1st Quarter 2014
Why Fear When You Have the Fed?
In December, the Federal Reserve took the first step in unwinding its quantitative easing bond- purchase program, with the “tapering” continuing after both of its subsequent first quarter meetings. As the market corrected in January, Fed officials went to great lengths to emphasize that while the hurdle was high, they reserved the right to reverse course if the economic situation deteriorates significantly. With such powerful assurances in place, the market rebounded and investors absorbed poor expectations for first quarter earnings, political tension in various Emerging Markets, the Cold War parallel in Crimea, and the first Chinese corporate bond defaults. It was not until Federal Reserve Chair Janet Yellen appeared to stumble in her first press conference, noting that interest rate increases could begin six months after the completion of the tapering that market leadership shifted among various fundamental and technical factors.
Positive momentum from fourth quarter earnings came to a grinding halt during the first quarter, a change largely attributed to the severe winter weather that gripped much of the United States, as aggregate estimated growth declined sharply. Fortunately, the onset of spring has brought an economic thaw as well. Data from ISI indicates bank lending is accelerating, trucking companies are reporting higher volume, employment trends are solid, and consumer sentiment is supportive. Analysts will clearly be paying close attention to forward company guidance during earnings season, and these data points suggest that the tone could be more positive.
Mid-cap stocks outpaced both large-cap and small-cap stocks during the quarter, while value significantly outperformed growth across the board. There was little consistency among the various fundamental factors that we watch, however. According to Bank of America/Merrill Lynch, low-quality stocks significantly outperformed high quality, but sector leadership tipped toward defensive names. As the yield curve flattened and expected earnings increased, the Utilities sector surged. Close behind was Healthcare, which continued its strong run from 2013. All other sectors fell well behind the two leaders. The cyclical Consumer Discretionary and Industrials sectors were the worst performing, likely attributable to the relatively weak Christmas season and weather disruptions.
Among dividend stocks, there was also little consistency. Data from Bank of America/Merrill Lynch showed an interesting reversal from 2013. Dividend yield rallied in March to be the top factor for the quarter. At the same time, the high dividend growth factor, which performed well last year, underperformed modestly. Clearly, the nearly 50 basis point (0.50%) decline at the long end of the US Treasury yield curve reduced the pressure on some high yielding stocks, as illustrated by the strong outperformance of both Utilities and real estate investment trusts (REITs).
The strong performance in March ended an extended period of underperformance for high dividend stocks. According to Ned Davis Research, March was the first month the highest yielding stocks in the S&P 500 (first quartile) outperformed the lowest yielding (fourth quartile) since June of last year. To put this in perspective, this streak eclipsed the six months of underperformance that began in September 2010 and was the longest period of consecutive underperformance for the highest yielding stocks since 1980.
The performance of high dividend growers had an adverse affect on the portfolio. Although the outperformance of some of the dividend-focused indices and Bank of America/Merrill Lynch’s dividend yield factor would suggest that the dividend-bias of our strategy might have helped performance, it did not. As we noted in our fourth quarter 2013 commentary, in the past two years the portfolio has gradually leaned toward cheaper, lower-yielding companies, rather than more-expensive, higher-yielding firms. This shift had a clearly positive affect on last year’s relative results, but the underperformance of the high dividend growth factor meant that this was not the case during the recent period.
Consumer Discretionary Weakness …
The Fund delivered a modest gain during the quarter, but noticeably lagged its Russell 3000 Value Index benchmark. Both stock selection and sector allocation were negative factors overall. Two of the portfolio’s largest relative deviations from the benchmark, Consumer Discretionary and Healthcare, accounted for much of the relative underperformance. Although an overweight in Consumer Discretionary didn’t help, stock selection was the real challenge as four of the Fund’s five largest negative contributors came from this group. In the case of Healthcare, a significant underweight in the second best performing sector in the market was largely to blame. The portfolio’s Healthcare allocation declined significantly during the fourth quarter of 2013 following the sale of three positions due to valuation. The relative positioning in these two sectors was entirely based on our bottom-up process, and we are comfortable with the current valuations and risk assessments of the holdings in these areas.
