3rd Quarter 2010 Commentary
Stocks Rally on Prospect of More Fed Easing
The rollercoaster trading pattern that has defined U.S. equity markets throughout much of 2010 continued during the third quarter. Stocks ground their way higher in July following the release of generally better-than-expected earnings results. By early August, however, earnings euphoria had faded and public comments from the Obama administration suggesting that they would not support a temporary extension of the Bush tax cuts for all taxpayers weighed on the market. By the end of August, stocks had ceded nearly the entire July advance.
On August 27, Federal Reserve Chairman Ben Bernanke made a speech at the Kansas City Federal Reserve Symposium in Jackson Hole, WY. In his comments, Chairman Bernanke indicated that the economy was weak and that the Federal Reserve stood ready to take additional action. While investors initially focused on Bernanke's comments about a weak economy, sending the market lower, their focus ultimately shifted to the prospect of additional quantitative easing. Paradoxically, the rally strengthened on weak economic data, as the probability of easing increased following comments by other Fed officials supporting Bernanke. In what has historically been the worst month of the year for equity markets, the S&P 500 Index rallied 8.8%—posting its best September since 1939. The Russell 2000 Index soared 12.5%, easily surpassing its best September on record.
Large-cap stocks marginally outperformed small-caps during the third quarter and growth outperformed value across all market-cap segments, with the margin being most significant among small-caps. While the price performance of dividend-paying stocks was mixed, fundamentals continued to improve. Of the approximately 7,000 publicly owned companies in the U.S., Standard & Poor's reported that 299 increased their dividend payment during the quarter versus 191 in the third quarter of 2009. To date, more than 1,000 companies have increased their dividend rate in 2010 and the number of reductions has declined by 84% to 117. This improvement is especially notable in the face of continued uncertainty around the state of dividend taxation after 2010. Performance of dividend-paying stocks, however, lagged due to significant underperformance in September. The highest yielding companies in the S&P 500 trailed the lowest yielding by 150 basis points.
Twelve of the Fund's holdings increased their dividend payments during the quarter. OneBeacon Insurance Group paid a $2.50 special dividend in addition to its regular payment. Additionally, four holdings announced increases in dividends payable during the fourth quarter 2010, including Microsoft and Cracker Barrel Old Country Store. These latter two firms had not increased their payment since 2008 and we welcome their renewed focus on growing the dividend.
More Positive Energy
The Fund outperformed its Russell 3000 Value Index benchmark during the quarter, and has outgained it by a substantial margin for the year-to-date through the end of September. The sectors with the highest contribution to relative performance during the quarter were Energy and Financials. Both strong stock selection and a significant underweight position aided returns within Financials. The underweight stake proved advantageous as Financials was the worst performing sector in the index. Outperformance among holdings from the insurance industry plus minimal exposure to diversified financial services firms contributed to the stock selection effect.
Within Energy, strong results from Alliance Resource Partners, Seadrill, and BreitBurn Energy Partners drove the Fund's outperformance versus the benchmark. Alliance Resource, a master limited partnership (MLP) primarily focused on producing and marketing coal to major U.S. utilities, reported solid second quarter volume and pricing growth in addition to increasing earnings guidance for 2010. The firm increased its quarterly distribution for the ninth consecutive quarter and noted that future distributions for 2010 will also increase. The strong performance has driven the stock to a significant premium to our assessed Absolute Value and we took the opportunity to reduce the position in the portfolio.
Seadrill is the world's second largest offshore drilling contractor. The company operates a fleet of 41 jack-up rigs, semi-submersibles, and drill ships in shallow, mid, and deepwater areas. The firm's excellent safety record and young fleet position it well against potential adverse legislation resulting from the disastrous Gulf of Mexico spill. This has helped the firm secure contracts at premium day rates and lock up 70% of the fleet's revenue generating capacity for the next 5 years, providing excellent visibility. The board of directors has demonstrated their conviction in the company's prospects by increasing the dividend aggressively, with raises in each of the last three quarters.
