4th Quarter 2013 Commentary - ASTON/Cornerstone Large Cap Value Fund
4th Quarter 2013
It was a period of robust returns for U.S. equities during the fourth quarter of 2013, helping the market to post its best calendar year return since 1995. The Fund’s Russell 1000 Value Index benchmark gained 10% during the quarter and 32.5% for the year. The environment for stocks at the close of the period was much the same as it had been following each of the previous three quarters of 2013. Each quarter produced positive market returns despite concerns over the Federal Reserve increasing interest rates, turmoil in the Middle East, and continued gridlock in Washington D.C.
Specific to interest rates, after falling to as low as 1.61% during the spring, the yield on the 10-year US Treasury bond surged past 3% during the fourth quarter, its highest level since mid-2011. The market thrust those concerns aside, driving equities higher. The market was not as kind to other asset classes, however, as bonds, commodities, and gold all delivered negative returns in 2013.
All 10 sectors of the benchmark were in positive territory for the quarter, led by the Industrials, Technology, and Consumer Staples sectors. Utilities and Telecommunications proved to be a drag on overall market performance for the consecutive quarter.
The Fund outperformed its benchmark by a sizeable margin during the quarter, pushing it ahead of the index for the full year. The top contributing sectors for the quarter were Technology, Financials, and Industrials. For the third quarter in a row, the lack of exposure to Telecomm and Utilities aided relative performance.
Western Digital and Google in Technology were the top two performing stocks in the portfolio during the quarter, with Western Digital also the Fund’s top performer for 2013. Strong cash generation and a commitment to return 50% of excess free-cash-flow to investors boosted Western Digital, as did the perception that the global demand for PCs has bottomed. This led investors to reward the stocks of suppliers to PC makers. Google’s continued dominance in search, as well as a mobile opportunity that was once considered a threat, only added to the firm’s strong position. We think YouTube and Android present large growth opportunities for the company in the long-term.
An overweight position and stock selection boosted Industrials, as Norfolk Southern, Parker-Hannifin, and 3M rounded out the portfolio’s top-five performing stocks. Railroad operator Norfolk Southern, a stock added to the portfolio in mid-2013, showed strength in both its Merchandise and Intermodal markets that offset weakness in the domestic coal business. The export coal business also showed a surprising uptick as demand from China for metallurgical coal was stronger than had been anticipated. The management team of Parker-Hannifin has a strong record of adding value for shareholders through mergers and acquisition (M&A), and investors were encouraged to hear from management that the company will continue to focus on attractive opportunities as they arise. In addition, its European business, which is undergoing a restructuring, appears to have bottomed and offered a more promising outlook. Finally, the positive results in Financials owed mainly to stock selection driven by Unum, Capital One Financial, and State Street.
The only sectors that detracted from relative performance during the fourth quarter were Consumer Staples and Materials. Although Wal-Mart delivered positive absolute returns, it underperformed the market as a whole. The lack of exposure to the Materials sector resulted in slight underperformance. Notably, the Fund’s 4.1% cash position was the biggest overall detractor given the strong overall market performance.
Among individual positions Bed, Bath & Beyond, Cummins, and tech giants EMC and IBM were the biggest laggards during the quarter. Bed, Bath & Beyond underperformed following its significant outperformance since it was added to the portfolio during the second quarter of 2013. Investors focused on BBBY’s strategy of using increased couponing, which in the short-term affects gross margins negatively. In addition, the company continued to make incremental investments in e-Commerce/IT initiatives that drove up near-term costs.
Cummins was the major detractor in the Industrial sector following its strong performance during the third quarter when it was the portfolio’s top performing stock. The company reported disappointing third quarter results and lowered overall guidance for 2013. Specifically, the company cited weaker results within their Power Generation segment in both India and Europe.
The global network storage sector has been notably weak the last five quarters, affecting EMC, as investors wondered if it is facing structural headwinds or whether growth will return as the economy and IT budgets improve. The market remains concerned about top-line growth at IBM even though the company continues to produce strong earnings reports. The IBM Roadmap—its goal of achieving $20 in earnings per share by 2015—appears to be achievable, though investors seem worried about the quality of recent earnings reports.
Two Buys/Two Sells
Aside from normal additions and trims to current positions, we added two new names to the portfolio (Baxter International and The Gap) during the quarter, and exited two others (State Street and Stryker) in keeping with our concentrated approach of holding just 30 stocks. Baxter is a $40 billion global, diversified healthcare company and a market leader in hemophilia and plasma derivatives. With its strong position in high-margin chronic care treatments and hospital core medical solutions, we think Baxter can enjoy fundamental tailwinds and improving margins going forward. The stock has been under pressure with the upcoming launch of a competitor’s longer-acting hemophilia treatment, but our valuation work suggests to us that these concerns are reflected in its current stock price.
Apparel retailer Gap operates under multiple brands, including The Gap, Old Navy, Banana Republic, Piperlime and Athleta. Years of same store sales and revenue declines have many questioning the firm’s relevance in a highly competitive space. The valuation opportunity seemed to reflect this view. Indeed, the stock had flat-lined for many years. In reality, the company has grown earnings steadily over the past several years, hired new management (including a chief designer from H&M), and implemented a strategy to return the company to its core competency. This combination of actual fundamental improvement and recent price declines has created an opportunity where seemingly little weight has been given to any successful reinvigoration of top-line revenue growth.
We sold State Street from the Fund following strong price performance. The stock was up more than 40% for the year, and considerably higher than the original purchase price back in the fourth quarter of 2012. The strong price performance made the stock less compelling from a risk/reward standpoint as it ranked close to the median of our investable universe. Stryker also rose significantly since our initial purchase for the Fund in August 2012. This weakened the valuation case for the name, allowing for better opportunities in the portfolio.
Despite the strong market returns the past two years, we continue to see attractive values in the market as equities within our universe are currently trading at 88% of fair value using normalized earnings. As we’ve stated before, we think fundamentals will determine value in this environment. Now, more than ever, is the time to focus on companies with strong and improving fundamentals that trade at attractive valuations.
This is an environment in which active management should step to the forefront. Our investment focus continues to be based on valuation. Within the 800 stock universe from which we select candidates for investment, 351 stocks remain undervalued in our estimation. Rising share prices and interest rates have lowered the level of discount from where it was a year ago, but attractive opportunities still present themselves among U.S. large-caps. Having fewer than one-half of the market trading below our estimate of fair value suggests that stock-picking, or active management, will be at even more of a premium in 2014 than it was in 2013. We look forward to the year ahead and welcome the challenges that it will bring. We thank you for the confidence that you have shown in us, and wish you all a happy and prosperous New Year!
Cornerstone Investment Partners
As of December 31, 2013, Western Digital comprised 3.71% of the portfolio’s assets, Google – 3.55%, Norfolk Southern – 3.21%, Parker-Hannifin – 3.52%, 3M – 3.37%, Unum – 3.02%, Capital One Financial – 3.34%, State Street – 0.00%, Wal-Mart – 3.58%, Bed, Bath & Beyond – 3.41%, Cummins – 3.48%, EMC – 2.29%, IBM – 2.23%, Baxter International – 2.47%, and The Gap – 1.95%.
Note: Value investing often involves buying the stocks of companies that are currently out of favor that 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.