4th Quarter 2012
Reversal of Post-Election Slump
The fourth quarter of 2012 provided a fitting end to what was a volatile, yet successful, year for equity investors. The broad market S&P 500 Index traded modestly higher in early October before experiencing a sharp, post-election decline. The slump reversed on surprisingly positive employment data, with stocks later propelled by rising optimism for a resolution of the fiscal cliff. The final surge arrived on December 31, as news emerged that lawmakers had finally cobbled together the framework for a deal.
Small-cap value stocks led the market during the fourth quarter and all of 2012, but the dispersion of returns was narrow for the year as the large-cap oriented Russell 1000 Index only outperformed the small-cap Russell 2000 Index by mere basis points. From a style perspective, value significantly outperformed growth across market-cap spectrum for both the quarter and the year.
High-beta (volatility) stocks led the market all year long and propelled the rally that followed the election, while high-yield stocks were blown away. Within the S&P 500, the highest beta stocks (fifth quintile) outgained the lowest volatility stocks (first quintile) by more than 10 percentage points for the quarter and the year. According to Ned Davis Research, stocks with the lowest dividend yields in the S&P 500 outgained the highest yielding by an astonishing amount (23.4% to 3.2%) for the full year, including by a six-percentage point margin during the fourth quarter.
The prospects for dividend investing brightened with the New Year, however. In December, a flurry of companies rushed to pay special dividends or move regular payments forward in response to a 3.8% dividend income surcharge related to healthcare reform and the risk that favorable tax treatment of dividend income would expire in 2013. After much speculation and concern, Congress finally passed the American Taxpayer Relief Act of 2012, averting the tax cliff. Although the debt ceiling and spending debates were put off until February, we were pleasantly surprised that the net impact of the bill on dividend stocks was consistent with, if not better than, our best case scenario.
While we expected that dividend taxes were going to increase, Congress exercised restraint in maintaining the status quo for most investors and increasing the tax modestly for investors in the top tax brackets. They preserved the parity between the treatment of capital gains and dividends. Most importantly, the new tax rates were made permanent, eliminating a significant uncertainty for taxable investors in dividend stocks.
Rough Quarter, Rough Year
The Fund underperformed its Russell 3000 Value Index benchmark during the quarter, and substantially underperformed for the year. This was the first time that the Fund had underperformed the index during a full calendar year since its August 2005 inception. At the same time, it has delivered returns with significantly less standard deviation (a measure of volatility of returns) than the benchmark through the end of 2012.
Both sector allocation and stock selection had a negative effect on overall relative performance in 2012, with stock selection within eight out of 10 sectors and sector allocation in five sectors hurting performance. Financials detracted from results the most owing to weak stock selection and an underweight position. Despite providing the highest absolute return in the portfolio, holdings in Financials underperformed the benchmark sector by more than seven percentage points. This underperformance was largely attributable to the lack of exposure to banking giants Bank of America, Citigroup, Goldman Sachs Group, and JPMorgan Chase & Co.
During the fourth quarter, stock selection negatively affected relative performance within six sectors, with the largest impact coming from holdings in Financials and Consumer Discretionary. The poor results in Financials were due primarily to positions in CME Group and PNC Financial Services, while Darden Restaurants and Kohl’s drove the underperformance in Consumer Discretionary.
Darden is the owner and operator of full-service casual dining chains, including Olive Garden, Red Lobster, and LongHorn Steakhouse. The stock gapped down in December after it pre-announced poor fiscal second quarter same-store sales and significantly lowered earnings guidance for its fiscal year ending May 2013. Several of the company’s promotions did not have the desired effect on sales and traffic, primarily due to a lack of focus on affordability. Darden also suffered from bad publicity relating to reports that it was exploring ways to minimize the costs of the new healthcare mandate by reducing employee hours. Despite these near-term obstacles, we think the firm has enduring restaurant brands with strong growth prospects, leading us to maintain the Fund’s position.
