1st Quarter 2013 Commentary - ASTON/Herndon Large Cap Value
1st Quarter 2013
Similar to 2012, the market has begun the year with extremely strong performance during the first quarter. Although the Fund’s absolute numbers would have put it in good position relative to its Russell 1000 Value Index benchmark for most quarters, if not years, we came up short this period. The underperformance does not dampen our enthusiasm. We continue to believe, as we do every day, that the portfolio is positioned to generate outperformance for shareholders over the long run.
The performance of the Russell 1000 Value was fairly broad, with six sectors—Technology, Consumer Staples, Healthcare, Utilities, Industrials, and Consumer Discretionary—outperforming the overall index. The Fund was overweight four of these six sectors, Utilities and Healthcare the exceptions, but stock selection yielded less than desirable results. Holdings in six out of 10 sectors underperformed their respective sector and/or the overall benchmark. In addition, the portfolio was overweight Energy and Materials, two of the index’s weaker sectors during the quarter. Overall, both stock selection and sector allocation were negative versus the benchmark.
Lagging Metals, Soaring Health
The portfolio sectors with the lowest level of contribution were Materials, Consumer Discretionary, and Technology. All of the Fund’s holdings in Consumer Discretionary and Materials underperformed, in the case of the latter owing to a high exposure to metals. Iron ore miner Cliffs Natural Resources, in particular, declined more than 50% due to concerns regarding capacity and demand for iron ore. Within Technology, only Western Digital among the Fund’s holdings outperformed, while the free-fall in Apple continued.
Apple poses a challenge to investors as it produces solid fundamentals, maintains a balance sheet without debt, and has a cash hoard that would probably qualify it as an emerging market country. Yet the company trades at a discount to the market because it has been awhile since it has released another revolutionary product amid competitive issues regarding its market share struggle with Samsung, among others.
Another laggard was independent energy company Newfield Exploration. The company has had challenges with its exploration and production portfolio. We believe these concerns are more than accounted for in the price of the stock, however. All three of the individual detractors to performance mentioned remained holdings in the portfolio.
Financials, Energy, and Healthcare were the three sectors with the highest contribution to returns during the quarter. Financials exhibited strong stock selection with eight out of nine stocks in the portfolio outperforming its benchmark sector. The only laggard in the group was top-10 holding Aflac. A majority of Energy stocks outperformed with most industry groups within the sector performing well except for the internationally integrated companies. Marathon Petroleum was the standout, as it continued to benefit from solid demand fundamentals for refined crude products.
Performance in Healthcare was aided by strong results from Health Management Associates and Gilead Sciences. Both companies benefitted from the soaring performance of the sector overall, and gained favor in the market with their improving company fundamentals. Along with Marathon, we continue to view these stocks as value creating opportunities and they remained holdings in the portfolio.
Staying the Course
Clearly, one of the areas in which we take pride as investment managers—stock picking—was under siege during the quarter. What happened? Did we lose our way? Has our process begun to be less effective? Did we change our process? The answer to these questions is a resounding NO! Nothing has changed in our process and we believe it to be just as effective as it has been in identifying value over time. What has become more pronounced is timing. As we constantly say, we cannot control the timing, duration or magnitude of outperformance. All we can do is position the portfolio to where we believe it can achieve it by identifying value creating opportunities based on closing the gap between a discounted stock price and solid company fundamentals.
Value is determined by a stock trading at a minimum of a 30% discount to what we believe is fair value. Creating is the soundness of the company in terms of the probability of continuing as a relevant, ongoing concern. Opportunity is the fact that sound fundamentals purchased at significant discounts typically reward investors quite handsomely… over time. It often takes time for the market to recognize value, and inevitably it is not in sync with the typical quarterly reporting cycle.
Some notable value creating opportunities identified and purchased during the quarter included Accenture, Campbell Soup, McGraw-Hill, United Parcel Service, and Nordstrom. Each stock met our criteria listed above and were fully vetted by fundamental analysis as to their potential as a portfolio holding.
