1st Quarter 2014 Commentary - ASTON/Cornerstone Large Cap Value Fund
1st Quarter 2014
Following a rewarding 2013, the first quarter of 2014 was a turbulent one for equity investors. The Fund’s Russell 1000 Value Index benchmark declined 3.6% in January, followed by a 4.3% recovery in February and an additional 2.4% in March, ending the quarter up just over 3%. This marked the seventh straight quarter of gains for the index. Markets seemed fixated on macroeconomic events, severe winter storms, and changes at the Federal Reserve in January. From our view, the most attractively valued stocks performed the worst with investors favoring either high dividend-yielding domestic utilities or smaller, more expensive, growth companies. The environment appeared to change as earnings season progressed and Corporate America showed its resiliency. Higher quality companies with more consistent earnings and cheaper valuations began to perform better.
Seven of the 10 sectors within the benchmark finished the quarter in positive territory, with Utilities, Healthcare, and Technology the three best performing areas. Consumer Discretionary, Energy, and Industrials were the three worst performing sectors in the index, all posting minor losses.
The Fund underperformed its benchmark during the period owing mainly to stock selection within Consumer Discretionary and Financials, and an underweight stake in Healthcare. Consumer stocks Mattel and Bed, Bath & Beyond were the portfolio’s two worst performing holdings. Weaker revenue from the holiday season led to a significant earnings miss for Mattel compared to market expectations. Results from key brands, such as Barbie, Fischer Price and, Hot Wheels were down year-over-year due to increased competition, a short shopping season, fewer movie-linked products, and further penetration of online shopping. The valuation and long-term fundamentals of the company continued to look attractive, and we took advantage of the decline to add to the portfolio’s position.
Bed Bath & Beyond was part of an overall pullback in retail names after the holidays. It missed investor expectations during its November quarter, as a slight decline in market share to online retailers was amplified by higher coupon redemption rates and increased inventory acquisition costs. This surprised investors that had generally bullish sentiments before the quarter. We think the company remains well positioned as a best-in-class retailer, and that continued investments in IT and omni-channel strategies should provide a base for a long-term opportunity.
Elsewhere, the Financials sector was hit by the underperformance of both Citigroup and ACE, while the lack of exposure to Utilities also hurt. Other individual detractors included Industrials firms Parker-Hannifin and Emerson Electric. Parker-Hannifin had a weak quarter, following two previous quarters of outperformance. The company announced in-line quarterly results, but many investors were expecting the company to beat estimates and increase guidance. It did increase its dividend, however, and confirmed its target payout ratio, signaling increased confidence in future cash flows. In addition, we think management has a very good record of adding value for shareholders through mergers and acquisitions (M&A) and internal improvements.
Given Emerson’s high exposure to Emerging Markets (more than a third of sales) it was hurt by the pullback in those markets early in the quarter. In addition, investors were concerned about the impact of increased spending as the company positions itself for future growth. We view the company’s high return on invested capital (ROIC) and cash flow yield relative to its peers as a base for high shareholder payouts.
Stock selection and an overweight stake in Technology boosted relative returns during the quarter. Microsoft and Western Digital were the top-two performing stocks in the portfolio. Investors transitioned away from the riskier growth companies within tech towards those businesses that have shown sustainable performance over time. A strong earnings beat from Windows and hardware led to improved gross margins at Microsoft, while the conclusion of the long CEO search process with the naming of company insider Satya Nadella removed much market uncertainty. In addition, the firm’s cloud products are gaining traction and its announcement that Office would be available for iOS devices provides support that the company’s earnings are not fully dependent on PC market growth.
Western Digital continued its recent impressive run (it was also a top performer during 2013). The company beat Wall Street estimates for the December quarter behind improved pricing, margins, and market share. The market continues to perceive improving potential for the core PC market and rewarded PC suppliers like Western Digital. Investors also have gained increased confidence that China’s antitrust agency will allow further integration of Western Digital and the Hitachi assets it acquired in 2012.
EMC also performed well after being a detractor to performance during the previous quarter. Investors supported larger technology names that represent sustained performance versus riskier opportunities with less-proven customer acceptance. The market also recognized that trends in the cloud, particularly for the largest customers, will still require significant on-premise storage, and EMC’s VMWare and Pivotal provide the necessary virtualization and integration tools and services to manage complex data needs.
Finally, the lack of Telecommunications stocks in the portfolio along with an underweight to Energy also helped relative performance.
Buys and Sells
We added W. W. Grainger to the portfolio and exited General Dynamics during the quarter. Grainger is a leading supplier of maintenance, repair and operating products in North America. The company is essentially a product aggregator and boasts more than 1 million products in its catalogue with more than half a million SKUs. Company management is well respected and known for its relentless process improvement obsession focused towards on-time delivery, market share gains in a highly fragmented market, and overall margin improvement. The stock had underperformed recently following a perceived weak quarterly earnings report. We believe these short-term concerns are overblown and that the company is well-positioned going forward.
Long-term holding General Dynamics was a top performer during the quarter and a strong contributor to performance the past 12 months, especially as investors broadly supported the defense sector as Russia’s annexation of Crimea stoked fears of political instability. As our investment case played out, the stock was no longer attractively valued relative to other opportunities and we exited the position from the portfolio.
Market turbulence during the first quarter didn’t change much for us. Our investment focus remains on valuation, as measured by our proprietary valuation tool. Within the 800 stock universe from which we select candidates for investment, 408 stocks remain undervalued in our estimation. Using normalized earnings, we now calculate the price of our universe at 85% of fair value. We see current equity excess return over a risk free rate at 4.5%, versus an historical average of 3%. As disciplined investors, we are sticking to our investment philosophy, which we think is simple, sensible, and proven over the long term. We believe that volatile periods, when stock prices diverge from the company fundamental value, while painful, create compelling opportunities for long-term performance.
Cornerstone Investment Partners
As of March 31, 2014, Mattel comprised 4.26% of the portfolio’s assets, Bed, Bath & Beyond – 3.61%, Citigroup – 2.80%, ACE – 3.48%, Parker-Hannifin – 3.93%, Emerson Electric – 4.04%, Microsoft – 3.89%, Western Digital – 3.68%, EMC – 3.14%, and W.W. Grainger – 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.