4th Quarter 2012 Commentary - ASTON/Herndon Large Cap Value
4th Quarter 2012
The Fund underperformed its Russell 1000 Value Index benchmark in 2012. After having a robust start to the year with a strong first quarter, we watched that lead gradually whittled down to a point during the fourth quarter where the portfolio trailed the index. As we often say, “We cannot predict the timing, duration or magnitude of outperformance. All we can do is attempt to position the portfolio to achieve outperformance.”
The performance of the index was relatively narrow, with only four sectors—Consumer Discretionary, Financials, Industrials, and Telecom—outperforming the overall index. Each of these sectors, absent Industrials, had a more domestic orientation than the broader index, which coincided with concerns regarding non-U.S. political and economic issues. The Fund was overweight Consumer Discretionary, neutral in Industrials, and significantly underweight Financials and Telecom due to valuation issues. The result was that we did not look quite like the market in terms of sector representation, and sector allocation had a negative overall effect. Nevertheless, the portfolio was able to keep pace with the index for much of the year despite looking a bit different.
The sectors within the Fund with the lowest level of contribution were Consumer Discretionary, Consumer Staples, and Materials. Collectively, Consumer Discretionary was out of step as all five of the portfolio’s holdings in the sector had lower returns than the benchmark sector. Just as location matters in real estate, timing matters in investing. In similar fashion, Consumer Staples holdings also had lackluster returns relative to the index sector. Finally, a holding in mining company Cliffs Natural Resources hurt returns in Materials, with the stock declining more than 35% during the year on concerns about the effect of steel demand in China on iron ore prices.
Other notable detractors from performance included Herbalife and Endo Health Solutions. Herbalife was targeted twice during the year by noted short-sellers (investors betting on a stock decline rather than a rise) for a business model the short-sellers have deemed a pyramid scheme that is doomed to fail despite 32 years of sustained growth and success. Our current analysis suggests it is a sound business and we have maintained the Fund’s position. Endo Health Solutions is facing generic drug competition at a time when it is trying to extend the patent life of a key drug focused on pain management. Of these stocks, including Cliffs Natural Resources, all remain in the portfolio as we perceive the issues facing the companies as temporary.
Holdings in five out of 10 sectors in the Fund outperformed their respective sector and/or the overall benchmark during the year. The three sectors with the highest contribution were Technology, Healthcare, and Energy. Strong returns from Apple and Western Digital aided performance in Technology, while Gilead Sciences and Express Scripts provided the boost to Healthcare. Biopharmaceutical company Gilead is seeing greater efficacy and success with its focus on infectious disease, including the Hepatitis C market coupled with its HIV franchise.
Refiners led Energy to solid returns, with HollyFrontier more than doubling during the course of the Fund’s holding period. The company benefited from solid crack spread margins for refined products. It is interesting that as of last year’s Annual Review, HollyFrontier was the third worst contributor in the portfolio. For 2012, it yielded the best return in the portfolio and the third highest contribution to performance. As we like to reiterate, we cannot control the timing, duration or magnitude of outperformance, all we can do is to attempt to position ourselves to achieve it. Patience is a part of that positioning.
Fourth Quarter Review
The portfolio underperformed in four out of 10 sectors versus their respective benchmark sector and/or the index overall during the fourth quarter of 2012. Sector allocation was positive and stock selection was negative. Performance for the Russell 1000 Value had a distinctly pro-cyclical growth tilt, as Consumer Discretionary, Financials, Technology, Materials, and Industrials were the five sectors that outperformed. Unfortunately, while the Fund’s sector exposure proved timely, with overweight stakes in Consumer Discretionary, Technology, Materials, and Industrials, stock selection proved less profitable.
The sectors with the lowest level of contribution were Consumer Discretionary, Consumer Staples, and Technology. Consumer Discretionary fell victim to retail exposure that had previously been a bastion of strength, as positions in discount branded retailers such as TJX Companies and Ross Stores disappointed as greater domestic consumer confidence seemed to put the discount area under pressure. In addition, weaker near-term fundamentals at for-profit educator Apollo Group caused that stock to decline significantly. Consumer Staples suffered as four out of five holdings declined, led by a sharp drop in Herbalife.
