4th Quarter 2013 Commentary - ASTON/River Road Dividend All Cap Value II Fund
4th Quarter 2013
The Great Unwind Has Finally Begun!
In what could prove a watershed moment for the current monetary cycle, on December 18, the Federal Reserve finally initiated a “taper” of its quantitative easing (QE) program, announcing a $10 billion reduction in monthly bond purchases. Although consensus expectations were for an initial cut coming in the first quarter of 2014, an unexpected breakthrough in Washington, D.C., combined with a flurry of constructive economic news, cleared the path for earlier action. For the first time in years, the U.S. Congress managed to pass a budget, signaling an end to the cycle of fiscal brinkmanship that had previously led Senator Schumer to declare the Federal Reserve, “the only game in town.”
The economy demonstrated positive momentum during the fourth quarter as both consumer confidence and spending finally returned to pre-crisis levels, with employment reports showing steady, albeit slow, improvement. In perhaps the most important test of the strength of the recovery, the federal government shutdown proved largely a non-event outside of the Beltway. The market keyed off this strength and grinded higher throughout the last two months of the quarter. In the end, the 32.4% return for the broad market S&P 500 Index for 2013 was its best return since 1997.
The tone for the fourth quarter earnings season remains subdued, however. Corporate profit projections have largely failed to reflect the more positive economic reports. Throughout 2013, analysts had to dial back earnings growth expectations, with the fourth quarter being no exception. Simultaneously, expected revenue growth has declined to a paltry 0.3%—not exactly the robust growth one would expect in prompting the Federal Reserve to reverse course.
High beta (volatility) stocks outperformed during the fourth quarter, but low quality and value strategies led for 2013. Indeed, multiple value factors including low price/sales, forward earnings yield, high free cash flow/enterprise value, and low price/book value dominated the list of top indicators for the year. The worst performing factor for both the fourth quarter and full year was dividend yield. Large-growth stocks led the way during the fourth quarter, but small-caps dominated overall in 2013.
After a great start to 2013, dividend stocks soured as interest rates climbed. Yield hungry investors bid up dividend stocks during the first four months of the year, unfortunately pushing valuations for high yielding stocks to increasingly problematic levels. High yield stocks reversed in early May as interest rates started to climb, but it was not until May 22, when Fed Chairman Bernanke hinted that a reduction in QE was on the table, that the fever broke. Dividend stocks suffered as interest rate expectations shifted rapidly during the early summer months. They continued to lag as both the stock market and broader interest rates advanced in the second half of the year. In the end, the astonishing headwind of 2012 was repeated in 2013, as the lowest yielding companies in the S&P 500 sharply outperformed the highest yielding, especially during the fourth quarter. The Fund underperformed its Russell 3000 Value Index benchmark during the quarter, but only marginally trailed for the full year. Given that it was another tough year for dividend strategies, the 2013 performance was a significant improvement on 2012.
Fourth Quarter Review
Stock selection in the Energy and Consumer Discretionary sectors had the biggest negative impact. Although five of the 10 holdings in Consumer Discretionary delivered positive relative results, one of the worst performers in the broader portfolio came from this group. None of the Fund’s five Energy holdings outperformed either the broader sector or the benchmark during the quarter.
The largest negative contributor was Western Union, a global provider of money transfer and payment services. The company reported excellent results in October, with transaction growth accelerating and margins expanding sequentially. Management announced that compliance and regulatory costs were expected to rise, however, likely causing operating profit to be flat in 2014 compared to 2013. Although disappointed at the news, we note that the increased compliance costs will raise the industry’s barriers to entry. We think price cuts instituted earlier in the year are helping to stimulate growth.
Restaurant chain and branded food producer Bob Evans Farms was another negative contributor during the period. The company reported weak restaurant traffic trends due to its Farm Fresh remodeling program and faced cost pressure in the packaged food business. Management continues to pursue cost rationalization initiatives that should improve profitability, and remains committed to returning cash to shareholders through share repurchases and a growing dividend. The stock was a top performer for the Fund during the third quarter and was largely in line with the benchmark for the year. We took advantage of the decline in price to increase the size of this high conviction position.