The three biggest detractors, all Consumer Discretionary names, were Staples, National CineMedia, and Coach. Office products supplier Staples reported disappointing quarterly results due to continued deterioration in the company’s retail segment, which accounts for about half of its profits. Comparable store sales were down resulting in lower margins due to fixed cost deleveraging. Partially offsetting the poor performance at the retail stores was staples.com, which grew sales by 10% driven by a rapidly expanding product offering. Although disappointed in the quarter and the firm’s failure to increase its dividend as expected, management is actively restructuring the Retail segment. There is also strong momentum in the online business, free cash flow remains substantially positive, and the balance sheet is solid. Our conviction in the position has declined, however, and we are closely monitoring the results of management’s efforts.
National CineMedia Inc. is a holding company that owns a 46.1% interest in National CineMedia, LLC (NCM), a partnership created by the three largest national theater operators—Regal, Cinemark, and American Multi-Cinema. It distributes an entertainment and advertising program that is played before feature films at movie theaters. The stock gapped down after reporting its quarterly results and giving a 2014 outlook that was below expectations. The shortfall was attributed to increased competition for advertising spending in the online and mobile video channels. The long-term competitive threat is not fully known, however, as the effectiveness of these new internet channels has not yet been proven. The company’s competitive advantage remains powerful given that theater attendees cannot skip advertisements and their demographics are well known to advertisers. Consequently, our conviction remains high and we expect the firm to be able to monetize what could prove to be a strong run for Hollywood over the next two years.
Strong international results for iconic accessories designer Coach were not enough to offset disappointing comparable North American sales. The North American handbag category grew during the period, suggesting that competitors are encroaching on Coach’s dominant market share position. Despite lower guidance for 2014, the company is expected to generate significant flow that it plans to spend on share repurchases this year, plus its growing Men’s and International businesses provide robust growth opportunities.
… While Consumer Staples Thrive
Consumer Staples and Industrials sectors had the largest positive effect on relative results. Seven of the 10 holdings in Consumer Staples helped relative returns, including two positions that were sold during the period—Walgreen and General Mills. Strong performances by the portfolio’s three Aerospace & Defense industry holdings drove the outperformance in Industrials.
The top individual contributor during the quarter was LCD display designer and manufacturer Corning. Despite announcing results above expectations in February, the stock sold off on concerns that LCD glass pricing would deteriorate in 2014. In March, however, the company announced an accelerated share repurchase and the transfer of Gorilla Glass capacity to its newly acquired, lowest-cost production facility in Korea. These moves corroborated management’s assessment that the LCD glass pricing declines were temporary and boosted confidence that the acquisition of the remaining 50% of its joint venture with Samsung late last year is already making positive contributions. We added to the position early in the quarter.
Defense contractor General Dynamics rallied as the company reported fourth quarter 2013 results ahead of expectations, closing out a year of impressive operating margin expansion and strong cash flow generation. In addition, the company announced multiple key contract wins, including one to provide military and commercial vehicles, training, and support services to the Canadian government for the next 14 years. The company stepped up its return of capital by retiring approximately 3% of shares through an accelerated repurchase agreement, increased its repurchase program further, and raised its dividend nearly 11%.
Dr. Pepper Snapple Group was the leading driver within Consumer Staples. The stock rallied after handily beating Wall Street expectations for the quarter, along with providing more upbeat guidance than expected. Management forecast further margin improvement despite continued sluggish volume trends. In March, we met with management to discuss new product developments and the potential for its cost reduction initiative to drive margins higher. The meeting supported our high conviction in the position and the firm’s willingness and ability to continue to grow the dividend in the future.
Four new positions were established and five sold during the quarter, but overall there were few significant changes to the relative positioning of the portfolio. The most significant change to relative positioning occurred in Industrials. The portfolio’s overweight to the sector was reduced after the sale of defense companies Raytheon and Lockheed Martin as they traded at significant premiums to our assessed Absolute Values. The Fund purchased these positions in late 2010 amid the concerns about sequestration-related spending cuts, and was well rewarded when the stocks surged in 2013. These sales were offset, in part, by the purchase of home security provider ADT. Other activity in the sector included another significant reduction in railroad operator Norfolk Southern and an addition to the position in Republic Services. The overweight position in Technology increased after additions to four current positions, including first quarter standouts Corning and Microsoft.