Off-mall department store retailer Kohl’s reported disappointing November same-store sales after signs of a positive turn in the business since late June. Despite the operational setbacks, the company has rewarded shareholders with stock buybacks, and in November the Board of Directors again increased the firm’s share repurchase authorization. With a healthy dividend yield, double-digit free cash flow yield, and strong commitment to shareholders, we are comfortable maintaining the position.
Elsewhere, global telecommunications company Vodafone reported weak first half results in November driven by a significant decline in service revenue in Southern Europe and impairments related to operations in Italy and Spain. Profits declined in both Northern and Southern Europe as the company faced intense competition and lower mobile termination rates. Although performance outside of Europe and the company’s 45% stake in Verizon Wireless were bright spots, it was not enough to offset the European results. Given the poor fundamentals of the business in Europe and uncertainty of future dividends out of Verizon Wireless, the dividend growth outlook for Vodafone has become increasingly challenged. We trimmed the position at a loss in accordance with our sell discipline.
The biggest negative stock contributors for the year came from a variety of industries. Railroad Norfolk Southern encountered slumping demand for carloads of coal as utilities switched to cheaper natural gas. Shares of Intel suffered during the second half of the year following a disappointing second quarter earnings release and cuts to guidance for the next two quarters. The stock bottomed in November when the company made the surprise announcement that President and CEO Paul Otellini would retire from the company and the Board of Directors in May 2013. Kohl’s fourth quarter slide made it one of the portfolio’s worst performers for the year.
Only three economic sectors in the portfolio had a positive absolute return during the quarter compared with seven sectors in the benchmark. Four sectors had a positive effect on relative results, with Energy providing the most significant impact owing to an underweight position. Sector allocation overall was also positive, aided by the Energy underweight and an overweight in Consumer Discretionary. Only two sectors aided relative performance during the year, with Energy again the biggest contributor due an underweight position and strong stock selection, and positive stock selection in Utilities adding value. Positions in Seadrill and Occidental Petroleum drove much of the outperformance in Energy in 2012.
Asset manager BlackRock was the top individual contributor to performance during the quarter. The stock rallied as lingering market concerns about the possibility of Chairman and CEO Larry Fink departing for the U.S. Treasury abated, allowing the market to refocus on the firm’s ongoing stellar execution in growing its global brand, diversified business lines, and ample free cash flow. Part of BlackRock’s strong contribution to the portfolio resulted from our decision to increase the position size during the second quarter of 2012. Shares have since approached our assessed Absolute Value, but we have maintained the position due to our favorable expectations for the company’s business model and attractive return-of-capital actions via ongoing dividend hikes and opportunistic share repurchases.
Industrial equipment and casket-maker Hillenbrand made two significant announcements that boosted its stock. It announced the accretive acquisition of German bulk material handling equipment manufacturer Coperion Capital to diversify its industrial equipment business and the company reported better than expected fourth quarter results, driven by stabilization in its core casket business, significant revenue growth, and margin improvement in the process equipment segment.
Steel producer Nucor sold off earlier in the year as economic concerns and bearish commentary from management regarding a rise in U.S. steel imports weighed on investor expectations. Those concerns eased as Nucor’s financial results came in above Wall Street expectations. In October the company announced better than expected third quarter results that, while down somewhat year-over-year, showed sequential growth. In addition, Nucor raised its base dividend for the 40th consecutive year.
The biggest contributors for the year were a mixed bag. Sabra Healthcare REIT made a number of acquisitions to grow its portfolio of properties and opportunistically reduced financing costs. Interest savings from aggressive refinancing as well as acquisitions are driving increased cash flow and our calculated Absolute Value. Real estate investment trusts (REITs) continued to deliver in 2012, and while we are not going to chase relative values to add to the portfolio’s limited exposure to REITs, Sabra is still trading at a discount to our Absolute Value.
