1st Quarter 2014
As we anticipated, volatility picked up significantly during the first quarter of 2014, as the Federal Reserve continued to reduce its experimental direct involvement in capital markets. Despite the increased volatility, the broad market represented by the S&P 500 Index managed to post modest gains for the period. Indeed, the S&P 500 finished the quarter within one percent of its all-time high. Market leadership continued to favor many of the more speculative issues and factors that have driven equity market returns for much of the past year.
We have long maintained that as the Federal Reserve unwinds quantitative easing, we are likely to discover unintended consequences throughout the markets. Much of the initial pick up in volatility seemed instigated by turmoil in the currencies of developing markets, which is emerging as perhaps the first visible consequence of tapering. The volatility was further fueled by a disappointing Christmas retail season and the Russian annexation of Crimea. The quarter ended with a meaningful sell-off in price-momentum stocks, though many still outperformed for the full period. We think the volatility in both Emerging Markets and price-momentum issues may prove to be the canary in the coal mine of broader market volatility as the Federal Reserve ends its purchases of bonds.
The Fund posted negative returns during the quarter, significantly lagging its composite 60% S&P 500 Index/40% Barclays US Government Credit Index benchmark. Equity performance was the major detractor during the period, as the portfolio’s sizeable stake in quality intermediate-term Corporate bonds outperformed US Treasuries and most other government fixed-income instruments. Both stock selection and sector allocation hurt returns relative to the S&P 500.
An overweight allocation to Consumer Staples detracted from performance. Staples have historically been viewed as a defensive area of the market, but currency headwinds and other issues in Emerging Markets directly affected many of the stocks in the sector. Although the recent round of Fed quantitative easing bond purchases (QE3) seems to have raised asset prices, it has not done much for the typical consumer. This was evident during the weak Christmas retail season, and continued to affect consumer-oriented companies.
The Fund’s underweight position in similarly struggling Consumer Discretionary helped performance, but was offset by adverse stock selection. Bed, Bath & Beyond fell after the company lowered earnings guidance for 2014. We eliminated the position given its strong relative performance last year and limited catalysts for improving earnings momentum. Ralph Lauren was weak due to cautious guidance provided by the company as a result of higher investments to position the company for international expansion and for standalone Polo stores.
Conversely, good stock selection within Technology was offset by an underweight allocation to the sector.
Stock selection within Industrials also detracted from relative performance. General Electric and United Parcel Service declined after strong performances in 2013, even as the sector delivered slightly positive returns. GE reported earnings in line with expectations but less-than-expected industrial margin improvement, leading us to reduce the position. UPS pre-announced earnings that were below previous guidance. The company was overwhelmed during the holiday season by much stronger-than-expected e-commerce volumes, a shortened holiday season, and bad weather, resulting in higher than expected costs. We view these issues as transitory. Increased online commerce is a positive demand driver for UPS, and we added to the portfolio’s position on the weakness.
An overweight position to Healthcare boosted portfolio returns, aided by solid performances from Biogen IDEC and McKesson. We had increased the Fund’s position in McKesson several times throughout the quarter in anticipation of its successful acquisition of Celesio. The company expects the transaction to be accretive to earnings in the first 12 months, and Celesio greatly broadens McKesson’s distribution network. Biogen has been a strong performer for several quarters, and we reduced the position as it traded close to our estimate of present value.
Among the portfolio’s winning tech picks were Juniper Networks, Google, and eBay. Activist investor Elliott Management disclosed a sizable position in Juniper during the quarter, and that it is actively advocating for meaningful operating and capital return policy changes. We have advocated and fully support these actions and believe the combination of earnings momentum and activist involvement should drive the shares higher. We increased the Fund’s position during the quarter. Conversely, we trimmed Google after its strong run owing to its position size in the portfolio and it being fully valued.
eBay reported earnings that slightly exceeded estimates and revenues in its Marketplace division were ahead of expectations. The company also disclosed that activist investor Carl Icahn had established a position in the company, nominated two people to the board, and proposed that the company spin off its PayPal unit. We think the involvement of a noted activist should refocus the market’s attention on the intrinsic value embedded in the company’s stock price.
Buys and Sells
We established three new positions in the portfolio during the quarter—Union Pacific, Yum Brands, and Walgreen. We believe that railroad operator Union Pacific will benefit from a recovery in agricultural and commodity volumes. Continued pricing discipline and productivity gains should also drive healthy incremental profit margins. Yum Brands operates the Kentucky Fried Chicken, Taco Bell, and Pizza Hut fast-food franchises. We think the company will experience a recovery in China after suffering sales declines due to concerns about the Chinese chicken supply chain last year. In addition, the company should experience margin expansion given its shift in most geographies to a franchise model.
