1st Quarter 2013
U.S. markets continued to surge during the first quarter and optimism grew as momentum built toward the end of 2012 continued into 2013. The Dow Jones Industrial Average eclipsed its 2007 peak and traders pushed the broad market S&P 500 Index above its 1,565 high water mark on the final trading day of March. Americans appeared to embrace the notion that while the economic recovery was slow, there were clear, observable improvements in the economy.
Unfortunately, as the quarter came to a close Europe again threatened to undermine the market’s gains in the form of a financial crisis in Cyprus. Although a second bailout agreement eliminated the ill-conceived plan to tax insured deposits, the mere proposal of this solution by the European Central Bank (ECB) and International Monetary Fund (IMF) served notice to depositors throughout southern Europe. U.S. markets largely ignored the headlines as they pushed toward new highs, but whether this apparently blasé attitude owed itself to ignorance or increased risk tolerance, it most likely indicates investor faith in the ability of the Federal Reserve and the ECB to contain the damage, yet again.
This was not a typical risk accumulation-rally, however. Consistent with a strong risk rally, low-quality stocks, as measured by Bank of America/Merrill Lynch, handily outperformed high-quality stocks, but high-beta (volatility) stocks significantly underperformed. Defensive sectors such as Healthcare, Consumer Staples, and Utilities all gained 13% or more and were the best performing areas in the S&P 500. A number of value factors were among the top indicators during the period as well. Clearly, market participants were more selective in the risks they were willing to take even as the market advanced.
Following the favorable resolution of the dividend tax uncertainty, dividend stocks performed well on an absolute basis. According to Ned Davis Research, the stark performance differential between high-yield and low-yield stocks that dominated 2012 was absent during the first quarter of 2013. The highest yielding stocks in the S&P 500 (first quartile) modestly outgained the lowest yielding (fourth quartile).
High Conviction Picks Surge
The Fund outperformed its Russell 3000 Value Index benchmark during the quarter. The outperformance was a bit surprising given the strong absolute return of the index. Since the Fund’s inception there have been 15 three-month periods in which the benchmark returned more than 10% and this is only the second time the portfolio has outperformed amid such a sharp increase (the other being the third quarter of 2010).
In a reversal of 2012, there was broad outperformance among our highest conviction positions. Of the Fund’s top-20 holdings at the end of 2012, 16 outperformed the benchmark during the first quarter! As we discussed in our fourth quarter 2012 commentary, the holdings that outperformed the benchmark last year were generally smaller than average in position size, while the portfolio’s largest positions were among the worst performers.
Both sector allocation and stock selection had a positive impact on relative results during the quarter. Holdings in eight of 10 sectors of the portfolio had a positive total effect on relative results, with stock selection in the Financials and Telecommunication Services sectors being the most significant.
The Fund’s top contributor was Sabra Healthcare REIT, which was also the top performing holding in 2012. In an earnings report that exceeded expectations, management announced further progress on savings from refinancing, which can serve as a basis to boost dividend growth, as well as diversification away from their largest tenant. Management laid out a clear path for continued diversification of tenant risk and expectations for the announcement of three multi-year deals (each for 10 new facilities) in the coming months. Investors have cheered Sabra’s progress, sending shares steadily higher the last several quarters. Given an attractive yield and strong execution by management, we maintained the position in the stock despite it having moved to a premium versus our assessed Absolute Value.
Drugstore network Walgreen’s shares steadily increased throughout the quarter as earnings exceeded expectations and investors realized the potential benefit to the firm from the implementation of the Affordable Care Act and the return of Express Scripts customers following last year’s dispute. Wall Street praised the announcement of a comprehensive 10-year distribution agreement with AmerisourceBergen. We believe that Walgreen’s partnerships with AmerisourceBergen and others provide the company with a long runway for business and dividend growth.
General Mills, BlackRock, and railroad Norfolk Southern rounded out the top-five contributors. General Mills rallied on news an acquisition offer for rival Heinz, and better than expected fiscal earnings and raised guidance for the fiscal year. The company raised its dividend and committed to returning greater levels of cash flow to shareholders next year with at least a 2% reduction in shares outstanding. We reduced the portfolio’s position for the first time as it traded at a premium to our Absolute Value. BlackRock was among our highest conviction holdings at the end of 2012, but we trimmed it multiple times during the quarter as it began trading at a significant premium. Norfolk Southern’s stock benefited from improved sentiment surrounding rail companies, but 2013 results may prove volatile.
Only four positions had a negative contribution to the total return and only five positions had a negative effect relative to the benchmark in excess of 10 basis points during the quarter. Two sectors had negative relative results overall, with stock selection in Technology having the most significant impact. Although holdings in Intel and Microsoft underperformed the broader portfolio, the sector’s return still beat the total return for the Russell 3000 Value.
American Greetings was the largest negative contributor to performance. In September 2012, the board received a premium buyout offer from CEO Zev Weiss and COO Jeffrey Weiss. The stock reacted positively, trading around the buyout price through the middle of January 2013. The stock sold off in late January on rumors that the Weiss family was having difficulty in obtaining financing for the buyout. (Note: On April 1, 2013, after quarter end, the company announced that its board had signed a definitive agreement to be acquired by the Weiss family and the stock jumped more than 10%.)
Another negative contributor was Occidental Petroleum, the largest independent exploration and production company in the United States. The company lowered its international production guidance, highlighting the divergence between its improving U.S. operations and periodic issues overseas. Wall Street also seemed to fret over the potential distraction caused by a dispute in the executive suite. We remain confident in CEO Stephen Chazen, however, and the company raised its dividend during the quarter—its tenth consecutive annual increase--and we believe there is significant value in the chemicals and midstream segments. We increased the Fund’s position to its initial target weight.