Offshore oil and gas drilling services firm Ensco and pipeline/processing master limited partnership (MLP) Williams Partners LP were among the notable detractors within Energy. We initiated a position in Ensco in November after the company increased its dividend by 50%. The stock rallied on this news, but shares limped along for the rest of the year after the announcement of the retirement of CEO Dan Rabun and an adverse fleet status report. With the integration of the Pride International acquisition complete and significant progress made on the renovation of Ensco’s fleet, we believe that Rabun’s retirement well timed, allowing for an adequate transition. The December fleet status report conveyed negative news on two ultra-deepwater rigs that we believe is short term. The position was established early in the fourth quarter and was promptly moved up to its initial target weight only to trade modestly lower as the market advanced in December.
All 10 sectors in the portfolio delivered positive absolute returns during the quarter. Sector allocation provided a significant contribution to relative returns as weightings in the portfolio aided results in nine of the 10 sectors, with overweight stakes in Industrials and Consumer Staples providing the biggest boosts.
The top-three individual contributors were Corning, Norfolk Southern, and Intel. Corning is the leading designer and manufacturer of glass found in LCD displays, with more than a 50% market share. In late October, the firm announced the acquisition of the remaining 50% of Samsung Corning Precision JV, along with a 10-year supply agreement with partner Samsung. The transaction allows Corning to expand its operations in Asia without additional capital expenditures. The deal materially increased our assessed Absolute Value as we had conservatively valued Samsung Corning at book value.
Railroad operator Norfolk Southern reported solid third quarter results as higher merchandise and intermodal traffic more than offset weakness in coal. The company was able to control costs and efficiently manage its network resulting in noticeable operating margin expansion. The stock was one of the portfolio’s worst performers in 2012, but has rebounded 69% off its November 2012 low, handily outperforming the S&P 500. We trimmed the position twice during the quarter as it rose to a significant premium relative to our calculated Absolute Value.
After several quarters of woeful PC shipments Intel’s PC Client Group posted a moderate volume decline as part of third quarter results that surpassed both Wall Street and our expectations. Although Emerging Market demand remained sluggish, management noted early signs of improvement in the U.S. and Western Europe. Finally, while guidance was far from robust, it also came in ahead of expectations. Given the attractive discount to value and yield, we increased the position during the quarter.
We established four new positions in the portfolio during the quarter, and eliminated four. There were few significant changes to the relative positioning of the portfolio overall, however. Continuing the trend from the third quarter, the most notable change in the relative positioning occurred in the Healthcare, where we increased the Fund’s already sizeable underweight position relative to the benchmark. At less than 3% of assets, the sector was the smallest weighting in the portfolio as of year-end. Consistent with our sell discipline, we eliminated the remaining positions in Pfizer, Johnson & Johnson, and Medtronic after each traded at a significant premium to our assessed Absolute Value. The Fund’s stake in Energy increased, but remained underweight the benchmark, with the addition of Ensco and Memorial Production Partners LP to the portfolio.
During the year, we established 12 new positions and eliminated 17, contributing to a portfolio turnover rate of 32%. Given the persistent need to address valuations during 2013, it was no surprise that the number of holdings in the portfolio moved lower. Although changes were modest quarter-to-quarter, our bottom-up process did lead to some significant changes in the relative positioning versus 12 months ago, most notably in Healthcare, Consumer Discretionary, and Energy.
Thoughts on Performance in 2013
The reason for the underperformance of dividend stocks in 2013 was quite different than 2012, and we believe this played an important role in the Fund’s more successful result in 2013. In 2012, a high beta rally propelled by central bank action in both the U.S. and Europe left defensive, dividend-oriented stocks in the dust. This past year, the culprits were rising interest rates and valuation concerns. There was little we could have done within the constraints of our investment process to outperform in 2012, but we anticipated and prepared for the dual pressures we faced in 2013.