Other notable contributors during the quarter included Waste Management, Compania Cervecerias Unidas, and United Parcel Service. Waste Management reported solid earnings and revenue growth as volume declines moderated for the third straight quarter, adding to investor confidence. The firm's industry leadership and well-choreographed strategy continue to yield results for investors, as management targets significant amounts of cash for dividends and share repurchases in 2010. With the Chilean economy are firing on all cylinders the country's largest brewer, Compania Cervecerias Unidas, delivered improved gross and operating margins from lower commodity costs and improved pricing. UPS reported excellent second quarter results and increased guidance with the firm noting improvements across all segments.
Six sectors had a negative total effect on the relative performance of the portfolio during the quarter, with stock selection in the Technology and Materials sectors having the largest negative impact versus the benchmark.
Notable individual underperformers included a slew of banks—BancorpSouth, Bank of Hawaii, and U.S. Bancorp. Mississippi-based BancorpSouth reported disappointing second quarter results as loan problems at the firm continued to increase after having delayed its 2009 annual report filing earlier in the year when auditors questioned the credit quality of some of its loans. The quick resolution of the disagreement with auditors led us to believe the firm was aggressive in identifying and reserving for problem loans. The recent earnings report, however, indicated that either the bank did not have an accurate assessment of its loan problems or credit deterioration in the Southeast, its primary area of operation, is not moderating with the rest of the country. In either case, our conviction in the stock declined and we sold the position.
Bank of Hawaii reported better earnings than a year ago on improving credit performance that exceeded our expectations. Net interest margin declined, however, due to an increased position in low-yield government securities. In addition, the securities portfolio increased to $6.0 billion, and now exceeds the loan book of $5.4 billion. As with other banks, this left investors wondering when the firm will return to loan growth. Until then, management continues to execute well upon those aspects it can control, including growing its market-leading low-cost deposit base, maintaining disciplined underwriting standards with a high quality reserve, and increasing its leading market position in ATMs. For these reasons, we continue to believe that the regional bank is one of the best positioned to benefit when the lending environment improves.
U.S. Bancorp is emerging from the credit crisis larger and stronger thanks to consolidation and a flight to safety. The overhang of financial regulation reform and the specter of an extended period of slow loan growth weighed on both U.S. Bancorp and the banking industry throughout the quarter. The firm was one of the first banks to repay TARP capital, is one of the most profitable banks, and has been outspoken about their intent to raise dividends whenever the regulatory and economic picture become clearer. Although we remain cautious about growth prospects and valuation for banks in general, we believe U.S. Bancorp is well positioned to capitalize on the continued consolidation of the industry and to lead when the economic recovery finally gains steam.
Elsewhere, the departure of CEO Brenda Barnes due to medical reasons combined with rising commodity costs and a difficult environment for consumers contributed to the drop in the stock of Sara Lee during the quarter. On October 4, however, the New York Post reported that the Board rejected a $12 billion offer by KKR to acquire the company. The stock opened that morning up 12% and closed a difficult trading day with a gain over 7%. We remain comfortable with the position as recent news supports our thesis that the divestment plan is unlocking value and because the company continues to reward shareholders with both substantial share repurchases and dividends during the wait.
While we build the Fund using our bottom-up investment process, we remain cognizant of the position of the portfolio relative to the benchmark. Turnover was relatively low and there were only modest changes in the relative positioning during the period. The overweight stake in Consumer Staples decreased slightly primarily as a result of the sale of the position in Brown-Forman, which was trading at a significant premium to our calculated Absolute Value. The underweight to Materials increased with the reduction of the Fund's position in RPM International as it was traded at our Absolute Value.
A total of three new positions were established during the third quarter, the largest of which was Federated Investors. The diversified investment advisor is the third largest domestic manager of money market funds (behind Fidelity and JP Morgan) with an 8.2% share. The firm generates significant amounts of free cash flow and pays an attractive regular dividend that has been raised every year since 1996. The company’s shares have been out of favor due to historically low yields in money market funds, which in certain Federated money market products is not sufficient to cover all of the fund's normal operating expenses. The company should benefit when the Fed finally signals a rise in short-term rates, and was trading at a 30% discount to our assessed Absolute Value at the time of initial purchase.
Where Will the Fed Lead Us?
Our market outlook is currently based upon an assessment of five factors. These factors include valuations, sentiment, monetary policy/credit trends, fiscal policy, and a "wildcard" of other key trends we believe may materially impact stock prices over the following six to 18 months. The time frame of our outlook aligns with our company valuation models, as well as the period we believe any investor can reasonably make assumptions about the future.
