2nd Quarter 2010 Commentary
The rally that began in early February continued through most of April but promptly reversed course on renewed worries over sovereign debt levels in Southern Europe. The Euro plunged sharply versus the US Dollar as structural issues in the monetary union were exposed. Although the immediate concerns were addressed by the intervention of the European Central Bank, the economic upheaval shook the European political establishment and initiated a broad call for fiscal austerity measures, including reduced government spending and higher taxes. Domestically, the economic picture changed rapidly during the quarter as the modest recovery stalled as unemployment claims remained stubbornly high, consumer confidence continued to weaken, and leading economic indicators took a marked turn for the worse. In the face of this onslaught of negative news, doubts about the pace of the economic recovery in the U.S. surfaced and debates about the likelihood of a "double-dip recession" began.
Investor confidence was dealt a further blow on May 6 when markets experienced one of the largest intra-day price swings on record. In a matter of minutes, some of the largest, most liquid securities on the New York Stock Exchange inexplicably dropped 25% or more. A few stocks briefly traded near zero. Later, investors would learn the extraordinary price action was not the result of a massive program trading error, as many believed, but rather actions related to the largely unregulated world of "high frequency" trading. In the wake of the financial crisis, the Madoff scandal, and other similar events, the Flash Crash was just another striking example of regulators' questionable grasp on rapidly developing technologies and strategies on Wall Street.
Overall, despite better absolute performance during the June decline, large-cap stocks underperformed small-caps during the second quarter. Increased fear and uncertainty led to strong relative results for dividend-paying stocks, however. The highest-yielding companies in the S&P 500 Index outperformed the lowest yielding by more than four percentage points. According to Bank of America/Merrill Lynch Quantitative Strategist Savita Subramanian, Dividend Yield was the best performing strategy among S&P 500 stocks by a wide margin. Standard & Poor's also reported that the number of firms that increased their dividend payment during the second quarter of 2010 was 44% higher than the previous year.
The Fund significantly outperformed its Russell 3000 Value Index benchmark amid an overall declining market during the quarter, outgaining the index in each of market-cap segment (small, mid, and large). Fourteen holdings increased their dividend payments during the period, including BreitBurn Energy Partners, a first quarter purchase by the Fund that re-initiated its dividend after eliminating it in 2009. An overweight stake in the Consumer Staples sector, along with strong stock selection in Financials, Energy, and Consumer Discretionary contributed significantly to the relative outperformance of the portfolio.
In a reversal from the first quarter, an underweight position in diversified financials and stock selection among commercial banks were major drivers of returns within Financials. Bank of Hawaii reported strong first quarter earnings driven by an increase in earning assets and lower non-interest expense. The bank's management team has a strong track record of conservative underwriting and prudent risk management. In recent quarters, the company has focused on increasing liquidity through incremental investment in high-quality, short-duration floating rate securities rather than the loan portfolio.
Within Energy, the continued outperformance of the portfolio's Master Limited Partnerships (MLPs) significantly contributed to returns versus the benchmark. Alliance Resource Partners is an MLP focused on producing coal for U.S. utilities. The firm reported solid first quarter results and increased production guidance for 2010, including an additional million tons of high-margin metallurgical coal. With 97% of 2010 production committed and priced, management had the confidence to increase its quarterly distribution for the eighth consecutive quarter. Its sudden price decline during the Flash Crash on May 6 also gave us an opportunity to increase the position in the Fund by 50% at an attractive discount to our assessed Absolute Value.
Other top individual contributors to performance were beverage company Compania Cervecerias Unidas and global medical research firm Pharmaceutical Product Development. CCU is Chile's largest brewer, its second largest wine producer, and its third largest soft drink producer. The firm controls 85% of the beer market in Chile thanks to its flagship brand Cristal, and is the go-to producer for foreign brands. The firm reported a modest increase in sales and operating margin despite adverse affects on production related to the February earthquake in Chile. By April, beer volume growth resumed and the water and soft drinks division led all categories. Business turned around for Pharmaceutical Product Development following three consecutive quarters of fewer new business wins and increased cancellations. The market welcomed the news and the stock traded sharply higher, providing an exit point to the position at a significant premium to our Absolute Value of $24 a share.
What Didn't Work
Individual stock selection was the main detractor from relative performance, as sector allocation had a minimal impact on the downside. The largest negative contributor during the quarter was specialty paint and protective coatings manufacturer RPM International. Sluggish housing starts and building permits weighed on the stock price, despite it having reported decent growth numbers during the first quarter. In June, the company announced that certain subsidiaries would enter Chapter 11 bankruptcy in order to resolve asbestos liabilities. The move stays RPM from any further liability and saves the company an estimated $50 million of cash flow annually. We reduced our Absolute Value modestly on the news, but we believe this is a positive resolution to the matter for the firm.
The aerospace & defense industry underperformed the broader market on heightened concerns about lower U.S. defense spending, and General Dynamics was no exception. GD has diversified revenue streams and limited project cancellation risk, and its exposure to the business jet market has had a positive impact in recent quarters. Still, on May 4 the Financial Times reported that lending standards for new business jets were tightening and used aircraft inventory was climbing. GD underperformed its peers on this news, despite reporting first quarter sales growth and strong demand for their newest Gulfstream G650 large cabin aircraft. The Fund has taken no action to date, but we are monitoring the position.