Stocks eliminated during the quarter due to sector adjustments and/or valuation or fundamental issues included Baxter International, United Therapeutics, Eli Lilly, Federated Investors, Halliburton, and Herbalife. These changes were primarily driven by the dynamic interrelationships of the 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 result of this and related activity during the quarter was an increase in the portfolio’s exposure to Technology, Financials, Energy, Materials, and Consumer Discretionary, while exposure to Healthcare decreased. All other sectors essentially remained the same when market appreciation or depreciation is taken into account.
Déjà vu is French and literally means “already seen”. While it seems strange, basically, déjà vu is the feeling, notion, or inclination that what you are experiencing has been previously experienced in a similar if not the same way. This first quarter has been a déjà vu experience for us.
The Fund’s absolute performance was reminiscent of the first quarter of 2012, though its relative performance was clearly not the same. Nevertheless, the opening of the first of four quarters has been a good one. The domestic economy appears to be on the mend at a tepid but gradually accelerating pace. The United States has become the dog more so than the tail of dictating global economic fortunes. The stock market is reflecting this optimism despite other headwinds that are yet to be resolved.
China is still not growing at the rapid rate of the recent past, Middle East unrest continues, Japan is not contributing very much growth, and Europe is still attempting to repair the tattered fragmented nations that make up the European Union. In essence, the United States is not a bad place to be. But, has it been given too much credit too soon?
We think that 2013 will be a defining year. Equities are becoming more attractive as Armageddon outcomes subside, replaced by less dire projections. Alternatives are still few when comparing equities to bonds and cash. At some point, the Federal Reserve will have to treat the markets like adults who can stomach real food rather than babies surviving on instant formula. The result will likely be higher interest rates. Rates will rise because inflation will rise because demand will dictate that limited supplies of goods and services must be purchased at higher prices. At least that is what the economics I was taught suggests.
If so, I think that the Fund’s current positioning will prove quite advantageous. The portfolio is positioned to take advantage of a resurgence of global economic growth. If not growth, at least a change in perception regarding the most draconian expected outcomes for growth. In essence, I think the Fund should benefit if the market agrees that cyclical, economically sensitive assets are priced too cheaply and the more defensive areas are priced too rich. I think the Fund should benefit if the global economic environment is deemed at least as attractive as the currently more highly prized domestic area. I think the Fund should benefit if investors again find assets attractive that trade at a significant discount to what the underlying assets should be worth.
I think the Fund should benefit when the market gets back to investing and ceases to be enamored by a fleeting sense of certainty and security that is more volatile than the current situation suggests. Areas such as the interest rate sensitive sectors like Financials, Utilities and Telecom have been propped up by the Federal Reserve induced strangulation of fair market prices of all things bonds. Once the vice grip is released and real underlying values are allowed to be ascertained, we think something interesting will happen. Assets will move more freely towards true value rather characteristic value.
Our approach to investing is based primarily on capital appreciation, though we are measured in total return. Dividend yield and income is coupled with capital appreciation to produce total return. Due to the dearth of opportunities in bonds, investors have focused on getting income from stocks, which has caused one out of a myriad of characteristics to be the primary object of desire. When yields move against them and equity assets are priced more appropriately, we think the full value of the asset rather than one characteristic will work in the Fund’s favor.
When will it happen? How grand will it be? How long will it last? I do not know. What I do think is that the Fund and its shareholders will be there to benefit.
Randell A. Cain, CFA
Principal and Portfolio Manager
Herndon Capital Management
April 2, 2013
As of March 31, 2013, Cliffs Natural Resources comprised 1.24% of the portfolio's assets, Western Digital – 2.51%, Apple – 1.59%, Newfield Exploration – 1.37%, Aflac – 2.71%, Marathon Petroleum – 3.42%, Health Management Associates – 3.00%, Gilead Sciences – 2.05%, Accenture – 2.02%, Campbell Soup – 1.16%, McGraw-Hill Companies – 2.65%, United Parcel Service – 0.99%, and Nordstrom – 0.80%.
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.