4th Quarter 2010 Commentary
By virtue of the leading sectors in 2010, the market clearly showed an affinity for a cyclical upturn. The four highest returning sectors in the Fund's Russell 1000 Value Index benchmark each gained nearly 25% or more. Real and potential demand on a global basis sparked interest in companies that may key growth at the commercial level. The possibility of complimentary consumer spending helped the Consumer Discretionary sector to be the best performing area in the index, rising 27.5%. Overall, performance within the benchmark was still fairly broad with six sectors—Consumer Discretionary, Energy, Industrials, Materials, Telecom, and Consumer Staples—performing better than the index itself.
The portfolio clearly benefited from superior stock selection in outperforming the benchmark since the Fund's March 31, 2010 inception. We have been able to find value creating opportunities in several sectors at the individual stock level while also having sector weights tilted toward exploiting aggregate opportunities. We have not attempted to select sectors from a macro perspective. Instead, we let the sector weights be determined from our bottom-up work on stocks.
Two holdings that made significant contributions to the Fund's returns since inception were CF Industries, within Materials, and specialty retailer Coach in the Consumer Discretionary sector. Both stocks remain a part of the current portfolio. Computer disk-drive maker Western Digital, contract oil and natural gas driller Diamond Offshore, and Freeport McMoran detracted from performance since inception. Only Western Digital remained in the portfolio as of year-end.
Fourth Quarter Review
The Fund outperformed the Russell 1000 Value in seven out of the benchmark's ten sectors during the fourth quarter, in outperforming the index overall. Stock selection and sector allocation were both positive with stock selection contributing 24% of outperformance and sector allocation 76%. That was unusual in that it was a near reversal of the typical attribution for our strategy, as stock selection generally tops sector allocation. It highlights again, however, the importance of our fundamental work at the security level as part of a carefully constructed sector allocation methodology to overall results. The three lagging sectors in the benchmark during the period were Consumer Discretionary, Industrials, and Consumer Staples.
The three sectors with the highest contribution for the Fund during the quarter were Energy, Financials, and Materials. Financials has been a significant contributor in absolute terms for several quarters, though the portfolio remains underweight the sector. We have predominantly centered on asset managers and specialty insurers since the inception of the Fund, while staying away from regional and commercial banking stocks that dominate the benchmark. We are gradually seeing an evolution of this focus to other financials such as credit card exposure with American Express, student loan exposure with SLM Corporation (formerly Sallie Mae) and less focus on insurers. Asset managers still account for approximately 50% of the exposure in the portfolio, though the Fund now only owns one insurance company, AFLAC, as three were sold as they reached our calculation of fair value during the period. Asset manager Waddell & Reed was among the top-three individual stock contributors during the quarter, along with previously mentioned CF Industries and Coach.
The sectors with the lowest level of contribution were Telecom, Utilities, and Consumer Staples. The commonality among these sectors is that, historically, they represent stability and low volatility in growth as well as returns. As the economy has continued to show signs of strength, investors have begun to gravitate toward areas with more cyclical exposure, leaving these groups behind.
Dean Foods, Avon Products, and Eli Lilly were the three stocks with greatest negative contribution to performance. With the exception of Dean Foods, the Fund continues to maintain a position in each of these securities. Dean Foods was sold due to our lack of confidence in its fundamentals, despite a still attractive upside in terms of valuation. The company has been caught in a quagmire of offering branded products in a highly commoditized area—dairy products. Although the company's premium branded products in competitive areas such as soy milk remain sound, pure dairy fare is being challenged by private labels and consumers trading down due to the economic cycle. We question whether the trading down phenomena is short-term or more secular in nature.
Currently, the Fund is overweight Energy, Consumer Staples, Materials and Technology. With the exception of Consumer Staples, which is traditionally considered a more defensive sector, all of the other sectors tilt more towards cyclical growth. We are not making a stand on the macroeconomic outlook but our process has revealed that collectively the companies in these sectors represent a higher percentage of value creating opportunities than the overall Russell 1000 universe. We are most significantly underweight Financials, Utilities, and Telecom.