Drugstore chain Walgreen is the largest in the U.S. and one that we think stands to enjoy synergies from a 2012 merger with Alliance Boots that benefits from its 10-year strategic distribution agreement with Amerisource Bergen. Demographics favor cost-effective pharmaceutical treatments, while the company can benefit from ongoing branded drug patent expirations and an incrementally larger insured population under health reform. We reduced the Fund’s position in Amerisource Bergen to fund the Walgreen position, as we see the latter as a better combination of valuation and earnings growth.
Notable additions to current positions included boosts to Mondelez International, Occidental Petroleum, and American Express. Snack food spinoff Mondelez is in the midst of major initiatives to improve margins to help drive earnings growth in the face of Emerging Market weakness and currency headwinds. In addition, the presence of activist investor Nelson Peltz now on the board should help ensure that management remains focused and accountable in achieving its goals. Occidental Petroleum announced several restructuring actions that we think should boost shareholder value. It raised its dividend, reached an agreement to sell its Hugoton field at a favorable multiple, increased its share repurchase program, and announced its intention to separate its assets in California into a separate publicly-traded company. The stock's price was at a meaningful discount to most net asset value (NAV) estimates, as well as our estimate of present value.
We added to American Express several times during the quarter. The company has experienced solid revenue growth, and a reduction in shares outstanding along with good expense management has allowed it to deliver mid-teens earnings growth. Following the company’s analyst meeting we have increased confidence in the firm’s ability to maintain that double-digit earnings growth.
EMC and Philip Morris International were sold from the portfolio. We believe that a cyclical recovery for EMC will be impeded by advances in storage technology, a secular shift to cloud storage, and eventually by architectural re-engineering. Although the firm should remain a strong competitor in data centers and incrementally in the cloud, we see few clear catalysts capable of materially increasing earnings growth or the stock multiple. Emerging Market exposure and currency fluctuations dampened the near-term earnings outlook for Philip Morris.
Noteworthy trims included Pepsi, Coca-Cola, and State Street. We reduced the positions in Pepsi and Coke as with other Staples stocks mentioned due to Emerging Market exposure and currency fluctuations. State Street was a weak performer during the period, and we reduced the position after the company lowered near-term estimates. The downward pressure on estimates was driven by continued low rates affecting net interest revenue, higher legal and regulatory costs, though year-to-date volumes and volatility are running closer to assumptions and are consistent with the low end of management’s revenue growth guidance.
Looking ahead, we think a moderate but synchronized global economic recovery and accommodative Central Bank policies throughout the developed world should support higher equity prices. As mentioned above, however, an increase in market volatility has developed, reflecting fair to full stock valuations, largely euphoric investor sentiment, and the lack of any meaningful correction in quite some time. The increase in volatility is likely to persist with the Federal Reserve reducing QE3 as we think the liquidity added to financial markets has contributed to higher stock prices and reduced investor sensitivity to risk. In fact, given that stock valuations are stretched already, the market may become even more volatile as market forces instead of Central Bank manipulation becomes a greater influence on asset prices.
We expect Treasury yields to drift higher as the Fed reduces its bond purchases, economic growth rebounds from weather-induced weakness and employment improves. The magnitude of the rise should be tempered by relatively moderate economic growth and continued low inflation, however. As corporate balance sheets remain in good shape and investors continue to seek incremental yield in a low interest rate environment, we continue to favor high quality intermediate bonds. We also remain approximately 10% shorter in duration than the benchmark in order to mitigate the negative impact of higher interest rates.
We think that the high-quality growth stocks that we favor are positioned well for a more volatile environment where a correction is long overdue. As the Federal Reserve winds down its bond-buying program, we think it prudent to take profits in issues that become more fully valued or disappoint fundamentally. This would enable us to take advantage of better buying opportunities as share prices adjust to free market forces.
Montag & Caldwell Investment Counsel
As of March 31, 2014, Ralph Lauren comprised 1.25% of the portfolio's assets, General Electric – 1.35%, United Parcel Service – 2.00%, Biogen IDEC – 1.95%, McKesson – 2.13%, Juniper Networks – 1.76%, Google – 2.47%, eBay – 2.04%, Union Pacific – 0.63%, Yum Brands – 0.60%, Walgreen – 1.38%, Amerisource Bergen – 1.16%, Mondelez International – 2.28%, Occidental Petroleum – 2.19%, American Express – 1.85%, Pepsico – 1.30%, Coca-Cola – 1.26%, and State Street – 0.96%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its 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.