2nd Quarter 2013
The Federal Reserve began to rein in the party during the second quarter of 2013, with the movement in the U.S. Treasury market among the most notable events. If the Fed’s intent was to use a series of speeches by its various representatives to inject uncertainty into the markets in May, it certainly succeeded. The yield on the 10-year U.S. Treasury bond rose from 1.67% at the end of April to 2.52% at the end of June.
Whether the Fed was trying to prepare the market for eventual tightening or was just trying to pop a nascent bubble is a subject of debate, but the immediate impact was clear. Popular bond substitutes, notably real estate investment trust (REITs), came under pressure during the second half of the quarter. The Fed’s June 19 policy statement was widely viewed as “the beginning of the end” for quantitative easing, and suddenly traders, perhaps overextended, began to shift their positions accordingly. As markets declined, Fed officials scrambled to prevent a sharp correction, noting loudly that any “taper” in bond purchases would be preceded by continued economic expansion.
The warning may be welcome, as markets seem to have outpaced corporate earnings. According to FactSet Research, first quarter aggregate earnings for the broad market S&P 500 Index were modestly better than anticipated, but top-line growth was negative due to weakness in the Energy sector. If management guidance is any indicator, the second quarter is unlikely to see significant improvement.
Dividend Stocks Punished
The shift in interest rates adversely affected high-dividend stocks during the quarter. Per Ned Davis Research, the highest yielding stocks (first quartile) in the S&P 500 posted a minor loss in significantly underperforming the rest of the index, while S&P 500 companies without a dividend were the best performers. Due to the spike in interest rates, the percentage of S&P 500 companies with yields in excess of the 10-year Treasury declined sharply to 38%, though that remains well above the long-term average of about 8%.
Investors generally favored risky assets but were more cognizant of value when looking at the performance of various fundamental factors. Low-quality stocks outperformed high-quality stocks, according to Bank of America/Merrill Lynch. Within the S&P 500, high-beta (volatility) stocks significantly outperformed low-beta, and traditionally defensive sectors such as Utilities and Consumer Staples were among the worst performing areas of the market. At the same time, value factors were among the top indicators during the period. If not for the decline in commodity prices and the underperformance of the Materials and Energy sectors, the results would have been reminiscent of a “risk-on” rally from recent years.
The Fund marginally lagged its Russell 3000 Value Index benchmark during the quarter. Performance was much more volatile than the final return would suggest, however, as the portfolio advanced strongly from the end of the first quarter through May 1, then lagged amid the Fed induced turmoil before recovering towards the end of the period. Five sectors had a negative overall impact on relative results, with the most significant coming from an underweight position in Financials. Stock selection was negative in seven of 10 sectors, and slightly negative overall.
The biggest individual detractor during the quarter was record management services company Iron Mountain. After reporting in-line quarterly results, the company released an update on its REIT conversion, explaining that the IRS was “tentatively adverse” to providing a private letter ruling that certain firm assets qualify for REIT purposes. Although the IRS disclosure does not necessarily preclude the possibility of an eventual REIT conversion, it does delay the process and lowers the probability of some of the potential upside associated with the REIT structure. We remain confident in the investment, even without a REIT conversion, as nothing has changed in its core business—which features high switching costs, high margins, and annuity-like cash flow. Company management is committed to its dividend in either scenario.
Telecomm company Telefonica Brasil traded sharply lower due to a sell-off in Brazilian stocks triggered by economic and social concerns, as well as a swift 10% depreciation of the Brazilian Real against the U.S. dollar. We are watching developments in Brazil closely, and hope that actions taken by the government in response to protests there will address concerns about corruption and wasteful spending. We believe that public and private investment in infrastructure is critical to putting Brazil back on a path to sustainable economic growth. We maintained the portfolio’s position given that the company is the market share leader with the highest quality network in the country, but our Absolute Value is under review.
After being a top performer during the first quarter, Walgreen reported results at the end of June that missed expectations, sending its shares lower. Although revenue, same store sales, and gross margin were all higher, investors appeared concerned by weak traffic comparisons that was hurt by competitor promotions, the introduction of cigarettes at several discount retailers, and subpar performance in low-income neighborhoods. Management has since retooled its promotion strategy, utilizing investments in a new Balance Rewards program to drive more directed promotions. We increased the Fund’s position on the weakness, believing that the company’s strategy will lead to steady increases in the dividend and our Absolute Value over time.
Strong Tech Picks
Stock selection in the Technology sector and an underweight stake in Energy were the most significant factors aiding relative returns. Microsoft, Intel, and Western Union were the tech standouts and among the top-five contributors to Fund performance during the quarter. Microsoft announced earnings in April that were slightly ahead of expectations driven by better than expected operating expense control, with strength in the Online Services and the Entertainment & Devices divisions offsetting weak PC demand. Several days later, an activist investment firm disclosed that it had established a $2 billion position in the stock, which still traded at a substantial discount to our assessed Absolute Value. The introduction of Silvermont chips finally makes Intel relevant in the mobile space, and we expect to see the firm make significant inroads in that market in the next 12 to 18 months. We added to Intel for the first time since 2011, once again making it the largest holding in the portfolio.
The Fund’s top performer during the quarter was futures exchange CME Group, powered by growing trading volume and growth in interest-rate futures. CME also saw strong volume growth in foreign exchange and equity index futures. After reaffirming our conviction in the company, we added to the position and maintained it throughout the quarter even as the stock began to trade at a modest premium to our assessed Absolute Value.