In addition to American Express and SLM mentioned above, another new holding added to the portfolio during the quarter was Herbalife. The nutrition and fitness retailer helped to replace part of the exposure from the sale of Dean Foods. As with all of the Fund's holdings, Herbalife was purchased after first being identified as a value creating opportunity followed by a detailed fundamental analysis of its business model.
A new year brings new challenges as well as new opportunities. We have begun to listen to market pundits trumpeting the current environment as a stock-picker's market. From our perspective, we are wondering why that statement is a revelation. As has been the case since the inception of our strategy, we have always focused on the promise of individual stock opportunities aggregated up into a diversified portfolio.
But, is this year different? While the Fund outperformed during the fourth quarter of 2010, we faced a significant headwind with the resurgence of the Financials sector which was the second best performing sector in the benchmark. The portfolio's Financials holdings outperformed the overall Russell 1000 Value but failed to keep pace with the Financial sector returns itself. This torrid performance from the largest sector in the index, which the Fund is underweight by nearly 10 percentage points (our maximum allowable level), caused us to further evaluate our stance on Financials. Was this performance an indication that the world had changed? Perhaps, our way of looking at Financials had become outmoded and insufficient to illuminate value within our investment universe. Or, maybe, we had simply lost our way as managers. A lot of soul-searching was undertaken for a relatively short period of underperformance.
We are not performance chasers but we do have to evaluate ourselves against a benchmark. We focus as much on how we generate upside as much as we do seeking to protect against the downside knowing that complacency and ego are a key part of the foundation of investment failure. Thus, we stepped back and assessed the fundamental environment to see why our process had failed to highlight many of the stocks that had clearly caught the market’s fancy at the end of the year.
In our assessment, we see an economic environment that continues to be on a path of getting better rather than worse. To some degree, less worse has become the new better: Unemployment is still quite high and companies are showing bottom line growth through cost-cutting and efficiency more so than tremendous growth in sales and revenues. Still, the forecast is cloudy at best. Only a skillful juggler could handle the many economic balls in the air to try and direct their portfolio. Alas, we have many skills here at Herndon Capital, but juggling is not a core competency.
Instead of looking outward to a less worse economic environment and trying to position the portfolio accordingly, we look at individual companies to see which ones appear to have temporarily lost the sparkle in investors' eyes yet may still have long-term value relative to their fundamentals. We believe that we have a portfolio of much greater value than today’s assessment by the market, which keeps us from worrying about the quickness of eye and hand coordination necessary to juggle the myriad of information available in the market. Our focus is on finding the value creating opportunities.
As we move through the quarter and the year, we will continue this process of seeking out value creating opportunities for investors. We know they are available and we believe we have assembled a portfolio of them that can yield long-term results more satisfactory than our benchmark, the Russell 1000 Value Index.
In terms of the Financials, we think that the fundamentals are still too poor to justify the valuations. Or, conversely, valuations are still too high to justify the fundamentals. The environment feels eerily similar to the hope without substance that surrounded many Technology stocks prior to and right after the Y2K euphoria. We may be proven wrong, but from our current perspective these stocks collectively do not represent value creating opportunities. Thus, we will have to occasionally lose ground to the benchmark in the near term when we find that the stocks or sectors du jour are unpalatable to our process and therefore, in our determination, unprofitable opportunities for investors over the long run.
Randell A. Cain, CFA
January 6, 2010
As of December 31, 2010, CF Industries comprised 2.68% of the portfolio's assets, Coach – 2.79%, Western Digital – 2.26%, American Express – 2.07%, SLM Corporation – 2.27%, AFLAC – 2.10%, Waddell & Reed – 3.35%, Dean Foods – 0.00%, Avon Products – 1.74%, Eli Lilly – 1.65%, and Herbalife – 0.97%.
Note: Value investing involves buying the stocks of companies that are out of favor or are undervalued. This may adversely affect the Fund's value and return.
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.