2nd Quarter 2010 Commentary
Following generally solid earnings results and stock price performance in April, the market hit a rough patch in May as global investors became increasingly worried about the possibility of a sovereign debt default in Greece. This concern spread to other weaker European countries –Spain, Portugal, Ireland and Italy—ultimately culminating in a significant support package by the European Union (EU) and the International Monetary Fund (IMF) to stave off a default. Concerns about the viability of the EU and significant weakness in the Euro relative to other currencies was a consequence of these events, adding to pressure on global markets through the end of the quarter. Additionally, slightly weaker data points out of China and the US pointed to the potential for slowing economic growth moving forward, further pressuring stocks across the board.
With all of the uncertainty in the market, frankly, we would have expected to see more of a rotation towards higher quality companies—which have been virtually ignored by investors for the past five quarters. Instead, the correlation between stocks and sectors was astoundingly high. According to work done by Goldman Sachs evaluating the S&P 500 Index since 2000, the average sector correlation was .88 by the end of June and for stocks was .62—both sitting at or close to all time highs for the last decade. Empirical Research Partners has looked a bit farther back at the correlations of large-cap stocks and found that since 1926, only 3% of quarters have experienced a greater degree of correlation than the quarter just finished. Valuations among the highest quality names continue to look incredibly attractive to us and while we don't know when the market is going to turn its focus toward them, we believe that over time a disciplined quality focus should result in positive results.
Weakness in Financials and Energy
The Fund generated negative absolute performance and modestly underperformed its Russell 1000 Value Index benchmark during the second quarter. Stock selection in Financials, Energy, and Healthcare were the primary detractors from returns. Shares of Goldman Sachs traded lower amid disclosure by the SEC in mid-April that it had filed a civil lawsuit against the company alleging fraud with regards to one of its synthetic CDO (Collateralized Debt Obligation) transactions marketed just before the financial crisis. The stock was also adversely affected by the uncertainty surrounding the Financial Services Reform Act being debated in Congress—particularly the proposed language requiring banks to fully separate all derivatives activities from the bank. Revenue pressures from the low absolute level of interest rates and concerns regarding price competitiveness in its core custody business led to lackluster quarterly growth at Bank of New York Mellon, causing it to underperform the market. The relatively large size of the position within the portfolio exacerbated its underperformance on results.
Oil companies Hess and Total SA detracted from returns within the Energy sector. Hess declined despite management reporting first-quarter profits that beat analyst estimates. The company more than doubled its crude oil production in the US over the same period a year ago while crude prices rebounded significantly from their lowest quarterly average in more than five years. These results were overwhelmed by concerns that the economic recovery may be more tenuous than previous thought and the disastrous BP oil spill, which weighed on the shares of energy stocks. Sluggish production growth, below average sensitivity to commodity prices and the strengthening of the US Dollar relative to the Euro pressured the shares of Total.
Elsewhere, weaker than expected forward guidance due to tougher comparisons in its upcoming quarters (versus previous quarters) and headwinds from the strengthening dollar pressured shares of medical device maker Medtronic during the quarter. Despite reporting solid quarterly results, Northrop Grumman took a breather, underperforming the market after performing quite strongly during the first three months of the year.
On the positive side, stock selection in Materials and Consumer Discretionary aided relative returns. 3M reported first-quarter earnings that exceeded analysts' estimates and increased its earnings guidance for the rest of 2010 as organic sales growth remained strong across a number of its divisions and margins came in at higher than expected. Retail and leisure stocks, in particular, contributed to relative returns among consumer stocks. Shares of toymaker Hasbro substantially outperformed the market as investors were optimistic that the company's movie tie-ins would benefit its financial results and spur demand for products. Finally, Public Service Enterprise Group traded higher, significantly outperforming the index.
Each year at this time, Russell Investments rebalances its style indices. This year, there were a number of changes that had a fairly substantial impact on relative positions in several sectors within the portfolio. Although we do not make changes to the portfolio as a result of benchmark rebalancing, we are cognizant of their impact on the risk profile of the portfolio. The biggest change in the Russell 1000 Value was its significant drop in exposure to Energy (roughly 700 basis points) and increase in Healthcare (nearly 500 basis points). The weighting in Consumer Staples also increased by nearly 400 basis points, with large increases in consumer products, food & beverage companies, and to a lesser-extent tobacco. Finally, the addition of Berkshire Hathaway to the benchmark is entirely responsible for the increase in Financials by more than 200 basis points.
In regards to the portfolio itself, we decreased its exposure to Financials during the quarter. The combination of the sector's poor performance and the Fund's underperformance within the sector largely accounted for much of the decreased exposure from last quarter. We modestly trimmed back exposure to several long-standing holdings to better reflect their current risk/reward profile compared to other opportunities in the sector. In addition, the on-going legislative debate of the Financial Services Reform bill did create a substantial amount of volatility which we took advantage of opportunistically. The most significant absolute change was the Fund's decreased exposure to the Energy sector through the trimming or elimination of a few holdings in favor of more attractive alternatives. Other changes included decreased exposure to retail names for more compelling ideas in other sectors, a modest increase to the Fund's Utility exposure, and most notably, the Fund took advantage of interesting valuation opportunities within the large-cap technology space.
Looking ahead, we remain much more optimistic regarding the prospects of the companies owned within the portfolio than we do about a dramatic rebound in global economic activity in the year ahead. We are not making bets on the direction and magnitude of the global economies moving forward, as we are confident in having found a collection of incredibly high-quality businesses with strong balance sheets, great free cash-flow generation, that we think are making wise decisions with the capital at their disposal. None of which is factored into their current valuations, and all of which should position them to help create long-term value for investors. We are compelled to continue upgrading the quality of the companies owned within our portfolio given the opportunity to do so at increasingly attractive valuations. Regardless of what happens in the second half of 2010 or 2011—economically, financially, etc.—we believe that the portfolio is well-positioned for the coming quarters and years ahead.
MFS Investment Management
As of June 30, 2010, Goldman Sachs comprised 3.12% of the portfolio's assets, Bank of New York Mellon – 3.49%, Hess – 1.62%, Total – 1.00%, Medtronic – 1.71%, Northrop Grumman – 2.47%, 3M – 1.40%, Hasbro – 1.31%, and Public Service Enterprise Group – 1.26%.
Note: Value investing often involves buying the stocks of companies that are currently out of favor that may decline further.
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.