Utility company Entergy also detracted from returns. As the operator of six regulated utilities, Entergy has several key rate cases in 2013 in jurisdictions where allowed return-on-equity may come under pressure. The future of its wholesale business is also hazy, as cheap natural gas-fired generation is depressing power prices, causing some nuclear operators to close high-cost plants. We had kept the position small due to the relatively low conviction and the stalled dividend. In the wake of recent quarterly results, we determined that while the current yield was attractive our conviction was unlikely to increase over a reasonable investment horizon, and we sold the position.
One Beacon Insurance Group and specialty chemical company Innophos Holdings were the other lowest contributors to performance. One Beacon reported fourth quarter earnings that were below expectations, driven by increased catastrophe losses and investment spending. Innophos, added to the portfolio in March, was among the lowest contributors not because of performance but due to the relatively small size of the position.
As markets continued to advance and valuations remained elevated, we focused on reducing or eliminating overvalued positions and rationalizing lower conviction positions. Four positions were established and five eliminated during the quarter. Six holdings that were among the top-20 at year-end were significantly reduced, with five of these trimmed due to valuation. We reduced the position in Lockheed Martin due to the risk that sequestration presented to its beleaguered F-35 fighter jet project. Although portfolio turnover was higher than in recent quarters, it was still well within what we consider a normal range, and little actually changed from the portfolio that underperformed during the post-quantitative easing (QE3) market surge at the end of 2012.
Changes in the relative positioning of the Fund were minor, the most notable occurring in the Industrials sector. The portfolio’s overweight position decreased due to the elimination of Waste Management, which was trading at premium to our assessed Absolute Value. This sale combined with the reduction in Lockheed was more than offset by an increase in Iron Mountain. Elsewhere, the relative overweight in the Consumer Discretionary sector increased primarily owing to the introduction of Coach and an increased weighting in Darden Restaurants. Within Energy, we eliminated ConocoPhillips as Occidental Petroleum was increased, and we introduced Williams Partners L.P. to the portfolio.
Williams Partners is a master limited partnership (MLP) that owns and operates approximately 15,000 miles of midstream and long haul transportation pipelines focused on gathering, processing, and transporting natural gas. With favorable secular tailwinds and a powerful geographic footprint of pipelines, we believe the company is positioned strongly to deliver an attractive, growing stream of cash flow to investors over our investment horizon. We think the firm’s shareholder orientation is in the right place as evidenced by its sizeable yield and growing distributions, which management intends to increase annually going forward. The stock was trading at a 23% discount to our assessed Absolute Value at the time of initial purchase.
After closely following negotiations in Washington D.C. for months, we were relieved that the most exciting news out of Congress this quarter was the first federal budget proposal from the Senate in four years. Despite warnings of fire and brimstone if the sequester spending cuts were allowed to occur, reality has proven much less drastic to date. This recent period of relative peace and quiet, however, could be interrupted by the secondary impacts of the small, yet perhaps important, global events such as the implosion in Cyprus.
The strong market performance during the first quarter has heightened our concerns about broader market valuations, however. Despite efforts to reduce and eliminate positions trading at premium valuations, our discount-to-value measure for the portfolio surged to its highest levels—indicating that valuations are rich. Without a return to healthy sales and earnings growth or an increase in merger and acquisition (M&A) activity, it is difficult for us to justify substantial increases in the valuations we are employing for holdings in the portfolio. The negative tone that has dominated recent management guidance is weighing on expectations for coming S&P 500 company earnings, now projected to decline. It is too early to make the call for a wave of M&A pushing multiples higher for mid-to-large cap companies.
The massive surge in quantitative easing recently initiated by the Bank of Japan could push the market even higher, but after years of quantitative easing in the developed world, the incremental benefits of these programs on earnings and the broader economy appear to be reduced. There is a very real risk that another wave of easy money and a more bearish outlook for bonds could effectively “de-couple” the equity markets from the broader economy and corporate earnings. The discount-to-value of the portfolio suggests that this may have already happened to some extent, but the impact could prove extreme if inflows into equities increase significantly in the coming quarters.
We were pleased with the performance of the Fund since the start of the new year. As expected, the resolution of tax uncertainty removed a significant headwind and even allowed the portfolio to outperform in a market where we would normally have expected it to lag. Strong dividend growth and large share repurchases suggest that company management teams are more focused on returning capital to shareholders, and the relative performance associated with these announcements demonstrates investor preference for this as well. Although we believe that modest earnings growth and multiple expansion will drive an attractive total return for U.S. equity markets in 2013, a market correction does appear to be due.
The Fund still has delivered the solid relative returns that we expect on days when the benchmark declined. If the market corrects, we believe the portfolio is well positioned to help cushion the blow. We remain focused on reducing positions that are trading at premiums to our assessed Absolute Value and taking advantage of individual opportunities as they arise.
River Road Asset Management
14 April 2013
As of March 31, 2013, Sabra Healthcare REIT comprised 2.00% of the portfolio's assets, Walgreen Co. – 1.99%, General Mills – 2.04%, BlackRock – 1.51%, Norfolk Southern – 2.03%, Intel – 1.91%, Microsoft – 1.06%, American Greetings – 0.74%, Occidental Petroleum – 1.79%, Entergy – 0.00%, OneBeacon Insurance Group – 0.44%, Innophos Holdings – 0.27%, Lockheed Martin – 1.03%, Iron Mountain – 1.60%, Coach – 0.98%, Darden Restaurants – 1.55%, and Williams Partners LP – 1.36%.
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.