United Parcel Service declined as investors began to question the sustainability of the economic recovery. The firm reported strong first quarter results in April, noting increased revenue across all segments. We substantially increased our assessed Absolute Value as we looked for continued improvement into 2011. In addition, we took advantage of the market sell-off to modestly increase the position in the portfolio.
While we build the portfolio using our bottom-up investment process, we remain cognizant of positions relative to the benchmark. During the period, the Russell indices were reconstituted, resulting in significant changes in the relative positioning of the portfolio. The most dramatic change occurred in the Energy sector where the benchmark allocation declined significantly to a weight of 10.3% as the portfolio's weight increased by a couple of percentage points to 11.4% owing to the addition of a new position and increases in two current holdings. As a result, the Fund went from a massive underweight to a slight overweight in Energy, primarily due to the rebalancing of the benchmark.
Conversely, substantial increases in the benchmark weighting led to notable changes in the portfolio's relative weightings in Healthcare and Financials. The Fund's relative underweight in Healthcare more than tripled after the reconstitution. As bottom-up investors, we will revisit the sector to ensure we are not missing value opportunities, but this shift will not force change on its own. The Fund's ongoing underweight stake in Financials also grew larger as we continue to look for opportunities in that area that meet our investment criteria.
Five new positions were established during the second quarter, the largest of which was UK-based wireless giant Vodafone. Interestingly, the firm owns 45% of Verizon Wireless, which we think presents a significant opportunity with three possible outcomes. The most likely scenario is that Verizon Wireless resumes its dividend payments. Vodafone has not received a dividend from its ownership stake since 2005 as its JV partner, Verizon Communications, has blocked dividend payments to pay down the debt from Verizon Wireless' acquisition of Alltel. This could be completed by the end of 2011 and resumed dividend payments could increase Vodafone's free cash. Secondly, Vodafone could sell its stake in Verizon Wireless, though the firm is hesitant to sell and realize substantial capital gains. Lastly, the two controlling partners could pursue a merger. This would greatly expand the international footprint of Verizon and rationalize the ownership structure of Verizon Wireless. Whichever way the situation plays out, we think it likely to be beneficial to Vodafone. In May 2010, Vodafone management announced their intention to grow the annual dividend by at least 7% per annum over the next three fiscal years, and was trading at a 25% discount to our assessed Absolute Value at the time of the Fund's initial purchase.
From the beginning, we believed this recovery would be more modest than was generally expected. Unfortunately, recent results affirmed our nagging concern that it is also quite fragile. In May and June, retail and auto sales decelerated, transports and industrials weakened, employment growth disappeared, and mortgage applications plunged. Although we expected that much like automobile sales after "Cash for Clunkers" the U.S. housing market would suffer after government support programs ended, we did not expect such a fall. The sudden turnaround was both material and surprising, and it is increasingly clear that the "animal spirits" of the U.S. economy have yet to be rekindled. We have noted an unusually high level of uncertainty among our clients, the management teams of the firms we invest in, and small business owners in our community. Considering the massive economic volatility of the last two years this is wholly understandable. The question becomes, what will carry us from here?
It is unlikely that the economy will grow at a robust pace in 2011 in the face of higher taxes, reduced stimulus spending, and continued deleveraging. We expect these headwinds will have an adverse impact on near-term growth and note with some trepidation that it is not difficult to paint a scenario of renewed declines. Even if economic growth rates remain positive, sub-optimal growth is not supportive of rapid job creation or higher wages. Such an outcome will not feel like a recovery to most Americans.
The good news is that the market correction has resulted in more attractive valuations. Even discounting for lower earnings estimates and multiples in 2011, at 82%, our portfolio discount-to-value indicator remains attractively positioned at the mid-point of its historical range. Thus, we think the market has already discounted lower growth for the second half of this year. Both inflation and interest rates remain low and, as long as China stays healthy, deflation remains a minor risk.
The real wildcard is the upcoming elections. While we believe there is no panacea for what ails this country, a fiscally conservative, pro-growth agenda in Washington could have a big impact on investor confidence. From our perspective, a cut in the corporate income tax rate, which remains among the highest in the developed world, and tax credits targeted at meaningful job creation would go a long way towards boosting confidence and spuring economic activity. Thus, IF (note this is a big if) we see positive sentiment after the elections, we believe the market could rally through the end of the year. If we do not see positive sentiment following the elections, given our reduced expectations for 2011, we could experience negative returns.
We believe a slowdown in economic growth supports a strong relative outlook for dividend investing and the Fund's strategy. The high-beta (volatility), low-quality trend appears to have faded. Although short periods of significant risk accumulation may still develop, given the economic backdrop it is unlikely that such an event will persist. In a low-growth environment, dividends could end up providing a significant portion of the expected total return of equity ownership. Our focus will remain on high-quality companies that have the ability to increase their dividend payment in a period of modest economic growth. The overall positioning of the portfolio has been defensive and we do not expect that will change in the coming months.
River Road Asset Management
July 14, 2010
As of June 30, 2010, BreitBurn Energy Partners comprised 1.31% of the portfolio's assets, Bank of Hawaii – 1.83%, Alliance Resource Partners – 1.81%, Compania Cervecerias Unidas – 1.24%, Pharmaceutical Product Development – 0.00%, RPM International – 1.59%, General Dynamics – 0.91%, United Parcel Service – 2.03%, Vodafone Group – 1.03%, and Verizon Communications – 1.04%.
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.
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.