3rd Quarter 2013
Fed Unwilling to Take Away the Punch Bowl Yet
Even as the market surge continued, the Federal Reserve downgraded its assessment of the economy on July 31, a change in tone that went largely unnoticed at the time, but one that would play a larger role in the weeks that followed. Despite this signal, the U.S. market pulled back modestly in August amid concerns about Fed “tapering” and a broadening of the conflict in Syria. U.S. equities traded steadily higher in early September as both of these concerns eased. On September 18, in the defining moment of the quarter, the Federal Reserve defied all expectations when it chose not to tighten. The market traded lower in the remaining weeks of the quarter as investors finally noted the Fed’s concerns about slowing economic growth as political rhetoric about a government shutdown ramped up sharply.
Robust earnings growth remained elusive. According to FactSet Research, aggregate second quarter earnings for the broad market S&P 500 Index were again modestly better than anticipated, but at 2.1% growth there was little to celebrate. The Energy sector remained under pressure as both top- and bottom-line results were significantly negative, while Financials surprised to the upside. Third quarter earnings growth projections for the S&P 500 have declined steadily the last three months, which appears reasonable given the modest growth the previous quarter, mixed economic results, and the negative tone of management guidance.
Small-cap stocks significantly outpaced large-caps during the third quarter, while growth dramatically outperformed value across the board. Looking at the performance of various fundamental factors compiled by Bank of America/Merrill Lynch, investors generally favored growth and momentum at the expense of value. In addition, low quality stocks (as defined by company return-on-equity) modestly outperformed high-quality stocks. Within the S&P 500, low beta (volatility) significantly underperformed, with defensive sectors such as Telecommunications, Utilities, and Consumer Staples the worst performing areas of the index. The worst performing factor during the period was dividend yield.
Strong Picks in Telecom and Utilities
The Fund slightly lagged its Russell 3000 Value Index benchmark during the quarter, keeping roughly in-line with the index for the year-to-date. Despite a surge during the first four months of the year, 2013 has been another difficult year for dividend stocks thus far, albeit for different reasons than 2012. The highest yielding stocks in the S&P 500 (with yields approximately greater than 3%) have underperformed sharply. Dividend-focused strategies, both active and passive, have generally underperformed the broader market and the Russell 3000 Value. In that light, the year-to-date results of the Fund are encouraging.
We think the portfolio’s strong year-to-date performance is a testament to our bottom-up discipline. As valuations dictated, we trimmed or eliminated a number of positions in large, defensive companies and generally replaced them with more cyclical companies trading at attractive discounts. This resulted in increases to already overweight stakes in the Consumer Discretionary and Technology sectors, the two best performing sectors in the benchmark year-to-date. In addition, there was strong contribution from unlikely sources—Utilities and Telecom. These two dividend-focused sectors have been among the worst performers in the benchmark year-to-date, but the portfolio holdings in Utilities actually outperformed the overall benchmark, while holdings in Telecom outperformed its respective benchmark sector by more than 17 percentage points.
Overall, all 10 economic sectors in the portfolio had a positive total return compared with eight in the benchmark. Driven by the positive contributions from seven sectors, overall sector allocation had a significant positive impact on relative results during the quarter. The previously noted stock selection within Telecom, as well as an overweight in Consumer Discretionary were the largest drivers of positive relative results.
Top individual contributors during the quarter included Walgreen, National Fuel Gas, and Vodafone Group. Walgreen recovered quickly following an earnings disappointment in June, which we used as an opportunity to add to this high conviction position. Our confidence was rewarded, and the stock’s strong performance helped drive it to become the largest position in the portfolio. The front-end traffic results that weighed on shares last quarter steadily improved as management retooled its promotion strategy. Meanwhile, the company had made significant progress on cost synergies related to its Alliance Boots partnership, and on October 1 reported strong quarterly results thanks to savings above its target. In July, Walgreen’s Board raised its dividend.
National Fuel Gas is an integrated natural gas utility that grew production more than 50% year-over-year, driving its second consecutive strong quarter and an increase in guidance for the year. The company also announced considerable drilling success within its extensive Marcellus acreage to which investors assigned little to no value. In addition to solid execution, management is considering forming its next pipeline network into a Master Limited Partnership (MLP) that could unlock additional value for shareholders. We increased the Fund’s position in July.
Global telecom firm Vodafone agreed to sell its 45% stake in Verizon Wireless to Verizon, validating our thesis that the company had significant break-up value. The deal value came in at the top of the rumored range, and maximized value for shareholders through a tax-efficient structure. Vodafone plans to distribute 40% of the cash proceeds as a special dividend with the Verizon stock component going directly to shareholders. We raised our Absolute Value to capture the value created by the Verizon Wireless sale and maintained our position as shares continue to trade at a discount.
Stock selection was negative in six of 10 sectors had a negative impact, with picks in the Consumer Discretionary and Technology sectors having the largest adverse effect. Although five of the 10 holdings in Consumer Discretionary outperformed the overall benchmark, only three outperformed the broader sector return.
The biggest detractor during the quarter was Telefonica Brasil, a leading wireless and wireline telecommunications company in Brazil. It was also one of the largest detractors during the second quarter, with its continued poor performance prompting us to exit the position in August. Prior to this quarter, the company’s fundamentals remained sound and we attributed the decline in stock price to depreciation of the Brazilian Real and the decline in the Brazilian stock market overall. Its second quarter earnings report in July, however, was significantly below our expectations due to sharply lower margins blamed on higher smartphone sales and investment in the sluggish wireline business. Synergies from the merger of the wireless and wireline segments have failed to materialize, leading us to lower both our assessed Absolute Value and conviction in the position.