The decline in Technology led us to coin a new cliché. Instead of “an apple a day will keep the doctor away” concerns regarding Apple’s ability to generate new and exciting products had us wondering if “an Apple a day keeps the alpha away.” (Alpha is a measure of risk-adjusted return.) Apple is one of the most profitable companies in the world and the success has caused skeptics to raise questions about the sustainability of those profits. The questioning is quite similar to concerns raised when Tim Cook took over for Steve Jobs. Thus far, Cook has proven to be quite capable, and we are sticking with the stock.
The three sectors with the highest contribution to returns for the quarter were Industrials, Energy, and Healthcare. Four out of five holdings in the portfolio outperformed in the Industrials sector, led by Copa Holdings. Air passenger and cargo operator Copa benefitted from strong growth in Latin America as well as expansion into North American flight routes. The Fund’s Energy holdings yielded a positive return versus a negative one for the benchmark sector with Patterson UTI rising strongly along with the continued performance of the previously mentioned refining holdings. Double-digit returns from Gilead Sciences and Health Management Associates led the gains in the Healthcare sector.
Stocks eliminated due to sector adjustments and/or valuation/fundamental issues were Express Scripts, Kronos, and Superior Energy. These changes were primarily driven by the dynamic interrelationships between sectors as we positioned the portfolio to exploit value creating opportunities. As we share regarding our investment philosophy, “We have a core process but no core holdings.” The higher level of stocks eliminated led to new positions in Ultra Petroleum, Southern Copper, Baxter International, and United Therapeutics.
The result of this and related activity during the quarter was that we increased the portfolio’s exposure to Consumer Discretionary and Materials, and decreased weightings to Energy, Consumer Staples, and Industrials. As a result, the portfolio ended the quarter overweight Energy, Consumer Discretionary, Consumer Staples, Technology, Industrials and Materials, and significantly underweight Utilities, Financials, Telecom, and Healthcare.
First Quarter OutlookThe Fund was fortunate to finish the year only moderately behind the benchmark. It was fortunate not because of the portfolio structure but because of the frantic nature of the market. Sound business fundamentals did not seem to matter as much as a Chicken Little approach to looking at the macroeconomic and political issues that dominated the headlines during the year, compressing valuations in some sectors as well as inflating valuations in others.
Thus, we enter 2013 with an eye towards where opportunity might lie if we are willing to invest courageously instead of cowardly. Courageous investing does not mean a foolhardy, cavalier approach with a disregard to prudence. Courageous investing is looking at the Chicken Little perspective and simply deciding whether this is the correct conclusion. To some degree, I believe that this is what shareholders actually pay us to do. We are expected to use our collective education, experience, and exposure to do the difficult things that might overwhelm the average investor, resulting in sub-optimal decisions. Instead, despite the difficulty of moving ahead and/or how uncomfortable we may feel, we are expected to press on to optimize the return opportunity for shareholders of the Fund.
In pressing forward for 2013, we have come off a solid year of absolute returns. The challenge exists in determining appropriate positions as we move forward. The portfolio is currently positioned for continued growth in the U.S. economy, the resumption of growth in Europe, and a continuation of growth in other geographic regions. We are not making a market call. We are making a valuation call based on appropriately pricing company fundamentals.
Fear kept some investors partially or fully out of a robust market in 2012. We stayed the course and shareholderswere rewarded with absolute returns. We will do the same in 2013 and hope for similar, if not better, results.
Randell A. Cain, CFA
Principal and Portfolio Manager
Herndon Capital Management
January 3, 2013
As of December 31, 2012, Cliffs Natural Resources comprised 1.80% of the portfolio's assets, Herbalife – 1.53%, Endo Health Solutions – 1.65%, Apple – 2.16%, Western Digital – 2.40%, Gilead Sciences – 2.72%, Express Scripts – 0.00%, HollyFrontier – 2.75%, TJX companies – 2.83%, Ross Stores – 1.51%, Apollo Group – 1.82%, Copa Holdings – 2.29%, Patterson UTI – 2.25%, Health Management Associates – 2.47%, Ultra Petroleum – 0.78%, Southern Copper – 1.08%, Baxter International – 0.97%, and United Therapeutics – 1.03%.
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.