that the tailwind of Federal Reserve policy of low interest rates and high liquidity should continue, while the headwind of higher levels of regulation, potential for tax increases and the implementation of the Affordable Care Act will keep the domestic economy from accelerating to a normal post-recession level.
Inflation is barely visible and while global economic growth could improve, it is likely to remain a slow expansion worldwide. We believe U.S. investors should benefit from a domestic focus to the equity markets. Small cap stocks provide attractive opportunities because fundamental innovation takes place in the small cap universe of companies.
Philip D. Tasho, CFA
CEO, Chief Investment Officer and Co-Founder
ASTON/TAMRO Small Cap Fund · ASTON/TAMRO Diversified Equity Fund
River Road Asset Management
Little has changed since we published our comments in March. Valuations across the equity landscape remain unattractive. This is especially true for high quality small and mid-cap stocks, which continue to trade at the high end of their historical range. Further, corporate profits appear to have reached a plateau and growth expectations for the remainder of 2013 continue to contract. The only exception is among certain segments of the high dividend equity universe, where the recent increase in interest rates led to a correction that has resulted in more attractive valuations. While M&A has been a powerful driver for our performance year-to-date, we have seen a slow down since July when valuations became especially unattractive. Further, deals are not being done at high multiples of earnings, which indicate that CEOs are taking a more conservative attitude toward valuations and future growth than investors. In March, we were concerned about a correction. Since that time stocks have moved higher, with only a couple of brief, shallow pauses. This can be credited almost entirely to the continuation of the Federal Reserve’s hyper-aggressive monetary policy. How long can this trend continue? It is difficult to say, as the Fed’s actions are historically unprecedented, the government bond market bubble is unwinding, and this equity rally has already become one of the longest on record without a 10% correction. However, we do feel confident in saying that this market cycle is closer to the end than the beginning and that investors should be particularly mindful of valuations, interest rate sensitive stocks, and other associated risks in their asset allocation models.
R. Andrew Beck
President, CEO and Senior Portfolio Manager
ASTON/River Road Dividend All Cap Value Fund · ASTON/River Road Dividend All Cap Value Fund II ASTON/River Road Small Cap Value · ASTON/River Road Select Value Fund · ASTON/River Road Long-Short Fund
The Fairpointe team remains positive on U.S. markets. Unemployment is improving, housing is on the upswing and capital spending is strong. Company balance sheets are in good shape, stock buy-backs are increasing and dividends are being raised. We are expecting a renewed trend by larger multi-national companies to look to the U.S. for growth and strategic acquisitions. The team is also encouraged by recent merger activity in mid cap companies. We are pleased to note that two of our holdings became take-over targets at significant premiums to their prices immediately preceding the acquisition announcements. In addition, manufacturing is moving back from Asia to both Mexico and the U.S. While equity valuations have moved up and no longer trade at depressed levels, the ASTON/Fairpointe Mid Cap Fund is attractively valued relative to the U.S. midcap benchmarks.
Thyra E. Zerhusen
CEO, Chief Investment Officer and Lead Portfolio Manager
ASTON/Fairpointe Mid Cap Fund
Lee Munder Capital Group (LMCG) – U.S. Growth Team
Despite macro and political concerns, performance in the past six months in the Small Cap Growth space has roughly doubled, up from +13% for the Russell 2000 Growth as of March 31, 2013 to up more than 30% YTD through late September. Valuation has expanded from roughly 17x NTM (Next Twelve Months) EPS to 20x P/E currently, compared to the seven year Median of 19.9x. That said, Small Cap companies as always remain sensitive to relatively small changes in their revenue and earnings potential. The recovery in Autos, Housing and Aerospace from recent years has continued to fuel gains in companies with exposure to those sectors. Energy stocks have rebounded as oil prices gained on positive, albeit choppy, economic growth combined with political concerns regarding supply. Going forward, we will continue to take gains in areas we feel are becoming more fully priced such as Energy. Areas with potential for unrecognized growth such as Healthcare and Technology continue to be fertile areas for new investment. With regard to the political headwinds, we do expect more noise in the fall and winter around the Budget and QE and that could increase some short term volatility. We would view this as an opportunity for increased longer term investment possibilities.
