4th Quarter 2010 Commentary
Equity markets moved steadily higher at the beginning of the fourth quarter on the expectation of significant Republican gains as the U.S. mid-term elections approached. In the days following the election, the market moved even higher even as a rhetorical battle over tax policy was waged. By December, it was reported that the deadlock had been broken and negotiations to extend the tax cuts had begun. The combination of loose monetary policy by the Federal Reserve Board and the tax cut extensions fueled a further surge in U.S. markets through the end of 2010.
Small-cap stocks outperformed large-caps during the quarter, and growth led value. The small-cap representative Russell 2000 Index outgained the large-cap oriented Russell 1000 Index by more than five percentage points. For the full year 2010, the outperformance of small- and mid-cap stocks was even more dramatic as those groups outperformed large-caps by 10 and nine percentage points respectively. For both the quarter and 2010, growth stocks outperformed value across the market-cap spectrum.
The fundamental landscape for dividend-paying stocks improved substantially as Congress agreed to maintain the current dividend income tax rate until the end of 2012. Standard & Poor's reported that 696 increased their dividend payment during the fourth quarter versus 484 during the last quarter of 2009—a 44% increase. In 2010, 1,792 companies increased their dividend rate and the number of dividend cuts declined 82% to 145. Unfortunately, the highest yielding companies in the S&P 500 Index significantly underperformed the lowest yielding for both the fourth quarter and 2010. Dividend-paying companies did outperform firms that did not pay a dividend in aggregate during the fourth quarter, however.
Return of the Volatility Trade
The high-quality theme that had emerged during the second quarter of 2010, and continued throughout much of the third quarter, faded amid the fourth quarter rally. Cyclical sectors again dominated the returns of the S&P 500 as Consumer Discretionary, Industrials, and Materials significantly outpaced more defensive areas such as Healthcare and Utilities. The dominant performance factor during the quarter, and for much of 2010, was statistical volatility (beta). Low-quality stocks also maintained their leadership position despite sporadic periods of outperformance for high-quality. According to Bank of America/Merrill Lynch, risky strategies including high-beta and small-size again outperformed less risky return-on-equity (ROE), low price-to-cash flow, and dividend-yield strategies.
The Fund lagged its Russell 3000 Value Index benchmark during the fourth quarter, as both sector allocation and stock selection had a negative impact on relative results. Stock selection in the Energy sector and an overweight stake in Consumer Staples were the largest detractors from relative performance. Although each of the portfolio's eight holdings in Energy outperformed the broader benchmark, not one topped the return of the benchmark's Energy sector return. When oil prices rise sharply, as they did during the fourth quarter, we have found that our bias towards firms with hedged production often weighs on short-term results.
The three holdings with the lowest contribution to total return were Clorox, Regal Entertainment Group, and AstraZeneca. Clorox reported disappointing fiscal first quarter 2011 results, including declines in revenue, volume, and earnings per share due to negative results from Venezuela and lower shipping revenue. Although the negative impact from Venezuela was in our forecast, product performance was weaker than we projected. In January the firm warned that second quarter results would be hurt by ongoing softness in U.S. markets. We remain confident in the company's long-term prospects, however, and have been encouraged by a significant dividend increase in May as well as plans to use proceeds from the sale of the firm's auto care business to repurchase a significant amount of the company's own stock.
The Fund initiated a position in theater operator Regal during the quarter as it traded lower on weak movie attendance. In 2010, theater attendance was hurt by a summer line-up that was among the weakest in more than a decade. We believe that concerns about an ever-shortening release window are overdone as it is unlikely to have a significant financial impact on operators within our investment horizon. The company announced and paid a special dividend during the quarter and a year-over-year increase in its regular dividend.