Notable Consumer Discretionary laggards included Staples and Target. In August, Staples reported disappointing second quarter results and management lowered its full year earnings guidance, leading to a sharp drop in the stock price. Strength in Staples’ commercial business was offset by weakness in its retail stores and international business prompted by the ongoing decline in paper-based office products. We believe that Staples can effectively manage the slow decline and focus on more non-traditional office supplies. We are also encouraged that company continued to generate strong free cash flow that it is using to repurchase stock and pay dividends during this transition. Target’s earnings release disappointed analysts as a massive rollout in Canada was less successful than hoped. Despite the setback, our conviction in the company remains high and we used the weakness to increase the portfolio’s position.
Two positions were established and four eliminated during the quarter. Overall, changes in relative positioning were modest, with the most significant change coming in Healthcare. Consistent with our sell discipline, we significantly reduced positions in Johnson & Johnson and Medtronic as both positions were trading at premiums to our assessed Absolute Value and, in the case of Medtronic, the surge in the stock price had taken the yield down to nearly 2%. That further increased the portfolio’s underweight position in the sector relative to the benchmark. The introduction of Rogers Communications offset the sale of Telefonica Brasil in contributing to an increase in the overweight stake in Telecom. Finally, the introduction of Qualcomm and increases to Western Union and Corning boosted the overweight to Technology.
The largest new position added during the quarter was Rogers Communications, a leading Canadian communications and media company that offers wireless, cable, and enterprise services. The company also owns several premier media and entertainment properties including the City network, Sportsnet, and the Toronto Blue Jays Baseball Club. Rogers has raised its dividend payment for eight consecutive years, most recently increasing its payment in February 2013. Using a sum-of-the-parts valuation, we concluded that Rogers was trading at a 23% discount to our assessed Absolute Value and had a 4% yield at the time of initial purchase.
In an industry where scale dominates, Rogers’ market-leading position in both wireless and cable creates a competitive moat. On the wireless side, it has amassed a high-end subscriber base with the best postpaid and smartphone mix among its peers, positioning the firm to reap the profits from increased data usage. Moreover, we think the major Canadian carriers stand to benefit from low wireless penetration rates, extensive infrastructure, and their unique quad-play proposition (mobile phone, home phone, TV, internet). Incumbent carriers saw their stock prices plummet as Verizon Communications entered the market. Our analysis, however, found that while a large non-Canadian carrier like Verizon might have the financial wherewithal, the opportunity to rapidly gain share and earn sufficient returns in Canada was limited. Speculation reached fever pitch but eventually broke after Verizon announced the acquisition of Vodafone’s stake in Verizon Wireless and acknowledged that the opportunity in Canada was limited. Although this string of events supported our investment thesis, increased competition and unfriendly regulation is always a risk for this industry.
There was very little support for a change to our fundamental outlook during the quarter. By all accounts, the U.S. economy continued to lumber along and corporate earnings are doing much the same. Politicians in Washington D.C. are busy bickering, but such polarization is now par for the course. Long-term interest rates moved higher but only modestly. The Federal Reserve’s decision to delay tightening was a surprise, not because of the reasons cited, but because it reversed the guidance that preceded it. Its statement and lack of action simply acknowledged the reality that the pace of job creation failed to accelerate during the summer and there was a volatile combination of budget and debt ceiling battles building in Congress.
Valuations appear fair and we think there is little reason to expect significant multiple expansion.
The current discount-to-Absolute Value of the top-20 holdings in the Fund is at the high end of its normal historic range. The measure declined slightly at the end of the second quarter as cheaper stocks moved into the top-20 and the assessed Absolute Values of our highest conviction positions increased. Although valuations are less of a concern than they were in early May, there is little justification for multiples to push significantly higher given stagnant earnings and economic growth alongside rising long-term interest rates. The possibility of a correction remains, but at this point the catalyst is likely to be external to the market (e.g. debt ceiling debate, the Fed transition, and conflict in the Middle East). As we have stated in the past, as long as the Federal Reserve, European Central Bank, and Bank of Japan are free to inject massive amounts of liquidity into the system, we doubt any correction would be deep or sustained.
Overall, we were quite pleased with the portfolio’s third and year-to-date results, especially given the sudden shift in interest rate expectations and the ongoing underperformance of dividend stocks broadly. 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 has weathered the period well and appears appropriately positioned for the months to come. Looking forward, our focus will likely remain on rationalizing positions trading at premiums to our assessed Absolute Values. Although we expect that the number of positions will continue to decline modestly, another sell-off in defensive, dividend-oriented stocks could quickly create interesting investment opportunities and push the number of holdings higher.
River Road Asset Management
As of September 30, 2013, Walgreen comprised 2.66% of the portfolio's assets, National Fuel Gas – 2.29%, Vodafone Group – 1.75%, Telefonica Brasil – 0.00%, Staples – 1.69%, Target – 2.08%, Johnson & Johnson – 0.37%, Medtronic – 1.27%, Rogers Communications – 2.12%, Verizon Communications – 1.40%, Qualcomm – 1.04%, Western Union – 2.22%, and Corning – 1.86%.
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.