4th Quarter 2013 Commentary - ASTON/Herndon Large Cap Value
4th Quarter 2013
The Fund underperformed its Russell 1000 Value Index benchmark in 2013, despite a strong second half recovery. Although frustrating, in most years the absolute return generated by the portfolio would have resulted in cheers not jeers. After a rough first six months to the year, on the heels of a challenging 2012, questioners could have wondered if we had lost our way. Had something changed, was something awry? The answer was a resounding, “No.” We invest for tomorrow every day. We simply had hit a rough patch, one somewhat longer that we typically have experienced. But we are encouraged by the Fund’s rebound during the second half of 2013, as it returned to outperforming its benchmark.
For the full year, the performance of the benchmark was quite broad, with six sectors outperforming—Technology, Consumer Discretionary, Industrials, Healthcare, Financials, and Consumer Staples. With the absence of more commodity-oriented and cyclical sectors such as Energy and Materials from that mix, it appears that the market has begun to believe again that the economy has turned the corner and growth is returning.
Stock selection contributed 100% of the Fund’s underperformance and sector allocation was slightly positive. Holdings within the Consumer Discretionary, Materials, and Industrials sectors delivered the lowest level of contribution to performance. TJX Companies was the only Consumer Discretionary holding able to outperform the benchmark sector. Simply put, we were out of step with some holdings, such as Coach and Yum Brands, which had a very contrarian performance experience. Southern Copper and Cliffs Natural Resources were the primary detractors in Materials on the back of a lack of confidence in China-related infrastructure spending. Cliffs Natural Resources was the Fund’s worst performer for the second consecutive year. Continued weakness in the iron ore market due to overcapacity for the current level of demand has made it challenging to return to previous levels of profitability. While we still like the long-term fundamentals of a company producing key infrastructure building and maintenance materials, our process dictated that we exit the position from the portfolio.
Industrials suffered on similar concerns to Materials, as mining equipment companies such as Joy Global and Caterpillar showed weakness in 2013. We continue to think that owning such firms over the full market cycle will prove a benefit, especially if the recent upturn in economic growth continues.
Despite significant underweight positions in Healthcare and Financials, and limited exposure to Utilities, these three areas provided the most positive contribution to relative returns during the year. Transformational catalysts revealed via acquisitions and drug approvals, respectively, for Endo Health Solutions and United Therapeutics boosted results in Healthcare. Asset manager Waddell & Reed nearly doubled, while options exchange CBOE Holdings rose sharply. In the case of Utilities, sometimes what you don’t own can be as important as what you own. The Fund had no exposure in this sector until the latter part of the year, as Utilities battled Telecom as the worst performing sector for the year. Telecom was actually the portfolio’s fourth highest contributor, with no exposure whatsoever.
Fourth Quarter Review
The Fund delivered strong relative and absolute returns during the fourth quarter, as six out of 10 sectors outperformed their respective sector and/or the overall benchmark. Sector allocation and stock selection were both positive, with the overwhelming amount of outperformance coming from stock selection. The quarter saw the return of a pro-cyclical growth tilt as all but one (Consumer Staples) of the five top performing sectors—Industrials, Technology, Consumer Staples, Consumer Discretionary, and Materials—typically fit that profile. The portfolio was overweight each of these sectors.
Healthcare, Energy, and Technology were the three top performing areas for the fund. Three out of four stocks outperformed in the underweight Healthcare sector, led by the previously mentioned Endo Health Solutions and United Therapeutics. Endo was much maligned by the market due to generic competition and was the portfolio’s third worst performer in 2012. Our patience and persistence was rewarded as the company made acquisitions that are transforming its long-term growth trajectory. Refiners led Energy to solid gains with Marathon Petroleum and HollyFrontier rising strongly, while frequently doubted and questioned tech stalwarts Western Digital, Apple, and Microsoft shined during the period as well.
Western Digital continued to surprise on the upside as it makes the transition from being viewed as a commodity component maker in the technology area to one that has value-added products in the transitioning world of cloud computing. Although the doubling of the stock validated our strategy, we still see promise as the cyclicality typically associated with the hard-disk drive maker is muted by its now more-diversified platform of offerings.
Holdings in Consumer Staples, Consumer Discretionary, and Industrials contributed the least to relative performance during the quarter. Our Consumer Staples picks were a bit out-of-sync as the market continued to embrace domestic oriented exposure. Only Altria, a purely domestic holding, outperformed for the portfolio in the sector. Our expectation is that as global growth eclipses the growth gaining traction in the U.S., multinational staples will perform better.