The portfolio’s weighting in small-cap stocks declined slightly during the quarter as we eliminated positions in Hillenbrand and substantially reduced the positions in Safety Insurance, OneBeacon Insurance, and Avista. All four firms had market-caps of less than $2 Billion at the end of the year, and were trading at substantial premiums to our assessed Absolute Values. In addition, while the yields for Safety Insurance and OneBeacon Insurance are quite high, neither has increased their regular dividend payment in some time.
The largest new position added during the quarter was battery and personal care product manufacturer Energizer Holdings. Its major brands include Energizer, Eveready, Schick, Edge, Skintimate, Playtex, Wet Ones, Banana Boat, and Hawaiian Tropic. The company was spun out of Ralston Purina in April 2000, and has since expanded into new categories via five major transactions. Management has utilized the firm’s ample free cash flow for the benefit of shareholders, reducing share count, lowering net debt, initiating a dividend in August 2012, and raising the payout by 25% a year later. A restructuring program is expected to drive a boost in savings, freeing up additional cash to support brand investments and return of capital strategies.
Our outlook for the U.S. market has changed little since the end of 2013. As we noted then, “If long-term rates remain relatively stable and earnings growth is positive, markets will likely advance in 2014, but if either condition fails, a downside scenario is increasingly likely.”
Concerns that adverse winter weather might mask what was already a weakening economy appear misplaced as economic reports show positive momentum after this winter’s disruptions. The decline in long-term U.S. Treasury rates has not led to a commensurate decline in mortgage rates, but home buyers should be comforted by their relative stability as we move toward the more busy spring season. The interest rate decline also provides some room for market multiples to move a bit higher, though projected 2014 earnings growth has decelerated thanks to weak expected first quarter results. As we move through earnings season, we suspect investors will downplay past results and pay close attention to guidance for the remainder of year. We believe there are reasons to be optimistic, but momentum has waned in years past, so we too will be looking for confirmation from management teams in the weeks to come.
Unfortunately, it is easy to identify some worrisome pressures outside the United States—the slowly ratcheting conflict in Ukraine, political issues in Turkey, concerns about the Chinese housing markets and corporate bond defaults, rising consumption taxes in Japan, etc. When these issues came to the fore during the first quarter, the resolve of the Federal Reserve’s new leadership was tested. In an apparent push to demonstrate her hawkish bona-fides, Ms. Yellen announced another cut to the bond purchase program, but also offered assurances that the Committee reserved the right to reverse course should the situation dictate. It is clear that the Fed is committed to its established course toward normalized monetary policy, but it appears Ms. Yellen is trying to walk a fine line.
The discount-to-Absolute Value of the top-20 holdings in the portfolio was 93% at the end of the quarter—just above the high end of the historical range of 82% to 92%. We remain concerned about elevated valuations, though our discount measure stood at stood at 99% at the end of the year. The bulk of sales in the Fund during the quarter involved smaller, overvalued positions.
Overall, we were disappointed with the portfolio’s results during the quarter, but perhaps we should not have been surprised given the very strong results for 2013 and the relatively weak momentum at the end of the year. The decline in long-term interest rates pushed the prices of bond-like stocks higher, but we do not expect this trend will last long if the Federal Reserve continues its march toward the resumption of normal monetary policy. Our almost singular focus on reducing positions trading at premium valuations will likely diminish if volatility remains elevated. The number of holdings in the Portfolio continues to decline, moving closer to the low end of our preferred range of 60 to 80 stocks, but as volatility increases, so too should opportunities for new investments. We believe the Portfolio is well positioned to benefit from an acceleration in both earnings and broader economic growth. Importantly, the improved relative performance in the volatile weeks since Ms. Yellen’s first press conference suggest that the current risk profile of the portfolio is consistent with our expectations.
River Road Asset Management
As of March 31, 2014, Staples comprised 1.14% of the portfolio's assets, National CineMedia – 0.81%, Coach – 1.38%, Corning – 2.55%, General Dynamics – 2.33%, Dr Pepper Snapple – 2.46%, ADT – 1.23%, Norfolk Southern – 1.00%, Republic Services – 1.43%, Microsoft – 2.36%, Safety Insurance – 0.45%, OneBeacon Insurance – 0.32%, Avista – 0.56%, and Energizer Holdings – 1.28%.
Note: Funds that invest in small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity. The Fund seeks to invest in income-producing equity securities and there is no guarantee that the underlying companies will continue to pay or grow dividends.
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.