2nd Quarter 2014
“The Great Moderation” Returns?
The S&P 500 Index closed the second quarter at new all-time highs. Risk perception remains unusually low as the volatility index (VIX) sustained average lows last seen in the 2006/2007 period. Equities, bonds, and commodities rallied in unison during the first half of 2014 for the first time since 1993. As this period of relative calm has stretched out, it has increasingly resembled “The Great Moderation” phenomenon popularized by then Federal Reserve Governor Bernanke in 2004 before it was discredited amid the financial crisis.
Large and mid-cap stocks significantly outpaced small-cap stocks in the second quarter. From a style perspective, among large-cap stocks there was a minimal difference between the growth and value benchmarks. Among mid- and small-cap stocks, the value index outperformed growth.
The odd relationship between increased risk appetite and outperformance for high dividend stocks that we noted in the first quarter continued in the second. According to Bank of America/Merrill Lynch, low quality stocks outperformed high quality yet the dividend yield factor was among the best performing in both the second quarter and year-to-date. The firms in the S&P 500 with the highest return on assets, return on capital, and return on equity – quality-related factors – significantly underperformed the average stock. According to Ned Davis Research, the highest yielding stocks in the S&P 500 generally had the best average return, while higher quality stocks had a significant drop-off in performance.
Consumer Discretionary Weakness
The Fund modestly underperformed the Russell 3000 Value Index benchmark for the quarter. During the quarter, stock selection had a negative impact overall as only four of the 10 economic sectors had a positive selection effect. Consumer Discretionary holdings were again the largest detractor for the second quarter, and this single sector accounts for the vast majority of the portfolio’s underperformance year-to-date.
The largest negative contributor in the portfolio during the quarter was Coach, an iconic American designer and manufacturer of fashion accessories, primarily handbags. The stock has been suffering and at the company’s investor day in June, Coach outlined details of a brand transformation strategy that calls for both store closures and fewer promotions, resulting in a steep decline in expected sales over the coming fiscal year. Not only is free cash flow declining due to the brand investments, but the management team also deemphasized the dividend by placing strategic acquisitions ahead of capital return to shareholders. We trimmed the portfolio’s position immediately following our detailed thesis review.
The second largest negative contributor during the quarter was Kohl’s, an off-mall department store retailer with more than 1,100 stores nationwide. Consistent with industry trends, Kohl’s reported a tough first quarter with results coming in below expectations. Comparable sales declined, primarily driven by weak traffic, with the steepest sales declines in regions most impacted by the unusually cold weather. Sales improved throughout the quarter and management maintained guidance for the year. With a dividend yield of nearly 3%, double-digit free cash flow yield, and a management team with a demonstrated commitment to shareholders, we are comfortable maintaining the position in the Fund’s portfolio.
Another negative contributor during the quarter was Darden Restaurants, a multi-brand restaurant operator. In May, shares reacted negatively when Darden agreed to sell Red Lobster to Golden Gate Capital for $2.1 billion. While the transaction price was disappointing, this outcome was preferable to the planned spin-off that management previously announced. In June, fiscal results and guidance missed expectations, sending the stock down again. Despite productivity initiatives, margins declined sharply due to higher food and overhead costs. Across the brand portfolio, new restaurant openings should continue to decelerate, increasing free cash flow and supporting the dividend. We maintained the Fund’s position during the quarter, but our overall conviction declined somewhat.
Boost from Consumer Staples and Industrials
Stock selection in the Consumer Staples and Industrials sectors had the largest positive impacts on relative results. Molson Coors Brewing was the leading driver of performance in the Consumer Staples sector while Iron Mountain was the strongest contributor within the Industrials sector during the period.
During the quarter, reports about a potential merger between SABMiller and Anheuser-Busch Inbev pushed shares of Molson Coors Brewing higher. The rumored deal would likely result in a forced sale of SABMiller’s stake in MillerCoors, which would give Molson significant leverage as Molson is the only firm that could fully integrate MillerCoors into its own operations and realize the full synergies of the acquisition. We added to the position following the announced dividend increase, the first in nearly two years.
