3rd Quarter 2010 Commentary
Strong Gains Amid Strong Correlations
Despite continued uncertainties regarding the pace of economic recovery in the US and elsewhere global markets staged a strong recovery during the third quarter, delivering double-digit gains. The high degree of correlation among sectors and stocks that we noted during the second quarter continued in earnest, muting the effect of stock selection in the portfolio. In fact, Barclay's has decomposed the market's correlation over time and noted that the portion of stock returns currently explainable by stock specific factors is approximately zero and has only been lower in two other periods since 1950.
We're feeling a bit of déjà vu when hearing arguments that stock selection and active management can no longer add value for clients. It seems eerily similar to the late 1990s when the discussion of the day was that the "old economy" and its traditional valuation metrics were dead. Well, we know how that one ended. As investors saw from 2000 to 2002, valuation did indeed matter—as it always has. We believe that bottom-up stock selection and active management will also show its value over the coming years as well, particularly when looking at the degree of dislocation we're seeing in the market for high quality companies today.
Several quarters ago we mentioned that we thought it was quite interesting that the dividend yield of AT&T was higher than its 10-yr corporate bond yield—certainly not an occurrence seen on a regular basis. Looking at the Fund's portfolio today, there are a number of companies in addition to AT&T whose current dividend yield is greater than their corporate bond yields, and a handful of others that are very close. Owning shares in these companies and clipping the dividend along the way with potential for growth on top of that seems like a pretty interesting investment opportunity, in our opinion. Additionally, other companies we own have been taking advantage of the increased demand for high quality corporate bonds to come to the market and refinance their debt or access new capital at increasingly attractive rates.
Materials Stand Out
The Fund outperformed its Russell 1000 Value Index benchmark during the quarter. The primary positive drivers were an overweight to the Materials sector, underweight to relatively lackluster Financials, and stock selection within Consumer Staples, Energy, and Technology. In Materials, paint and coatings manufacturer PPG Industries pre-announced that the second quarter would be better-than-expected and then delivered actual results that bested its pre-announced range with strength across all of its businesses. The belief that Air Products & Chemicals, the world's largest supplier of hydrogen and helium, would be successful in acquiring rival Air Gas at a price lower than expected coupled with news that another competitor would be raising prices drove that stock higher.
Within Consumer Staples, Philip Morris International's strong second quarter results fueled by solid price increases that more than offset volume declines within developed markets, led to solid gains. The firm's relatively high exposure to Emerging Markets and lack of exposure to the US were both positives as increased concerns about the pace of future economic growth in the US took center stage during the period. After performing poorly last quarter, energy firm National Oilwell Varco's good quarterly results showed an improved order profile that highlighted its attractive valuation. In addition, the acquisition of BW Offshore's Advanced Production and Loading subsidiary –which we believe will help the company move more into the production side of the market—provided a boost.
Technology firm Oracle rebounded sharply from its underperformance during the second quarter on strong quarterly results, both in revenues and margins, and the announcement that it had hired former Hewlett-Packard CEO Mark Hurd to be its new President following his abrupt resignation from Hewlett Packard. Mr. Hurd is widely expected to be a strong contributor to Oracle, particularly with respect to the firm's integration of recent acquisition Sun Microsystems.
The main detractors from performance during the quarter included stock selection within Industrials and Healthcare, as well as underweight positions in Telecommunications and Utilities as the market rotated toward higher-yielding securities. Increasing concerns about the prospects for defense budget cuts negatively affecting Lockheed Martin in the Industrial space, as future revenue and margin prospects pressured the stock. Medical-device maker Medtronic delivered weaker-than-expected results, especially in firm's cardiovascular business which took investors by surprise, causing the stock to significantly underperform the market.
Among the weakest individual performers were MetLife and Prudential Financial. Following strong relative performance last quarter, MetLife took a breather as it came to market to raise equity capital to fund its pending acquisition of AIG's international insurance operations after reporting solid second quarter results. Increased speculation that Prudential Financial would purchase AIG's Japanese insurance businesses (a transaction which was ultimately announced on the last day of the quarter) dampened its share price despite reporting solid second quarter results.
Outlook and Positioning
The biggest change in the portfolio during the quarter was the decreased exposure to retail stocks. The reduced exposure is mostly a function of the strong performance of a few holdings that pushed up valuations and made them less attractive to hold. Conversely, the Fund's exposure to Technology and Healthcare increased. Poor performance within the medical device segment, particularly for the cardiovascular focused names, provided an opportunity to add to existing positions in high quality businesses at even cheaper valuations.
Looking ahead, we remain much more optimistic regarding the prospects of the portfolio than we do about a dramatic rebound in global economic activity in the coming year. We are not making investments based on the direction and magnitude of global economies, however, but have found a collection of what we believe are high quality businesses. These holdings have strong balance sheets, great free cash flow generation, and we think they are intelligently allocating the capital at their disposal—none of which appears factored into their current valuations and all of which should position them to create long-term value for investors.
We feel compelled to continue upgrading the quality of the companies owned within the portfolio given the opportunity to do so at increasingly attractive valuations. As of September 30, 2010, the 3-year average Return on Equity (ROE) of the portfolio stood well above that of the Fund's Russell 1000 Value benchmark, while its price/earnings ratio stood at a discount. Regardless of what happens economically and/or financially in the remaining quarter of 2010 and into 2011, we believe that the portfolio is well-positioned going forward.
MFS Investment Management
As of September 30, 2010, AT&T comprised 3.28% of the portfolio's assets, PPG Industries – 1.83%, Air Products & Chemicals – 1.24%, Philip Morris International – 4.21%, National Oilwell Varco – 1.36%, Oracle – 2.53%, Hewlett-Packard – 0.35%, Lockheed Martin – 3.47%, Medtronic – 1.79%, MetLife – 2.40%, and Prudential Financial – 2.00%.
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.