As fundamental investors, our approach emphasizes valuations above all else. When stocks are cheap, we get excited. When stocks are expensive, we get worried. Last quarter, we stated that the decline in equities had created more value in stocks, setting the stage for additional upside. Since we made that statement on July 13, small-cap stocks have rallied about 9%. As a result, our discount-to-value indicator for the portfolio has moved from slightly below average to near the high end of its historical 65% to 82% range. Our valuation models currently incorporate only modest expectations for growth and margin expansion in 2011. Unless growth reaccelerates or companies are able to further reduce costs, this signal indicates that value has again become increasingly scarce.
Regarding sentiment, we consider the outlook and economic assessment offered by trusted and insightful CEOs of the companies we follow. We will also consider the sentiment of investors, taking a contrarian approach to the consensus opinion. When investors are ebullient, we are cautious, and vice versa. By mid-October, investors were once again bullish enough to warrant a cautious approach to the market. Additionally, CEOs across a broad range of industries and market caps continue to sound a cautious tone.
Monetary policy is an important variable. Since the end of World War II, the Federal Reserve's monetary policy has made a significant impact on both economic growth and financial bubble formation. Since neither fiscal stimulus nor the previous monetary stimulus was successful in jump-starting a healthy recovery, the Federal Reserve has indicated it would pursue another round of quantitative easing (QE).
Whether you believe the Fed's next round will be effective in stimulating growth probably depends on whether you believe we are in a typical, post-war recession or a period of longer-term structural deleveraging, akin to that of the 1930s. The former camp believes this recession is like most others in the past 50 years, and that by lowering interest rates the Fed will spur credit demand and, ultimately, jump-start a sustainable recovery. The latter believes that lowering rates will do little to stimulate growth. In a period of sustained deleveraging, there is simply less demand for credit by both consumers and businesses. There is also less desire to lend by banks, which have significantly raised their credit standards. The deleveraging camp further believes that any additional stimulus might further devalue the dollar and/or create bad inflation. Bad inflation creates greater liabilities (higher commodity costs such as energy and food), but does not increase assets or income (home prices, income, etc.).
While the ultimate outcome probably lies somewhere in-between, with interest rates near zero and the Fed's efforts thus far having generated little growth, we are leaning toward the structural deleveraging camp. Furthermore, we see a major risk for value equity investors if the Fed inflates demand for stocks without an underlying improvement in the economy. This is the definition of a financial bubble and as most investors today are aware these end very, very badly.
Fiscal policy remains a significant uncertainty and one that will not be fully answered until well after the November elections. Among the "wildcard" factors, we are closely monitoring merger and acquisition (M&A) activity, which at its current heightened level has been bullish for stocks. We expect the broader trend will continue as companies seek to acquire growth and private equity firms seek to invest their abnormally high levels of cash before they are required to return it to their investors. On a more bearish note, we are closely monitoring the trends in housing and employment, which remain negative.
As most of these factors would indicate, we are cautious on the market at these levels. While we cannot say that stocks are over-priced, our measures indicate they are near the high end of our historical valuation range. Given this, if the Fed does induce another risk rally in stocks we would urge investors to stay focused on high quality investments. We further believe the chances of the Fed inducing bad inflation are alarmingly high.
Fortunately, we believe that the relative outlook for the Fund is strong. If our fundamental concerns dictate the path of the market, the conservative nature of the portfolio and the steady stream of income should help to reduce the downside risk. If further Fed intervention pushes the markets higher still, declining interest rates should only increase the demand for alternative sources of income, including dividend-paying stocks. We remain steadfastly focused on high-quality companies that have the ability to increase their dividend payment in a period of anemic 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
18 October 2010
As of September 30, 2010, OneBeacon Insurance comprised 0.87% of the portfolio's assets, Microsoft – 0.99%, Cracker Barrel Old Country Store – 1.81%, Alliance Resource Partners – 1.88%, Seadrill – 1.48%, BreitBurn Energy Partners – 1.88%, Waste Management – 3.16%, Compania Cervecerias Unidas – 1.45%, United Parcel Service – 2.16%, Bank of Hawaii – 1.54%,U.S. Bancorp – 0.55%, Sara Lee – 1.49%, RPM International – 1.00%, and Federated Investors – 0.94%.
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.