Another new holding in the Fund, pharmaceutical company AstraZeneca, traded lower following its earnings report, as the negative impact of drugs coming off patent more than offset growth from key franchises. In December, AZN received a letter from the FDA requesting additional information on blood thinner Brillinta, effectively delaying the drug's U.S. approval. The drug is already approved in Europe. Although the stock declined following the announcement, the delay in Brillinta is immaterial to the firm's near-term earnings, as the potential multi-billion dollar drug will need years to ramp up. While the company faces a severe patent cliff in the near term, as of 2009 it had 10 drugs that earned more than $1 billion in revenue. It has shown a clear commitment to shareholders through stock repurchases, management compensation, and its dividend, and was trading at a 19% discount to our assessed Absolute Value at the time of purchase.
Four holdings were sold at a premium to their respective Absolute Value price targets during the quarter, 17 holdings increased their dividend payments, and three—Coca-Cola Enterprises, American Eagle Outfitters, and Regal paid special dividends. An underweight stake in Healthcare and stock selection within Utilities were the biggest contributors to relative returns. The portfolio remains significantly underweight the pharmaceutical industry (even after the addition of AstraZeneca), which makes up the majority of the Healthcare sector and returned just 1% during the period. Strong results from National Fuel Gas and UniSource Energy drove the outperformance for the holdings in the Utilities sector.
The three holdings with the highest contribution to total return were Sara Lee, ConocoPhillips, and Genuine Parts. In the past, the value of Sara Lee has been impaired by the firm's conglomerate structure, tax inefficiencies, and the decentralized management of its operating subsidiaries. In October 2009, management announced the sale of its international personal care line to Unilever and pledged to use the proceeds to execute a $1 billion stock buyback plan. The management team noted their intent to continue to divest non-core assets at attractive multiples and return the proceeds to shareholders through share repurchases. Subsequently, Sara Lee announced seven divestitures with only two occurring at valuations below the firm's market multiple. Following these transactions, both private equity and strategic bidders have emerged and we expect a decision by the Board of Directors on the firm's future in the coming months.
Integrated energy company ConocoPhillips merely reported an in-line third quarter—with weaker production results offset by a major improvement in refining results—but the market is taking notice of the firm's restructuring success during the past year. The firm used the proceeds from the sale of non-core assets to reduce debt and repurchase roughly $1.3 billion in stock. The company plans to repurchase more stock and raise its dividend in 2011. Genuine Parts reported strong fiscal third quarter results with an overall increase in sales and improvement in operating margin, in addition to raising its 2010 earnings guidance.
The Fund outperformed the Russell 3000 Index during the year, as both sector allocation and stock selection had a positive effect on the relative returns. The all-cap structure of the portfolio was a key source for both absolute and relative returns in 2010. As noted earlier, small- and mid-cap stocks significantly outperformed large-caps during the period. The higher exposure to smaller companies was important, but the relative performance of the holdings was the bigger driver of results. Holdings in the portfolio outperformed the benchmark in each of the three market-cap tiers.
For the second year in a row, stock selection within Energy was the largest positive contributor to relative performance. This was primarily driven by the strong performance of Seadrill and holdings in a number of Master Limited Partnerships (MLPs). Seadrill is the world's second largest offshore drilling contractor and with recent contract signings has locked up 70% of its revenue generating capacity for the next five years, providing excellent visibility. In October, the firm launched an aggressive new building program to capitalize on lower rig construction costs, long-term deepwater rig demand, and improving opportunities for premium jack-up rigs. They also acquired two ultra-deepwater rigs currently under construction that are scheduled to go into service in 2011. Its Board has demonstrated its conviction in the company's prospects by increasing the dividend aggressively, with raises in each of the last four quarters.
Stock selection in Financials and Consumer Discretionary also contributed significantly to relative results. In addition to the performance of Genuine Parts during the fourth quarter, holdings in the Consumer Discretionary sector outperformed on the strength of restaurant operator Cracker Barrel Old Country Stores throughout the year. Operational improvements, stock repurchases, and an improved balance sheet led us to raise our Absolute Value for the company after each quarter of the calendar year without a change to its multiple. The company also announced a substantial increase to its annual dividend during the month of September.
For the full year 2010, stock selection within Industrials and Materials was the largest detractor from relative returns. The underperformance in the Materials sector was particularly drastic as Nucor led a group of holdings that delivered feeble returns versus their sector peers.
