2nd Quarter 2014
The Fund’s underperformance vs. the Russell 1000 Value Index for the second quarter overwhelmingly came down to one sector, Consumer Discretionary. Stock selection within the sector detracted from results. The Fund’s holdings in the sector are still quite attractive in our view based on our thorough analysis of fundamentals and valuation.
For the quarter, sector allocation was positive while stock selection within the sectors drove the Fund’s underperformance. Performance for the Russell 1000 Value was fairly broad with five sectors outperforming – Technology, Energy, Utilities, Consumer Discretionary, and Materials. The Fund’s positioning from a sector perspective was positive as the portfolio was overweight each of these sectors with the exception of Utilities. During the quarter, the Fund benefited from the portfolio’s pro-cyclical growth bias, which has been in place for several quarters now.
The three sectors with the highest contribution for the quarter were Energy, Consumer Staples, and Telecom. Energy was the best performing sector in our portfolio for the quarter and was the second best performing sector in the Russell 1000 Value, lagging top performing Technology by only nine basis points. Six out of 13 stocks outperformed the sector with exploration and production companies doing quite well with the run-up in oil and natural gas prices coinciding with the current Middle East conflict. In Consumer Staples, each of the Fund’s five holdings outperformed the sector.
The sectors with the lowest level of contribution were Consumer Discretionary, Technology, and Materials, with Consumer Discretionary accounting for nearly 75% of the Fund’s underperformance.
The portfolio was correctly overweight Consumer Discretionary as a sector; however, of the portfolio’s four holdings in the sector, three are retail oriented and all three underperformed quite significantly in the quarter. Two of the stocks, TJX Companies and Ross Stores, suffered due to a gradual broadening of consumer tastes to premium brands and a slowdown in fundamentals. In our opinion, the fundamentals of these companies are far superior to the average retailer. Nevertheless, the market sold off these stocks at levels that we would continue to purchase.
The other stock, Coach, declined significantly as the company’s turnaround is expected to take longer and cost more than the market had expected. In our opinion, the negative news is overly discounted in this stock and the current valuation gives little to no credit for the firm’s solid balance sheet, cash flow, operating margins, profit margins, return on equity, supportable dividend and resulting yield. The company is a global brand that, in our view, has been caught in a virtuous cycle of defending its uniqueness and premium price point while attempting to fend off a ferocious and successful attack in the U.S. market from other affordable luxury brands.
Buys and Sells
Stocks eliminated during the period due to sector adjustments or valuation/fundamental issues were Ultra Petroleum, Holly Frontier, Murphy Oil, Neustar, SLM Corporation, and Navient. These changes were primarily driven by the dynamic interrelationships of the sectors as we position the portfolio to exploit value creating opportunities. As we share regarding our investment philosophy, “We have a core process but no core holdings.”
We established positions in Copa Holdings, Verizon, Gilead, AmerisourceBergen, Endo International, and Accenture. We purchased these holdings after first identifying each individual stock as a value creating opportunity followed up with fundamental analysis to vet out the potential as a portfolio holding.
As a result of this and related activity during the quarter, we increased the Fund’s exposure to Health Care, Consumer Staples, Industrials, and Telecom. We decreased exposure to Energy, Technology, and Financials. All other sectors remained the same with the exception of market appreciation or depreciation.
In terms of investment opportunities, the Fund’s portfolio maintains a pro-cyclical growth posture with an eye toward geographies outside of the United States. We do not have a thematic bias. We believe seeking out value where it is most easily found will be more profitable. The U.S. has dominated investors’ thinking as a bastion of safety. Safety has come at a price that may no longer be valid or warranted. The U.S. will be a participant in the resurgence of global economic growth, but it likely will not be the leader. Maturing developing markets that still have an appetite for global brands may prove to be the engines for corporate growth. We think that our portfolio is well represented with such companies.
While the most recent quarter did not turn out the way we or our clients would have desired from a relative performance perspective, we believe our analysis of our attribution reinforces that we are invested in the right places and that, with a reasonable amount of time, the performance of our holdings may positively reflect why each has a place in our portfolio. We currently have the deepest and broadest group of analysts in the history of Herndon who work diligently in helping us to vet out our investment ideas. Our analysts are comfortable challenging ideas with an emphasis on facts over opinions. As a result, we are at ease with facts that support our investment positions even if the market is slow in agreeing; but, we are intellectually honest enough to consider facts that might indicate we are wrong. Thus, we try to adopt a balanced, healthy perspective in our analysis.
As we enter the third quarter, we are excited about the prospects of the Fund’s portfolio. The portfolio had similar growth, significantly higher returns on equity, and a higher dividend yield coupled with a lower valuation than the Russell 1000 Value benchmark. We believe that maintaining this relationship over time should provide the opportunity for a better than average return.
Randell A. Cain, CFA
Principal and Portfolio Manager
Herndon Capital Management
As of June 30, 2014, TJX Companies comprised 2.57% of the portfolio’s assets, Ross Stores – 1.68%, Coach – 1.11%, Copa Holdings – 0.93%, Verizon – 1.03%, Gilead – 1.04%, AmerisourceBergen – 1.10%, Endo International – 1.09%, and Accenture – 0.99%.
Note: Value investing involves buying the stocks of companies that are currently out of favor and 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.