Kimberly-Clark, a global health and hygiene company that manufactures and markets tissue, personal care, and healthcare products, repeatedly topped analyst quarterly estimates and raised annual earnings guidance. The company also committed more than a $1 billion to share buybacks in 2012 and had one of the highest dividend yields among its peers. Finally, BlackRock’s fourth quarter rally and shareholder friendly actions made it one of the year’s top performers as well.
Among the Fund’s 73 holdings at quarter end, 14 had increased their regular dividend payments and two—Pfizer and Sysco—announced dividend increases payable during the first quarter of 2013. Eleven holdings either paid a special dividend or accelerated their regular payments to the fourth quarter due to the uncertainty surrounding the fiscal cliff and potential dividend tax increase in 2013.
Four new positions were established and four eliminated during the quarter, but turnover was relatively low and there were only modest changes in the overall relative positioning of the portfolio. The position in Energy increased marginally with the introduction of Occidental Petroleum, reducing the portfolio’s substantial underweight slightly. The introduction of Emerson Electric and Geo Group boosted the Fund’s overweight in Industrials despite the sale of United Technologies at a premium to our assessed Absolute Value.
The largest new position added during the quarter was Emerson Electric, a leading industrial manufacturer that serves a wide customer base with a diversified portfolio of products. The company focuses on high quality, strong service, and innovation (1,000+ patent portfolio) to differentiate itself from competitors. This has led to consistent returns and an economic moat despite the competitive nature of its industry. Management has a stated goal of returning 50% of annual cash flows to shareholders through dividends and repurchases. The company is a dividend aristocrat with double-digit compound annual growth in its dividend since 1956. The stock was trading at a 16% discount to our assessed Absolute Value at the time of initial purchase.
Another notable change for 2012 was the addition of two new Master Limited Partnerships (MLPs). MLPs have played an important role in the portfolio in the past, but we sold most of these holdings as valuations soared at the end of 2009. The past year marked the end of 12 consecutive years of outperformance for MLPs versus the S&P 500 as measured by the Alerian MLP Index. The group garnered significant attention in recent years, but finally succumbed to a wave of new equity issuance, poor energy sector performance, and tax concerns. This pull back offered the opportunity to begin building a position in the group again, and we are evaluating others for consideration in 2013.
Thoughts on Performance in 2012
In terms of relative performance, 2012 was clearly a challenging year for the Fund. Not only was it the first calendar year that it underperformed its benchmark since inception, but the magnitude of relative underperformance was significant. In analyzing the results, we’ve previously noted the remarkable underperformance of high-yielding and dividend-paying stocks, but also want to highlight two other factors that contributed to turning 2012 into a perfect storm against the Fund.
Although high-yield stocks underperformed dramatically, stocks with high dividend growth rates surged. According to Merrill Lynch’s Quantitative Strategy (MLQS) team, dividend growth was one of the best performing factors for the year, despite dividend yield being one of the worst. We focus on companies that can and do grow their dividend, but the market in 2012 was dominated either by companies initiating a new dividend or those that significantly increased their dividend payout from a previously low yield. The vast majority of these companies did not qualify for inclusion in the portfolio before their dividend increases as they did not meet our minimum yield requirement.
An analysis of the portfolio’s holdings also revealed that losses from individual stocks were limited, but so was the size of the portfolio’s biggest winners. Of holdings with a positive (18) or negative (8) impact of 25 basis points or more, the average weight of the winners was only 0.92% versus a 1.76% average weight for the eight big losers. We were too conservative in our position sizing, especially among holdings that had lower yields. Thus, the income bias of the our strategy essentially proved to be an impediment.
The lesson we have learned from this is to realize that we need to be increasingly conscious of a company’s total potential shareholder yield. This is a function of not only the current yield, but expected dividend growth and planned share repurchases. Last year demonstrated that while we cannot lose sight of the portfolio’s dividend income objective, in a low rate and (increasingly) low growth environment, additional components of total shareholder yield demand more attention. We correctly identified during the third quarter that sizing was an issue and a need to better assess a holding’s conviction, discount to value, and total shareholder yield at the time we initiate a new position to better capitalize on our best ideas.
