2nd Quarter 2012 Commentary - ASTON/Herndon Large Cap Value
2nd Quarter 2012
Different Is Good
Although the Aston Fund has only been around for a few years, during the second quarter Herndon Capital closed 10 years of managing its institutional large-cap value strategy. We like to think that perhaps we have learned a thing or two during the journey. How have we survived and thrived this long in a highly competitive asset management landscape?
We have done it by doing something different. We have frequently gone against the grain. I often tell my five children, “If you want something different, you must do something different. Otherwise, you should only expect to get what everybody else has.”
In investing, we see the same world, issues, and contextual environment as other investors. But, rather than riding along with the prevailing tide of optimism and/or pessimism, we swim towards what we think is the best opportunity. Salmon during their mating season swim upstream against the natural flow of rivers, sometimes hurling their bodies upward against rapids to reach a place where they can spawn. In pursuit of value creating opportunities, we frequently do the same. We dare to embrace the swelling tide of negativity or neglect surrounding certain stocks and sectors to ferret out what we consider to be the best possible opportunities. As some salmon lose ground or even their lives in their quest, we also will experience some setbacks. The setbacks are part of the process of reaching the goal.
For the salmon, the goal is the next generation. For us, the goal is delivering excess returns for investors. Both we and the salmon continue in pursuit of our respective goals. It is simply what we do.
Swimming Against the Tide
During the second quarter the Fund experienced one of those setbacks. The portfolio underperformed as we swam against the momentous, swelling mass of uncertainty and negative speculation associated with the economic challenges of Europe, the decelerating (although still decidedly positive) growth in China, and the electoral mystery of the next U.S. president. Near in terms of U.S.-centric securities and dear in terms of basic necessities, known growth rates with little deviation were held as precious. Thus, defensive areas of the market such as Telecom, Utilities, and Healthcare were the best performing and only positive sectors within the Fund’s Russell 1000 Value Index benchmark during a down quarter overall.
The portfolio had no holdings in Telecom or Utilities, and was underweight Healthcare. Stock selection in Healthcare also hurt due to the lack of exposure to large-cap pharmaceutical stocks. In addition, a number of holdings within Industrials proved too cyclical for the prevailing investment environment, detracting from returns. Sectors in which the portfolio was overweight suffered the near-term wrath of the market as global growth concerns coupled with political uncertainty prevented the merits of solid fundamentals and attractive valuations from being celebrated.
The three biggest negative individual contributors to performance were Herbalife, Coach, and Western Digital from the Consumer Staples, Consumer Discretionary, and Technology sectors respectively. These stocks all have global businesses with a bit more associated variability, and therefore concerns, about their expected level of earnings. In addition, the stock of Herbalife came under siege following its last earnings call after questioning from a well-known hedge fund investor. Concerns raised have proved unfounded, though the stock has yet to rebound. Each of these stocks remained a portfolio holding as of quarter end as we continue to view them as value creating opportunities.
The sectors with the highest contribution to performance were Financials, Technology, and Energy. Only Financials actually delivered a positive contribution in outperforming its respective benchmark sector by more than six percentage points. Having less capital-market and interest-rate sensitive holdings aided results. Technology had neutral stock selection while Energy was positive.
American Capital Agency, Altria, and TJX Companies comprised the three top individual contributors. In contrast to the negative contributors, each stock here represents businesses that are domestically focused with low volatility in their business models coupled with a fairly tight range of expected earnings. All remain in the portfolio as current value creating opportunities.
Staying the Course
Despite the short-term setback during the quarter, we maintained the portfolio’s weightings and actually increased exposure to the far-reaching characteristics of more globally focused, volatile in terms of earnings impact by economic fluctuations, and uncertain in terms of current actual growth rates. Why did we look so different and risk underperformance?
The market’s quest for clarity and abhorrence for the unknown typically results in an over-emphasis on both. We acknowledge and believe there is more that we do not know than what we actually know, making us wary of chasing short-term market fluctuations. Finally, in the extreme, as the market runs to excess, opportunities are constantly being created.
We find great opportunity in sectors that have been overly punished. Overly is the operative word. We cannot disagree with the direction the market has taken with some of the more cyclical sectors. We just find issue with the magnitude. Overweight sectors in the Fund represent where we think negativity has been taken to an extreme. Conversely, underweight sectors represent where positivity has also run to an extreme.
As of quarter-end, the Fund was overweight Energy, Materials, Technology, Consumer Discretionary, and Consumer Staples. With the exception of Consumer Staples, we believe we were in the right place at the wrong time. The result was the quarter’s underperformance.
The Fund eliminated three positions from the portfolio and initiated holdings in six others during the quarter. Accenture, Marathon Oil, and Waters were sold due to sector adjustments and/or valuation/fundamental issues. ConocoPhillips, Joy Global, Harris Corporation, Newfield Exploration, Marathon Petroleum, and Whiting Petroleum were all added. Each stock was purchased after first being identified as a value creating opportunity followed by our usual fundamental analysis to vet its potential as a portfolio holding. The significant number of new Energy purchases coincided with the reconstitution of the Russell indices, resulting in an increase in the portfolio’s exposure to the sector.
Clarity surrounding the aforementioned issues of Europe, China, and the presidency will likely cause the market to reassess the murky view of where true value lies. If so, we believe the Fund is well-positioned.
If an investor has little confidence that the global and domestic economy is on an upward sloping line for the long term, then there is little to no reason to be invested in equities or equity-like instruments. If the confidence is there, which we do have, then investing during times like these may be difficult and daunting, but should be done.
Although the line of growth averages out to be one number in the end, there will always be fluctuations around that average number. Economic cycles are what the name implies, cycles of economic growth. The cycles can be high, low, positive or negative. Policies can influence the cycle but policies alone will never repeal the cycle. Investors pay dearly at the extremes when this simple fact is forgotten, but can also benefit significantly when it is remembered.
We try to stay aware of the simple facts and truths that are sometimes lost in the clouds of uncertainty. Being aware and prudent guides our process to where the best opportunities currently reside. We think time and patience will reward our diligence.
The journey continues.
Randell A. Cain, CFA
Principal and Portfolio Manager
Herndon Capital Management
July 1, 2012
As of June 30, 2012, Herbalife comprised 2.35% of the portfolio's assets, Coach – 2.62%, Western Digital – 1.80%, American Capital Agency – 2.70%, Altria – 2.89%, TJX Companies – 2.99%, ConocoPhillips – 2.09%, Joy Global – 0.90%, Harris Corporation – 1.84%, Newfield Exploration – 0.72%, Marathon Petroleum – 0.67%, and Whiting Petroleum – 0.32%.
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, 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.