4th Quarter 2012
Signs of an economic recovery continued around the globe during the fourth quarter. Among the positives witnessed were industrial production picking up, manufacturing sectors rebounding, a recovery in housing, improving economic conditions in China and Japan, and a low interest rate and inflationary environment. Politics once again dominated the headlines, however, with the U.S. Presidential election, concerns over the fiscal cliff, and struggles in Europe and the Middle East seeming to rule the day. Given this macroeconomic influence, markets experienced increased volatility and higher correlations during most of the quarter. These conditions proved to be a tough environment for active managers as most benchmarks finished close to the top quartile in their universes. High benchmark results have historically proven to be unsustainable and active managers tend to perform better during the periods following such spikes.
The Fund’s Russell 1000 Value Index benchmark finished the quarter in positive territory in gaining 1.5%. Consumer Discretionary was the best performing sector of the index, followed by Financials, and Technology, which were also positive. On the downside, Telecommunications was by far the biggest laggard, with Energy delivering losses as well. Lastly, Utilities proved to be a drag on overall market performance as the pursuit of dividend yield earlier in the year had pushed these stocks to unrealistic valuations. The Fund underperformed the benchmark for the period in posting a small loss.
Stock selection in the Technology, Consumer Discretionary, and Consumer Staples sectors were the primary detractors from performance during the quarter. After having been the best performing stock in the portfolio through the first three quarters of the year, Apple retreated 20% during the final quarter as investors focused on the competitive threats to the company’s dominant iPhone and iPad products. Microsoft followed a weak third quarter with an underperforming fourth quarter. Global PC demand remains weak and the disappointing early reception by consumers for Windows 8 led to a retreat in the stock. The marked panned Hewlett-Packard’s long-awaited restructuring plan as likely insufficient to prevent continued market share loss by the company. The stock was the Fund’s worst performer for the year, and given the continued fundamental deterioration in its business, we sold the position.
Another individual holding that notably detracted from performance during the period was Teva Pharmaceuticals. At its annual Investor Day in December, new CEO Jeremy Levin laid out the company’s strategy going forward. Although the plan seemed reasonable, it could take some time to bear fruit. Overall, investors seemed disappointed with the firm’s outlook and penalized the stock. The company still is one of the more attractive names in our work, though, and remains a holding in the portfolio.
The top contributing sectors for the quarter were Industrials and Financials. An overweight stake in Industrials boosted by the performance of Eaton and General Dynamics aided relative performance. Eaton was the best performer within the Industrial sector and the second best stock in the portfolio. Following the completed acquisition of Cooper Industries, Eaton’s revenue mix is expected to be more diversified, primarily derived from an electrical business that is viewed as less cyclical. The market has thus begun to re-rate Eaton’s prospects, rewarding the stock with a higher price for its earnings.
Stock selection drove performance in Financials as Citigroup and Morgan Stanley were two of the top four performers in the portfolio. After a strong third quarter, the market viewed an abrupt and surprise change of the CEO and other top management at Citigroup favorably. The company has a renewed focus on execution and expenses, and is supposed to announce its first dividend increase since 2007 early in 2013. The market reacted positively to an improving capital markets environment that should be a major benefit to Morgan Stanley. In addition, the Smith Barney integration into Morgan Stanley’s wealth management business appears to be going along as planned and has had a diversifying effect on the company as a whole.
The Fund’s lack of exposure to the Telecom and Utilities sectors, two of the market’s worst three sectors during the fourth quarter, also aided relative returns. Both traded down as investors tired of defensive stocks as optimism about the future increased.
Buys and Sells
Despite strong equity market performance in 2012, we think valuations remain compelling—both on traditional measures and Cornerstone’s proprietary valuation work. Our Fair Value Model now indicates that 72% of the stocks in our 800 stock large-cap universe are undervalued. Using normalized earnings, we now calculate the price of the universe at 74.8% of fair value.
We added four new names to the portfolio during the fourth quarter—3M, Johnson & Johnson, State Street, and Qualcomm. 3M has underperformed the market the past two years despite consistently growing earnings and improving fundamentals. We think that a higher exposure to international markets has kept the stock from reaching the valuation levels we believe that it deserves. Johnson & Johnson remains one of only four U.S. companies to maintain a AAA credit rating. The company has a rock-solid balance sheet and strong drug pipeline, with a valuation that we think is attractive. Custody bank State Street has underperformed the broader market for the last several years (in a weak global economy with low interest rates and increased regulatory capital requirements) despite a long history of resilient earnings and returns. We see upside to the attractively valued stock over the long-term as the macroeconomic concerns subside.
Qualcomm is the world's largest fabless semiconductor producer and the largest provider of wireless chipset and software technology, which powers the majority of all 3G devices commercially available today. The company continues to benefit from the proliferation of smartphones globally, recently adding the market share leader in its chip business (Apple). Qualcomm is a quality company with a cheap valuation. It is at the center of a high growth industry, benefiting from overall industry growth in its patent portfolio and in its integrated circuit business through its market share.
In addition to the above-mentioned Hewlett-Packard, we sold Eli Lilly, Staples, and Vale from the portfolio. A long-time holding, we parted with Lilly given strong outperformance over the past two years as our investment thesis has played out. We purchased Staples during the third quarter based on extremely attractive valuations and our belief that its domestic business was fundamentally sound. During the fourth quarter, management detailed a global turnaround plan that, in our opinion, didn’t truly address some of the fundamental deterioration that is going on at the company. Lastly, iron ore producer Vale is a name that we exited as concerns began to mount over the Brazilian government’s influence over the company. Investors, including ourselves, began to question whose best interest management is trying to appease—shareholders or the Brazilian government. Given these conditions, we decided to exit the name.
We continue to find considerable value in the market and are enthusiastic about the portfolio’s positioning as well as our ability to improve the quality of the holdings while still owning market leading, cash flow rich, and attractively priced companies in the process. We are determined not to be swayed by the whims of the market, which appear to be changing quarter to quarter. Although there may continue to be periods of strength and weakness, we will not stray from our sensible and time-tested process .
Cornerstone Investment Partners
As of December 31, 2012, Apple comprised 4.06% of the portfolio’s assets, Microsoft – 3.47%, Hewlett-Packard – 0.00%, Teva Pharmaceuticals – 3.38%, Eaton – 3.86%, General Dynamics –3.17%, Citigroup – 5.01%, Morgan Stanley – 3.50%, 3M – 2.94%, Johnson & Johnson – 1.92%, State Street – 2.06%, and Qualcomm – 2.34%.
Note: Value investing often involves buying the stocks of companies that are currently out of favor that 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.