Although our outlook is not a forecast, our perspective of the economic and market environment can affect our stock valuations and portfolio positioning. Valuations are the primary driver of our outlook. When stocks are cheap we get excited, but as the discount declines we get more cautious. With our discount-to-Absolute Value calculation for the portfolio at 93%, we are again cautious about broader market valuations especially as earnings growth slows.
Despite modest economic growth and firmer employment data, US Federal Reserve monetary policy remains hyper-aggressive. Chairman Bernanke has explicitly expressed his strong preference for higher asset values during periods of deflationary pressure and deleveraging. He also recently declared the Fed would continue to provide extraordinary stimulus until unemployment reached 6.5%. While it is unlikely we will see a 6.5% headline unemployment figure in 2013, 7% is a possibility if growth accelerates. Furthermore, Fed officials Bullard and Plosser have stated that quantitative easing (QE) measures could end at 7%. Either way, we think the Fed continues to stimulate equity prices, but if unemployment drops more quickly than expected, the Fed is likely to begin to withdraw its more extraordinary stimulus measures sooner than the market currently anticipates.
Fiscal policy is poised to be the major headwind as we look ahead, however. Higher taxes, lower federal spending, fewer economic incentives for business, and the upcoming debt ceiling debate collectively represent the greatest risk to our outlook. As recently reported by the New York Times, upper income earners now face the heaviest tax burden in more than 30 years. The debt ceiling debate promises to be highly contentious and, according to ISI Research, spending cuts are highly unlikely to produce the longer-term savings necessary to keep credit rating agencies from further downgrading U.S. debt. Various actions already taken in association with the fiscal cliff are likely to shave an estimated 1.0% to 1.5% from Gross Domestic Product (GDP) in 2013. That massive drag comes at a time when corporate profit growth is slowing dramatically. If there is one concern that should keep investors up at night, it is the chaos and policies currently emanating from our capitol.
There is a profound and lingering nervousness among businesses, consumers, and investors hanging over this recovery. That is not uncommon following a major financial crisis, especially one resulting in massive credit deleveraging. Fortunately, stocks have thus far successfully climbed the wall of worry. With China averting a hard landing and European tail risks diminishing, we see investors facing fewer global macro concerns in 2013 than in 2012. Closer to home, ongoing improvement in both employment indicators and the housing market could lift sentiment. This should be positive for fundamental stock pickers, as investor focus shifts away from the macro and toward the micro.
The threat of a significant dividend tax increase has hung over the heads of dividend investors for more than a decade. There is little doubt that some of the underperformance in 2012 was the market discounting this risk for 2013. The permanent removal of that threat clears the way for dividend-oriented strategies to participate in what we believe is a secular bull market for “income replacement” securities. Therefore, we anticipate that there will be some reversion of the 2012 underperformance in 2013, which should contribute positively to expected return over the near- to intermediate-term. We remain steadfast in our focus on stocks with high and growing dividends, healthy balance sheets, and attractive valuations, as well as opportunities presented by heightened market volatility.
River Road Asset Management
16 January 2013
As of December 31, 2012, CME Group comprised 1.20% of the portfolio's assets, PNC Financial Services – 1.25%, Darden – 1.22%, Kohl’s – 1.43%, Vodafone – 1.47%, Norfolk Southern – 1.92%, Intel – 2.12%, Seadrill – 0.00%, Occidental Petroleum – 0.99%, BlackRock – 2.16%, Hillenbrand – 1.46%, Nucor – 1.45%, Sabra Healthcare REIT – 1.76%, Kimberly-Clark – 2.41%, Pfizer – 1.73%, Sysco – 2.08%, Emerson Electric – 1.32%, Geo Group – 0.51%, and United Technologies – 0.00%.
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.