Andrew Morey, CFA
Partner and Portfolio Manager
ASTON/LMCG Small Cap Growth Fund
River Road Asset Management
The operating environment for the majority of the small cap businesses we follow has not changed meaningfully during the first nine months of 2013. Mixed operating results and anemic earnings growth has reinforced our belief that the current profit cycle has reached a plateau. Based on recent earnings reports and management commentary of the hundreds of businesses we analyze, we are expecting another quarter of flat to slow earnings growth in Q3 2013. Despite stagnant operating results and an uncertain profit environment, small cap prices have risen sharply over the past year. We believe the divergence between stock prices and profit trends is noteworthy and could indicate we may be approaching the later stages of this market and profit cycle. At current prices, we believe most small cap stocks are expensive and are not adequately compensating investors relative to risk assumed. As a result of our unwillingness to overpay, as of August 31, 2013, the Portfolio’s position in patience (cash) recently reached an all-time high. As the current profit cycle matures we anticipate opportunities will resurface. Meanwhile, we are committed to our investment discipline and will remain patient until prices improve.
Eric Cinnamond, CFA
Vice President and Portfolio Manager
ASTON/River Road Independent Value Fund
Silvercrest Asset Management
While the 24/7 media cycle frets over taper/no taper, the next Fed chair, a possible U.S. government shutdown, upcoming debt ceiling negotiations, higher interest rates, the latest Mid-East crisis and the China slowdown, the tone coming from most management teams presenting at recent investor conferences strikes us as fairly constructive with continued modest growth in the U.S., and signs of some stabilization in Europe. Valuations, while certainly higher than a year ago, do not strike us as excessive, particularly when matched against the general strength of corporate balance sheets and still solid cash generation. We are still finding interesting companies to examine at reasonable valuations. We remain hopeful of a more vibrant merger and acquisition cycle, particularly if global growth remains below par. With noise omnipresent, the risk of a “correction” is always there, but at this time we don’t see a new bear market looming.
Roger W. Vogel, CFA
Managing Director and Portfolio Manager
ASTON/Silvercrest Small Cap Fund
Are U.S. equities attractive? Yes and no. At the market level, valuations are no longer cheap, but they are not excessive, either. As earnings growth has diminished, the market has had to rely on multiple expansion to move higher, which is not the healthiest of dynamics, but steady (albeit slow) improvement in economic fundamentals could lead to a re-acceleration of profits. Within the market, there is a greater degree of dispersion between “winners” and “losers”, creating long and short opportunities. Volatility has diminished, but Washington’s dysfunctional approach to the budget and the debt limit is a source of uncertainty. Are non-US equities attractive? Again, yes and no. Japanese equities ran up on massive monetary stimulus, but the jury is still out on “Abenomics,” and the country’s debt load and demographic trends remain daunting. European stocks appear relatively attractive, but the Eurozone has done very little to address its structural problems. Emerging markets have been under pressure, but going forward there will be greater differentiation between individual markets. China’s economy is likely to avoid a “hard landing,” but excessive leverage and poor lending practices are very serious threats to the financial system. Is fixed income and credit attractive? Once again, yes and no. The coming “sea change” in Fed policy will continue to push longer Treasury yields higher, but “tapering” is not imminent and short-term interest rates will remain low for some time, not just in the US but in Europe and Japan. Corporate credit markets continue to be supported by the “search for yield,” but historically low spreads and default rates are unsustainable. In sum, investors face a “damned-if-you-do-damned-if-you-don’t” set of circumstances. Given the likelihood that 1) equity returns will not be able to sustain the pace that they have enjoyed this year, 2) fixed income is undergoing a secular reversal of fortunes, and 3) policy surprises will lead to spikes in volatility, we believe that a judicious allocation to alternative investment strategies can dampen volatility and enhance diversification.
Frederick C. Lake Ronald A. Lake
Co-Chairman, Treasurer and Co-Founder Co-Chairman, President and Co-Founder
ASTON/Lake Partners LASSO Alternatives Fund
By many measures the equity market is fully valued and many companies are signaling caution with regard to future growth, yet the equity market has remained strong. Certainly, several key economic indicators including retail sales, the PMI, inflation measures, the federal deficit, and initial unemployment claims are trending in a positive direction. The prospective that the glass is half full is prevailing over the glass is half empty and unless the economy goes into an unlikely tail spin or valuations get stretched meaningfully from the current levels, this trend should continue.