Regional banks BancorpSouth and People's United Financial, plus utility firm Exelon were the three holdings with the lowest contribution to total returns. BancorpSouth announced in February 2010 that it would delay filing its 2009 annual report due to auditor questions about certain asset quality indicators, including the allowance for credit losses. When the bank filed its delayed annual report just two weeks later, the increase in provision expense was modest and seemed to be confined to the bank's real estate acquisition and development portfolio. We incorrectly assumed that the quick agreement with auditors and the relatively modest addition to provision expense indicated that this well-respected bank had been overly optimistic with regards to a small number of loans. When second quarter 2010 results revealed another surprising increase in problem loans, we were left with only two possible conclusions: either the firm's loan portfolio was deteriorating just as other banks in the region were beginning to show some improvement, or the bank did not have a clear understanding of the extent of their problem loans. As either conclusion represented a deterioration of the fundamental story, we immediately liquidated the position.
When the Fund established a position in People's United, we expected the firm's strong capital position would be deployed in a large, accretive acquisition given its excess capital. That failed to materialize in 2010. In May, its Board of Directors signaled their displeasure and replaced the CEO. Since that time the firm has repurchased stock, raised its dividend, and completed the acquisition of two banks with $3.1 billion in assets. This is exactly the outcome we expect to see from this company.
Exelon is a utility services holding company with operations in Northern Illinois and Pennsylvania. We established a position in the portfolio after the stock was nearly cut in half due to falling energy prices, the credit crisis, and negative analyst sentiment. Analysts were concerned about the company's extended and futile hostile takeover battle for NRG Energy. When Exelon's bids eventually fell through, however, the stock failed to rally as expected. After successive quarters of weak results and the firm's failure to raise the dividend, we eliminated the position at a loss during the third quarter.
During the fourth quarter, turnover was relatively low and there were only modest changes in the relative positioning of the Fund. The portfolio's weighting in Energy decreased, primarily the result of the elimination of two of three MLP holdings—Alliance Resource Partners and Encore Energy Partners. Both positions were sold as they traded at a significant premium to our assessed Absolute Value price target. As a result of these sales and the strong performance of the sector, Energy moved from an overweight position at the beginning of the quarter to an underweight by year-end. The Fund's stake in MLPs has reached a historic low as only BreitBurn Energy Partners remained in the portfolio.
Stakes in Financials and Healthcare increased slightly during the quarter. Within Financials, the purchase of Sabra Healthcare REIT and additions to positions in Compass Diversified Holdings and Federated Investors slightly reduced the Fund's still substantial underweight to the sector. We continue to search for opportunities in the sector and to identify compelling opportunities outside of the banking industry. The underweight in Healthcare was also reduced modestly, mainly as a result of the introduction of AstraZeneca.
While most fundamental value managers cringe when asked about their outlook for stocks or the economy, we believe a manager’s outlook can be an important factor driving portfolio positioning. From our perspective, it would be difficult to create a valuation without some opinion regarding the broader business and investment environment, especially in a macro dominated market like the one experienced in 2010. As outlined in our third quarter commentary, our market outlook is typically based upon an assessment of five factors: 1) valuations; 2) monetary policy/credit trends; 3) fiscal policy; 4) CEO and investor sentiment; and 5) a "wildcard" which typically includes a few key trends that we believe may drive stock performance, or impact our valuations, over the next six to 18 months.
Our outlook 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 September rally had diminished the value available in our investment universe. Over the past few months, stocks have continued to rise sharply. The rise was partly offset by increased forward estimates for holdings in the portfolio which, in turn, increased its discount to value. Estimate revisions in the past few months led to an increase in our Absolute Value calculation for 10 of the portfolio's top-20 holdings and a decrease for 4. In the end, the discount to value of the portfolio decreased from 91% of Absolute Value at the end of the third quarter to 92% at the end of the year. This level reflects that stocks are fully valued, but also shows that (at least by our internal indicator) to some extent the strong market performance in the fourth quarter was underpinned by improving fundamentals. In this regard, fourth quarter earnings may be especially important to market performance in the first half of 2011. If we see reduced expectations, the market is likely to suffer.