Another positive contributor was Iron Mountain, a leader in physical information storage. The firm received a favorable tax ruling from the Internal Revenue Service, enabling Iron Mountain to convert to a real estate investment trust (REIT). The stock appreciated on the news and we expect the annual dividend to possibly double. The company’s new REIT structure will greatly enhance both returns-on-capital and return-of-capital through higher dividends and we increased the Fund’s position during the quarter.
Lastly, within the Information Technology sector, semiconductor company Intel was the top contributing holding during the quarter. Shares of Intel marched higher through most of the quarter before spiking on June 13 after the company raised revenue and margin guidance for the second quarter and the full year. The change was driven by stronger-than-expected PC volume and we maintained the Fund’s position during the quarter.
Persistent low interest rates have pressured the valuations of many higher yielding stocks and our value-focused discipline has generally led us to more attractive opportunities among lower yielding stocks. As a result, portfolio yield has been below our stated objective for some time. During the quarter, the five portfolio positions with yields below 2% sharply outperformed.
One new position was established during the period and one was eliminated. Overall, there were few significant changes to the relative positioning of the portfolio. The portfolio’s overweight to the Consumer Discretionary sector was reduced by trimming a position in Coach and eliminating portfolio holding Staples, due to accumulated unrealized losses. These sales were offset in part by further additions to established portfolio holdings Cinemark Holdings and Shaw Communications.
We reduced the portfolio’s underweight in the energy sector during the period. The addition of a position in National Oilwell Varco was largely responsible for the shift. National Oilwell Varco is one of the largest global equipment suppliers to the oil and gas drilling industry and the company has consistently generated free cash flow, which has allowed management to increase the dividend over the last few years. In our view, the company’s aggressive technology investment creates a competitive advantage and the firm should benefit from the trend of increasing engineering complexity of oil and gas.
We continue to expect modest economic and earnings growth throughout the balance of 2014. Combined with supportive monetary policy, this should fuel the market’s further advance, although we expect an increase in volatility as the “taper” comes to an end. It still appears that any significant disruption is likely to come from outside the U.S.
The Federal Reserve is slowly draining the figurative punchbowl and continues to set the tone for the markets, carefully balancing hawkish actions with dovish rhetoric. Fed Chair Janet Yellen does not want to be perceived as causing a recession by tightening too quickly, in light of the declining labor participation rate and the continued struggles of U.S. consumer.
Reported job growth remains steadily positive and unemployment claims have moderated, but wage growth is stagnant and U.S. consumers are not coming out to shop. The key question is whether consumer-driven industries, like retail and restaurants, are in the midst of a legitimate bargain bin sale or are increasingly littered with value traps. Growth in consumer industries appears limited and it is unlikely that the U.S. consumer will come storming back in the second half of the year. We still see plenty of investment opportunities in consumer-related industries, but as we look forward, we will do so with more measured optimism.
The discount-to-Absolute Value of the top 20 holdings in the portfolio was 92% at the end of the quarter – at the high end of the historical range of 82% to 92%. The discount to value among the other holdings in the portfolio has remained stubbornly high at 97%. Despite the market rally, we have successfully maintained an attractive valuation among the largest positions, but we will need to increase our focus on eliminating overvalued stocks among our smaller positions. As the number of positions in the portfolio inches closer to the lower end of the expected range of 50 to 75 stocks, this will require a redoubled effort to identify new investment opportunities.
We were disappointed with the continued poor performance of holdings in the Consumer Discretionary sector in the second quarter, if only because it offset strong performance across so many other areas in the portfolio. The sell discipline was designed to address just such a problem and we have already moved on, wiser for the experience, and are focusing on new opportunities. The continued decline in long-term interest rates is supporting the strong performance of the highest yielding stocks, but this will get harder to sustain as the Fed begins to talk about the resumption of normal monetary policy. Portfolio positioning remains biased toward continued economic expansion, a strengthening consumer, and a rise in interest rates that is likely to follow both these in turn.
River Road Asset Management
As of June 30, 2014, Coach comprised 0.12% of the portfolio’s assets, Kohl’s – 2.05%, Darden Restaurants – 1.34%, Molson Coors Brewing – 2.10%, Iron Mountain – 2.14%, Intel – 3.95%, Cinemark Holdings – 1.66%, Shaw Communications – 1.50%, and National Oilwell Varco – 0.85%.
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.