Elevated valuations helped to drive 10% portfolio turnover during the quarter and 21% turnover year-to-date through the end of June. The increased turnover also reflects the ongoing evolution of the portfolio’s sizing discipline, as highlighted in our fourth quarter 2012 commentary. Since the beginning of the year, we have tightened this discipline (especially around new positions) and the results have been encouraging. Of the seven positions added, Staples and Western Union were among the top-20 holdings at the end of June. Before tightening our discipline, it is unlikely we would have ramped up our sizing as quickly and captured as much upside from these new, high conviction additions.
Indeed, Staples was the largest new position added during the period. The office products industry faces significant headwinds in several of its core products (paper, ink, printers, etc.) as the use of paper declines. Staples, however, has expanded into several non-traditional office product categories such as facilities and breakroom supplies. The company plans to triple its product assortment on Staples.com, which should help offset declines in paper related products and accelerate the company’s transition from a brick-and-mortar retailer to an online company. It initiated a dividend in fiscal 2005 and has raised it every year except for fiscal 2010. The stock was trading at a 24% discount to our assessed Absolute Value at the time of initial purchase.
On a sector level, changes in the relative positioning of the portfolio were modest. The most significant change occurred in Consumer Discretionary, which increased with the introduction of Staples and additions to Coach, Hasbro, and Kohl’s that more than offset the sales of American Greetings and Regal Entertainment Group. The huge underweight in Financials increased due to the reduction in Sabra Healthcare REIT and the sale of Commerce Bancshares. Both were reduced at significant premiums to our Absolute Value, with the timing of the reduction in Sabra especially fortuitous as we cut the position in half throughout May at prices well above where the stock ended the quarter. The relative underweight in Utilities also increased, primarily from the elimination of UNS Energy. We trimmed UNS substantially in April and May as it traded at a significant premium to our Absolute Value, and sold the remainder at a modest premium in June.
Reports of the Death of Dividends Are Greatly Exaggerated
As interest rates surged and high dividend stocks (particularly REITs) underperformed during the quarter, the media pounced—suggesting that rising interest rates signaled the end of the dividend trade. Although dividend stocks may not outperform to the degree they did during the first four months of 2013, there is little historical support for the contention that they should underperform in a rising rate environment. During the most recent tightening period (2004 to 2007), dividend stocks, as measured by the Dow Jones Select Dividend Index, outperformed the S&P 500 handily. In a recent piece, Ned Davis Research went back to 1977 to examine the performance of dividend stocks in periods where the 10-year Treasury bond was above its long-term trend, but found no support for a bearish scenario. Without a doubt, rising interest rates can be a headwind for some dividend stocks (e.g. REITs, MLPs, and highly-levered firms), but that blanket statement is not true for all. If interest rates are climbing because economic activity is accelerating, it is positive for equity investments, dividend-focused portfolios included.
The lesson here is that valuations matter, even for traditionally defensive stocks. At the end of first quarter, the discount-to-Absolute Value for the top-20 holdings in the portfolio (our guide to the general level of valuations) spiked to 97%, the highest mark we have seen since the inception of the Fund. In our view, as the margin of safety provided by an attractive discount declines, even traditionally defensive investments become less “safe.” As such, we were concerned that dividend stocks would participate more heavily in a near-term correction than history would suggest, and we believe second quarter results demonstrated just that.
The Fund recently marked its eight-year anniversary, and the recently completed quarter is one we will remember, and remark on, for a long time. There is also a chance that it will become identified as the beginning of a new phase in the market. The dividend universe has changed over the years, driven by lower dividend income tax rates and the aging baby boomer cohort. Undoubtedly, as the forces at work change further in the next eight years, dividend strategies will have to continue to evolve to remain relevant.
In the pursuit of our dual investment objective of high current income and long-term capital appreciation, we are fortunate to be armed with two powerful tools. The first is our firm’s Absolute Value philosophy, which serves as a compass pointing toward opportunity and, hopefully, away from problems. The second is the flexibility at the heart of the design of our Dividend All-Cap Value strategy. As the opportunity set expands or contracts in areas, be they small-cap stocks, large-cap stocks, REITs, MLPS, Income Trusts, Technology, Financials, “High Alpha,” “High Yield,” or “Core,” we are free to adapt so that the portfolio continues to thrive. We are continuously seeking to identify how the universe of dividend-stock may evolve over time, but there are likely to be surprises along the way. Fortunately, we sought to design the strategy with sufficient latitude to help us navigate unexpected outcomes.
Overall, we were quite pleased with results of the portfolio during the second quarter, especially given the sudden shift in interest rate expectations. We believe this is “the beginning of the end” of the persistent low interest rate environment that we have experienced since 2009. We have long noted that such a period would present a challenge for the strategy, but the consistent application of our Absolute Value philosophy has resulted in a portfolio that we believe is well positioned for the remainder of 2013.
River Road Asset Management
As of June 30, 2013, Iron Mountain comprised 1.16% of the portfolio's assets, Telefonica Brasil – 1.04%, Walgreen – 2.14%, Microsoft – 1.63%, Intel – 2.37%, Western Union – 1.71%, CME Group – 1.85%, Staples – 1.80%, Coach – 1.11%, Hasbro – 1.95%, Kohl’s – 1.85%, and Sabra Healthcare REIT – 0.79%.
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.