In his landmark book Winning on Wall Street the legendary Marty Zweig said that, "The major direction of the market is dominated by monetary considerations, primarily Federal Reserve policy and the movement of interest rates." That was true when Marty published the book in 1986 and has never been truer than the past decade, but the Fed's influence may be diminishing. The Fed's mandate is to "promote maximum employment, stable prices, and moderate long-term interest rates." Therefore, as long as prices are stable, the Fed is going to pursue full employment, which most commentators would equate to an unemployment rate of 6%. This means quantitative easing (QE), QE2 and so on, if necessary. Unfortunately for the Fed, neither commodity prices nor bond yields are cooperating. This means the Fed's tools are becoming less effective and perhaps even dangerous. For now, the Fed is fueling the rally, but investors and even the Fed may consider alternative strategies if this trend continues.
From our perspective, the most important development for markets during the fourth quarter was the election and subsequent extension of the Bush tax cuts. Along with the additional tax incentives signed into law by President Obama, investors have finally received the much needed clarity and stimulus required to sustain a recovery. While the cuts do nothing to address the longer-term deficit issue, which will hang over the incoming Congress, it was a big part of the year-end rally.
This tax clarity was particularly important for dividend-focused strategies. Since the fourth quarter of 2007, we have noted the possibility that the tax rate on dividend income would increase sharply at the end of 2010. We recognized the risk that dividend stocks could underperform modestly if capital gains taxes were not increased commensurately. The can has now been kicked down the road, but we fully expect to go through the same exercise again in the second half of 2012. Until then, we look for robust dividend growth to continue as before.
Over the past few months, we have seen signs of improving sentiment among the firms and CEOs that we follow as well. Unfortunately, investor sentiment is flashing a warning sign, as evidenced by the study of the American Association of Individual Investors indicating excessive optimism. We see the same among mutual fund managers, with studies showing very low cash levels.
In the wildcard category, our biggest concern—and what we consider the number one threat to a sustained market recovery in 2011—is rising commodity prices, particularly oil. Many of the Fund's holdings are seeing input prices spike higher, which foretells lower margins for non-branded goods and services. On a positive note, companies are flush with cash and access to capital is easing, which should continue to support robust merger and acquisition activity. The recent European debt issues have had little impact on domestic markets. Although U.S. state and municipal fiscal crises are likely to be a headline, the impact on stocks may not be material if earnings continue to meet expectations. We are concerned about housing and the backlog of foreclosures looming in 2011, but if the economy continues to grow at 3% or more and employment continues to improve, the impact may also be negligible on stocks. As far as employment, we expect the improvement to continue to be painfully slow—just like the recovery in the broader economy.
Regardless of what happens we are pleased with the quality and positioning of the Fund and, thus, the opportunity we believe lies ahead. We remain steadfastly focused on stocks with high and growing dividends, stable growth, attractive valuations, and healthy balance sheets. Despite the market advance, we have been successful in finding value and enhancing the overall portfolio through active positioning. Last year was a period of high equity correlations and high volatility performance. We believe that trend will fade in 2011, creating excellent opportunities for our Absolute Value style of investing.
River Road Asset Management
14 January 2011
As of December 31, 2010, Clorox Insurance comprised 1.87% of the portfolio's assets, Regal Entertainment Group – 0.71%, AstraZeneca – 1.20%, Coca-Cola Enterprises – 0.97%, American Eagle Outfitters – 0.89%, National Fuel Gas – 0.64%, UniSource Energy – 1.35%, Sara Lee – 2.12%, ConocoPhillips – 2.10%, Genuine Parts – 2.06%, Seadrill – 1.62%, Cracker Barrel Old Country Store – 1.82%, Nucor – 1.30%, People's United Financial – 0.91%, BreitBurn Energy Partners – 2.25%, Sabra Healthcare REIT – 0.80%, Compass Diversified Holdings – 0.85%, and Federated Investors – 1.75%.
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.
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.