2nd Quarter 2014
The equity market continued to move higher during the quarter with central banks around the world infusing liquidity into the global economy. Much of that liquidity seems to be seeking returns in the securities markets. We believe this is one reason that higher yielding, as opposed to momentum, stocks have performed well thus far in 2014. The obvious question is how much longer this upward bias in the overall equity market will continue. Ultimately, the U.S. Federal Reserve will cease pumping liquidity into the economy and interest rates will rise. When it does, equities are likely to undergo a meaningful correction. As the old adage goes, “When the Fed pulls the punch bowl the market goes down.” The problem for investors is that timing these events is extremely difficult.
Given the current environment, we see every reason to remain cautious in the type of stocks held in the portfolio. We believe that volatility will remain low until either the economy picks up meaningfully or the rate of inflation forces the Fed to act and raise rates. For now, we believe this low volatility environment will persist. Therefore, we see no reason to change our focus on investing with a value emphasis in above-average dividend-yielding stocks able to generate positive free cash flow.
Although the pricing of the call options we sell against holdings in the Fund has come down, reflecting both lower actual as well as perceived volatility, the cost of protecting the portfolio against a significant market correction has also declined meaningfully. The CBOE Volatility Index (“VIX”), a measure of the daily volatility of the S&P 500 Index, is at historically low levels, meaning that the cost of put options has fallen close to the reduction in the value we receive for the call options that we sell. We were able to buy put options to help protect 150% of the notional value of the portfolio for a current cost of less than 60 basis points during the quarter.
Winners and Losers
The Fund posted modest gains during the quarter, but trailed its unhedged S&P 500 Index benchmark. This isn’t entirely unexpected given the portfolio’s low volatility characteristics, notably a beta (a measure of volatility relative to the benchmark) of less than half the S&P 500. The Fund performed in-line with its hedge-equity peers.
Although the equity holdings in the portfolio performed better than the index, the cost of owning put options to guard against a significant market decline offset those gains, as did the fact that a fair number of call options traded “in-the-money.” We continue to look at the portfolio’s call positions as a source of cash, and seek to close them when the combination of stock price and the value of the call approaches our calculation of intrinsic value.
Stakes in Consumer Discretionary stocks, primarily a holding in Coach, was the main detractor among the portfolio’s equity holdings. Coach declined substantially after its CFO indicated at a recent analyst meeting that an expected 2014 transition would not take place until 2017. We immediately reduced the position by half and rolled the options of the remaining position to a lower strike price, generating some near-term cash. We did not sell it outright given its high current yield and sizeable free cash flow. The U.S retail operation is at the heart of the company’s problem, but we believe it is being addressed with an array of new products and a rationalization of its U.S. store base. The company continued to grow rapidly in Asia.
Stock selection in most of the other sectors aided performance, with picks in the Utility, Energy, and Industrials sectors standing out. The three best individual performers were Entergy, ADT, and Alcoa. Electric power generator Entergy reported an increase in earnings versus expectations and an above-average current yield. Merchant power prices improved as a function of higher natural gas prices. As is often the case when a stock goes up meaningfully, however, the strike price of the calls we sold reduced the upside capture somewhat.
We purchased most of the Fund’s stake in electronic security firm ADT at less than $30 after it announced quarterly results that were below expectations. While most analysts focused on the prospect of competition, we became convinced that there was a significant opportunity as the firm’s non-compete agreement with Tyco expires during the fourth quarter of 2014. Given its positive free cash flow and above-average current yield, we remained comfortable holding the stock in the portfolio.
We think Alcoa performed well because investors began to realize that it is now a value-add metals company, not a commodity producer subject to the volatility of the price of aluminum. Unfortunately, the quick spike in the stock ran up against the strike price of the call option that we sold, capping some of the gains.
Buys and Sells
We either lowered or eliminated three positions from the portfolio during the quarter, and established five new positions. Huntsman was the position completely eliminated, while Microsoft and Public Service Enterprise were both reduced after having greatly exceeded the strike price of the call option we sold. Holding positions that are well above the strike price severely reduces the upside capture of a stock in a rising market.
Three of the stocks added comprised meaningful positions in the portfolio, namely EMC, Republic Services, and Waste Management. EMC fits the type of Technology company that we favor—one with the free cash flow to potentially increase their dividends significantly. The company also has a slew of new high gross margin and cloud-oriented software products that we believe can help boost revenue growth in coming years.
Waste Management and Republic Services resemble unregulated utilities in our view. Both have growth prospects owing to their ability to buy smaller companies at favorable prices and stand to benefit from a recovery in the industrial segment of the economy. We see these two companies as moderate growth entities that have above average current yield and the potential to grow their dividends over time.
We view of the risk level of the portfolio on a valuation basis to be considerably below that of the S&P 500 Index. We continue to seek stocks paying healthy yields trading at cheaper prices (as measured by price/earnings) than the index. We believe our hedging strategy, coupled with below market valuation, should lead the Fund to deliver significantly reduced volatility relative to the overall market.
As of June 30, 2014, Coach comprised 1.84% of the portfolio’s assets, Entergy – 3.67%, ADT – 3.41%, Alcoa – 2.71%, Microsoft – 2.25%, Public Service Enterprise – 0.50%, EMC – 3.31%, Republic Services – 2.43%, and Waste Management – 2.29%.
Note: By selling covered call options, the Fund limits its opportunity to profit from an increase in the price of the underlying stock above the exercise price, but continues to bear the risk of a decline in the stock. A liquid market may not exist for options held by the Fund. If the Fund is not able to close out an options transaction, it will not be able to sell the underlying security until the option expires or is exercised. While the Fund receives premiums for writing the call options, the price it realizes from the exercise of an option could be substantially below a stock’s current market price. Premiums from the Fund’s sale of call options typically will result in short-term capital gain taxes, making it ill suited for investors seeking a tax efficient investment. The use of derivatives by the Fund to hedge risk may reduce the opportunity for gain by offsetting the positive effect of favorable price movements. There is no guarantee that derivatives, to the extent employed, will have the intended effect, and their use could cause lower returns or even losses to the Fund.
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.