Among individual detractors were real estate investment trusts (REITs) American Capital Agency and Apartment Investment and Management, which suffered guilt by association as the REIT sub-sector of Financials continued to struggle. We discriminately see value in these stocks, in contrast to the bulk of REITs. We view the concerns regarding tapering as overblown, and still see the stocks as value creating opportunities.
Throughout the year, the Fund was overweight Energy, Consumer Staples, Consumer Discretionary, Materials, and Technology. We were most significantly underweight the aforementioned Financials and Healthcare along with negligible exposure to Utilities that was not initiated until the latter half of the year.
Stocks eliminated during the fourth quarter to sector adjustments and/or valuation/fundamental issues were Mastercard, Federated Investors, and Copa Holdings. These changes were primarily driven by the dynamic interrelationships of the sectors as we position the portfolio to exploit value creating opportunities. As we share regarding our investment philosophy, “We have a core process but no core holdings.” Stocks taking their place included Kellogg, AES, Oasis Petroleum, and SM Energy. Each stock was purchased after first being identified as a value creating opportunity followed up with fundamental analysis to vet out the potential as a portfolio holding.
The result of this and related activity during the quarter was increased exposure to Energy, Consumer Staples, Utilities, and Consumer Discretionary, and decreased holdings in Industrials, Healthcare, and Financials. All other sectors essentially remained outside of market appreciation or depreciation.
First Quarter Outlook
Entitlement reform. Talk about a flashpoint issue in Washington, DC politics. One side wants to provide for the continuation at a certain level of support. The other side says we cannot afford to continue to do so. Who is right? Time will tell.
In investing, there is another type of entitlement reform taking place. It is the constant reevaluation of the proper price for individual stocks in the market. As conditions change, the proper price should change as well. For some investors, certain stocks and sectors have reached a state that makes entitlement a proper title to be accorded to them. For example, in spite of lagging returns, increased regulation, and more moderate business platforms, some investors still compare pre-2008 valuations to current valuations for Financials. We cry foul.
Coaching youth basketball for my youngest son, foul is the word I hear most often at his games. Sometimes, I agree (when it is in our team’s favor). Other times, I disagree (when the referee clearly has it wrong).
For the largest sector in the Fund’s benchmark, one dominated by diversified financials and banks, I cry foul when the fundamentals clearly do not support current valuations and investors simply replay the same old valuation tape. As some investors hearken for the good ole days, we gauge the portfolio’s weighting and exposure based off the current situation. We are underweight Financials.
Financials is just one example of how we enact our own entitlement reform and try to wisely allocate capital to the sectors most undervalued and most deserving. Our entitlement reform has further positioned the portfolio with overweight stakes in Energy, Materials, Technology, Consumer Staples and Consumer Discretionary.
This positioning continues to be skewed towards an economy that we think will strengthen, with rising inflation and increasing interest rates. We see the Federal Reserve tapering at a measured pace as the economy allows; but, the pace will likely quicken. While some investors fear negative stock results as a consequence of the tapering, we think that being positioned in undervalued stocks provides a measure of protection that makes us confident of the portfolio’s sector allocations and individual stock positions.
Will 2014 mimic 2013? I don’t know. The question we constantly seek to answer in the affirmative is, “Is the portfolio populated with value creating opportunities?” The answer is an unequivocal yes. There is always value in the market. Our quest, objective, and reason for being is to find it.
Randell A. Cain, CFA
Principal and Portfolio Manager
Herndon Capital Management
As of December 31, 2013, TJX Companies comprised 3.14% of the portfolio's assets, Coach – 1.78%, Yum Brands – 1.89%, Southern Copper – 0.38%, Cliff Natural Resources – 0.00%, Joy Global – 2.41%, Caterpillar - 0.23%, Endo Health Solutions – 0.68%, United Therapeutics – 2.74%, Waddell & Reed – 2.73%, CBOE Holdings – 2.77%, Marathon Petroleum – 2.95%, HollyFrontier – 2.18%, Western Digital – 3.52%, Apple – 2.81%, Microsoft – 2.20%, Altria – 2.28%, American Capital Agency – 1.10%, Apartment Investment and Management – 1.74%, Kellogg – 1.80%, AES – 0.95%, Oasis Petroleum – 0.97%, and SM Energy – 0.90%.
Note: Value investing involves buying the stocks of companies that are currently out of favor and may decline further.
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.