2nd Quarter 2010 Commentary
Exogenous shocks to the economic and ecological system overwhelmed markets in different ways during the second quarter, surpassing previous concerns regarding the sustainability of fundamentals to justify the continued rise in the stock market.
In Europe, the Greek debt crisis heightened investor worries about the credit worthiness of some nations, with possible spillover effects into Spain and Portugal. Fiscal austerity has become the call of the day as developed countries appear to be getting collective religion on years of uncontrolled spending without the requisite resources to meet future payments. China has given indications that it will let its currency rise in an effort to control economic growth that could spiral into inflation. The combination of the two has given pause to thoughts of unfettered growth in that part of the world. Domestically, the United States is dealing with sputtering (read as tepid but still positive) economic growth combined with a potentially unparalleled natural disaster due to the BP oil spill in the Gulf of Mexico.
Thus, the backdrop of "Happy Days Are Here Again" has been replaced by frequently occurring discussions of double-dip recession possibilities. Instead of getting more clarity, the waters have gotten quite murky in terms of investor rationale for enthusiasm with current investment opportunities. The wall of worry has steepened.
But, just as a map and compass are necessary for you to know where you are and where you are going, so does a sound investment process help you to navigate a difficult investment environment. Navigation does not imply smooth sailing but should keep you directionally correct.
Quarterly Review and Positioning
The Fund underperformed its Russell 1000 Value Index benchmark by slightly less than a percentage point for the quarter. Stock selection was negative while sector allocation was positive. Positive performance within the benchmark was fairly narrow, with only three out of 10 sectors outperforming—Telecom, Utilities, and Consumer Staples. It should be noted that the three outperforming sectors only accounted for an average collective sector weight of 15.9% of the benchmark. Of these three sectors, the Fund is currently only overweight Consumer Staples. Thus, it was a very challenging quarter to outperform with more than three-quarters of the benchmark underperforming.
Other overweight sectors within the portfolio are Energy, Materials, Health Care, and Technology. Yes, Technology. Technology has become a sector that our process indicates has an increasing percentage of value creating opportunities, leading us to incorporate opportunities from the sector into the portfolio at a higher rate. As a result, we have added to the Fund's position in Microsoft and initiated a position in IBM.
In terms of specific attribution, negative contributions to performance came from the Materials, Utilities, Technology, Health Care, Industrials, and Telecom sectors. Individual holdings that detracted from performance the most were Copa Holdings, Kinetic Concepts, Cliffs Natural Resources, and Freeport-McMoran. Top positive individual stock contributors were Sunoco, TJX Companies, Assurant, and Renaissance Re Holdings.
Stocks eliminated due to sector adjustments and/or valuation or fundamental issues were Frontier Oil, Aeropostale, Stancorp Financial, Apache, and Energen. Positions initiated were CF Industries, McDermott, Frontier Communications, UGI Corporation, and Goldman Sachs. Each stock was purchased after first being identified as a value creating opportunity followed by fundamental analysis to vet out its potential as a portfolio holding. The result of this and related activity during the quarter was that the Fund increased its exposure to Energy, Technology, and Industrials. We decreased exposure to Consumer Discretionary and Financials. All other sectors remained the same taking into account market appreciation or depreciation.
What is going to happen? Things are bad and only going to get worse. Things are good and will only get better. If we could only pin our surety on one or the other, then our decision would be simple. If it were the former, then we could return investor assets as they move their asset allocation to 100% cash. Why? Earning nothing is better than losing everything. If it were the latter, we can get the band back together to play the remix of "Happy Days Are Here Again."
Regardless of the emotional pendulum that swings to extremes and the sensationalized news reports that increase the anxiety levels of market participants, we think that reality exists somewhere in between. The market is not going to hell in a handbasket and trees still do not grow to the sky. Instead, investment opportunities are created in the extremes. Too much enthusiasm is likely a good reason to sell and too much pessimism is usually a fairly good indicator to buy. The issue is how do you know?
While we cannot be certain, we try to sway the odds of probability in our favor by trying to objectively measure a company's prospects regardless of the current environment. The Fund's holdings are not fly-by-night operators. Most, if not all, are market leaders in their respective industries with solid long-term growth prospects supported by prudent capital structures. When the stock market prices them as anything other than that, we have to evaluate. Superman only exists in fantasy. Thus, no company has the power of invulnerability. Similar to kryptonite's impact on Superman, economic cycles expose companies' weaknesses, though that does not necessarily lead to certain death. So, when some companies are talked about as core holdings, the pressure to support inflated valuations usually proves too much and unfounded.
Conversely, as in the children’s book, "Leo the Lion", Leo eventually found his roar which always existed but was not timely. We believe that many companies are already roaring but the market is not paying attention. Why are they ignored? In most cases, it's because these companies have not been anointed as the chosen few. Instead of seeking the too big to fail, in our opinion, it is better to seek companies that are too good to ignore at current valuations.
Amid this turbulent environment, we think this is the right type of approach. Champions are crowned after they win, not before. Defending champions who lose are still called champions, but their championships exist in a bygone era. We seek those companies that will be crowned champions due to a combination of attractive fundamentals and less than equally enamored prices. Instead of simply owning former champions because of what they did, we think it is more profitable to seek those which have bright prospects to do good things as firms and great things as stocks.
The wall of worry is steep. We think that the best way to climb it is with companies that are structured for the long-haul even if they are priced for a short life due to negative market perception. We will continue this process of seeking out these value creating opportunities as we move onward through the quarter and the year.
Randell A. Cain, CFA
July 7, 2010
As of June 30, 2010, Microsoft comprised 1.69% of the portfolio's assets, IBM – 2.04%, Copa Holdings – 2.97%, Kinetic Concepts – 2.64%, Cliffs Natural Resources – 1.26%, Freeport-McMoran – 1.66%, Sunoco – 2.52%, TJX Companies – 3.61%, Assurant – 2.58%, Renaissance Re Holdings – 2.23%, CF Industries – 1.79%, McDermott – 0.97%, Frontier Communications – 0.96%, UGI Corporation – 2.09%, and Goldman Sachs – 1.03%.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.