As investors clamored for alternative sources of income in the low yield environment, valuation and interest rate risks became intertwined. In an effort to maximize yield, income-focused investors bid up high yielding stocks, creating valuation concerns and increasing their interest rate sensitivity. As such, trimming overvalued positions in the portfolio often reduced interest rate risk as well. We often found new, attractively valued opportunities among lower yielding (2% to 3%) companies even though the Fund’s yield steadily declined as we refused to stretch for income. As long as valuations remained attractive, our high conviction was reflected in increased position sizes, despite the lower yield, as interest rate expectations shifted higher.
The result was a bottom-up approach with a significant top-down impact. According to Ned Davis Research, in both 2012 and 2013 the lowest yielding stocks in the S&P 500 outperformed the highest by more than 20 percentage points! In 2013, however, the highest yielding stocks (first quartile) underperformed substantially as interest rates increased, but the impact was much less pronounced for lower yielding companies (second quartile), which had come to represent a much larger part of the portfolio. As we would expect, the highest yielding stocks bore the brunt of the interest rate increase, while lower yielding stocks performed generally in line with the broader market. In that light, the benefits of the earlier shift toward lower yielding stocks is evident.
Focusing on valuations also reduced the effect of rising rates on the Fund’s higher yield holdings. The portfolio was less affected by the prevailing rise in interest rates, an outcome we credit to our bottom-up, value-driven investment discipline and the ability to be selective with the investments we make in this group. These results confirm our assertion that, all else being equal, high yield stocks should underperform as interest rates climb, but if they are cheap the impact can be significantly reduced. In the end, our value discipline resulted in fewer investments among higher yielding stocks the last couple of years, but it also prevented the group from significantly detracting from overall results.
As we look ahead to 2014, we expect that the gradual rise in long-term interest rates that began in 2013 will continue. The Federal Reserve appears to be committed to the path of reduced bond purchases as long as the economy does not reverse course. The key for dividend-focused investors is that overvalued, high yielding stocks will likely continue to struggle during this process. That said, we look forward to the opportunities this should create. As rates move higher, we suspect that individual investment opportunities among the highest yielding stocks will present themselves, and the Fund’s overall yield will begin to climb.
Yet, further multiple expansion may prove difficult in 2014. Consistent with the later stages of a market cycle, earnings growth was anemic in 2013 and much of the sharp advance was fueled by multiple expansion. Multiples could move higher in 2014, but that looks increasingly unlikely in the face of weak earnings growth and rising interest rates. As long as long-term rates remain relatively stable and earnings growth remains positive, markets will likely advance, but if either condition fails, a downside scenario is probable. To that end, we suspect the Federal Reserve will be closely monitoring long-term rates as they reduce the pace of bond purchases and will move quickly to dampen any strong upward momentum.
Valuations also remain a concern, especially among smaller positions. The discount-to-Absolute Value of the top-20 holdings in the Fund was 91% at the end of the quarter, but more troubling is the rising discount-to-value among the other holdings in the portfolio, which stood at 99% at the end of the year. Our ongoing efforts to maintain an attractive discount among our largest, highest conviction positions have been largely successful, but in the period to come, we will likely need to increase focus on reducing and eliminating overvalued stocks among smaller positions.
Overall, we were pleased with the portfolio’s results given the shift in interest rate expectations and the ongoing underperformance of high dividend stocks. We have long noted that such a period would present a challenge for the Fund, but we think the consistent application of our Absolute Value investment philosophy has resulted in a portfolio that had weathered the period relatively well and appears appropriately positioned for the months to come. Although we suspect that the number of positions in the portfolio could decline further, the underperformance of high yield stocks has already begun to create more opportunities, and we could see this pick up further if rates continue to climb in 2014.
River Road Asset Management
As of December 31, 2013, Western Union comprised 1.93% of the portfolio's assets, Bob Evans Farms – 1.13%, Ensco – 1.51%, Williams Partners LP – 1.92%, Corning – 2.14%, Norfolk Southern – 1.61%, Intel – 3.00%, and Memorial Production Partners – 1.03%.
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.