There are two adages in the investment business we try not to forget, “don’t fight the Fed” and “don’t fight the tape”. On that note, we at Anchor are finding investment opportunities that fit our valuation and fundamental parameters, so while we remain cautious about the environment it has not kept us from making new commitments. This combination of remaining cautious and focused on value is the way to manage risk in what is clearly an uncertain environment. Finally, we are a hedged portfolio because all of our positions have call options while maintaining the ability to also hold put positions on domestic equity indices. While this reduces our up capture it also significantly lowers the volatility and risk of the portfolio.
Ronald L. Altman
Senior Vice President and Senior Portfolio Manager
ASTON/Anchor Capital Enhanced Equity Fund
Baring Asset Management (Barings)
Equities remain our preferred asset class at Barings and we prefer cash as the best diversifying hedge against equities rather than commodities or bonds. We believe that near term growth prospects are better in developed markets than emerging markets. Monetary tightening by central banks of the developed world is probably some years off and therefore we will stay focused on cyclical growth drivers rather than value. We expect that the news flow from Europe will gradually improve over the next year, if the political status quo is confirmed by the German elections. We see huge potential in Japan, particularly if there is agricultural reform and an ending of excessive capital investment. By international standards, the U.K. is cheap and there should be some short-term momentum in equity markets ahead of next year's election. Of course, jitters remain, particularly Syria, oil, and the endless saga of southern Europe, but overall we remain reasonably constructive on the developed world's equity markets.
David Bertocchi, CFA
International and World Equity Manager
ASTON/Barings International Fund
Lee Munder Capital Group (LMCG) – International Team
Emerging markets have materially lagged U.S. and other developed market equities on a year-to-date basis. Concerns about slower economic growth combined with increased geo-political risks due to the civil war in Syria have created substantial uncertainty. Given this backdrop, the EM asset class continues to fluctuate between risk-on and risk-off compared to developed markets which have been more consistently biased toward risk-on. When we look at volatility for our stock selection and risk factors in emerging markets, we find it is nearly 40% higher currently than it was in the first quarter this year, making it a difficult environment for active stock selection.
Despite this challenging environment, we believe this performance divergence has created an opportunity for the emerging asset class. Emerging markets are now cheaper and offer better long-term growth prospects than developed markets. The average P/E for the MSCI EM Index is currently at 12x versus 16x for the Russell 1000 and 17x for MSCI EAFE. In addition, while the average long-term growth rates for EM have come down, they are still higher than developed markets. LMCG’s core quantitative approach will continue to seek exposure to the asset class, which we believe is attractive on a relative basis, by looking for stocks that have attractive valuations combined with strong earnings growth prospects and high quality earnings.
Gordon Johnson, PhD, CFA
Lead Portfolio Manager
ASTON/LMCG Emerging Markets Fund
Taplin, Canida & Habacht (TCH)
Contemplation of life with less Federal Reserve influence has driven the 2013 bond market. Taking its cue from more upbeat speeches delivered by the Fed Governors in May, the market built an expectation of when and how fast the Federal Reserve Board would begin to reduce its five-year stimulus program, and consequently, long-term interest rates rose materially. In an unexpected turnaround, however, in its September 18th statement, the FOMC removed some of its more hawkish language, once again emphasizing its focus on economic growth over inflationary concerns. Chairman Bernanke intimated in his comments that members wished to assess the impact of the recent rise in long-term interest rates on the economy and would continue monitoring economic data to determine its path for tapering the quantitative easing program. Markets interpreted the most recent announcement as a sharp shift in Fed policy, with both Treasury securities and risk assets broadly rallying on the news.
Despite the surprising outcome, our broad outlook for the economy and interest rates has not changed materially. We continue to believe the improvement in economic conditions will likely sustain a long-term bias toward higher interest rates; however, we also believe the recent statement reiterates that the Fed will remain supportive of systemic liquidity. We believe this environment will be supportive of spread sectors over the long term. Nonetheless, we recognize economic recovery and monetary policy and leadership transitions are prone to greater uncertainty, which may result in added volatility as we move towards long-term expectations.
Alan M. Habacht
ASTON/TCH Fixed Income Fund
Definitions: Earnings Per Share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability.
Price-Earnings (P/E) Ratio is a valuation ratio of a company’s current share price compared to its per-share earnings.
This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. The information contained herein was provided by Subadvisers utilized by Aston Asset Management, LP (“Aston”). The Subadvisers are not affiliates of Aston and their views do not necessarily reflect those of Aston. All views presented are current as of the date of this communication, but are subject to change.
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