1st Quarter 2011 Commentary
The Fund outperformed the index during the first quarter of 2011. Stock selection and sector allocation were both positive with stock selection contributing roughly 74% of the outperformance and sector allocation 26%. Seven of 10 sectors in the portfolio bested their respective sector and/or the overall benchmark during the period.
Performance for the Fund’s Russell 1000 Value Index benchmark was fairly narrow, with only four sectors—Energy, Industrials, Consumer Discretionary, and Materials—outperforming the overall index. A more cyclical tilt was clearly evident in the market's direction during the quarter. Economic statistics continue to improve, which has given the market reason to embrace sectors and stocks with more economic sensitivity.
The three sectors in the portfolio with the highest contribution to performance for the quarter were Financials, Energy, and Healthcare. This fairly eclectic mix demonstrates how our approach to bottom-up investing runs contrary to a more top-down approaches trying to chase broader trends. The Fund’s position in Financials more than doubled the benchmark’s sector returns, despite a significant underweight, as a concentration on asset managers benefitted from the market’s upward momentum. Holdings in Energy were fairly diversified and rose along with commodity prices as unrest in the Middle East moved to center stage. Marathon Oil and Exxon Mobil were two of the top-three individual contributors to returns. Within Healthcare, an emphasis on specialty pharmaceuticals that are finding creative ways of navigating the dreaded patent expiration cliff helped as investors reassess the sector’s prospects. In addition, medical-device manufacturer Kinetic Concepts was among the top performers.
Areas with the lowest level of contribution were Industrials, Consumer Discretionary, and Telecom. The portfolio’s Industrial holdings lacked the cyclical leverage that made the sector the second best performer in the Russell 1000 Value. As a result, the sector generated a modest decline with one stock in particular, Copa Holdings, negatively affected by higher energy prices. Consumer Discretionary performed relatively well with the exception of Coach which declined owing to its 20% revenue exposure to Japan. We have a great deal of sympathy for those affected by the disaster that has struck Japan. Despite this event, we are still confident in the long-term prospects for Coach. The Fund’s one holding in Telecom, Windstream, does not have the transformative business prospects of Verizon and AT&T, yet we believe that the firm is quite competitive in their rural niche areas providing telecom services.
As of the end of the first quarter, the Fund was overweight Energy, Consumer Staples, Materials, Technology, and Healthcare. It remains significantly underweight Financials, Industrials, Utilities, and Telecom. The sector over- and under-weights should not be taken as a signal of a certain perspective on the market. Our investment philosophy simply dictates that our prized value creating opportunities, derived from our bottom-up analytical work, are currently most pronounced in those sectors that are overweight, and lacking in those that are underweight.
Positions were initiated in Strayer Education, Gilead Sciences, and Annaly Capital Management to increase exposure in the Consumer Discretionary, Health Care, and Finance sectors, respectively. Each stock was purchased after first being identified as a value creating opportunity and rigorously vetted by fundamental analysis for their potential as a portfolio holding.
Stocks eliminated due to sector adjustments and/or valuation or fundamental issues were Patterson-UTI, Murphy Oil, Conoco Phillips, and Hansen Natural. The first three holdings were Energy companies, with the last coming from Consumer Staples. Energy holdings in the portfolio have been rapidly approaching our upside potential targets, hastened we believe by the rise in the commodity prices associated with the unrest in the Middle East. In addition, Murphy Oil was sold due to fundamental concerns.
The result of this and related activity during the quarter was that the Fund increased its exposure to Healthcare, Financials, Consumer Discretionary, and Industrials. Exposure was decreased in Energy and Materials. All other sectors essentially remained the same with the exception of market appreciation or depreciation.
We are moving towards another proverbial wall of worry scenario. It appears that a historic movement of revolution and reform is underway in the Middle East. The violence and unrest has clearly become a point of interest for the world as a rather crude form of democracy appears to be spreading. The result has been concern over precious oil reserves that the world depends upon.
Japan has had a disaster of historic proportions with the ramifications and consequences still unclear. It is expected that the resiliency and ingenuity of the people along with the support of world-wide relationships will find them victorious over the situation. The question is how and when. Economic growth is still tepid within developed markets across the globe, and these exogenous shocks to the economic system are hindering rejuvenation even though they have not completely derailed the progress.
Domestically, the run for President of the United States has just begun. President Obama has launched his campaign against a field of Republican competitors. Will the changing tides of economics and stock market performance result in a second term? We will see.
Are there things to think about? Yes. Are there things to worry about? Yes. Are there always things to think and worry about? Yes. So, is this time really different? No.
Problems and issues are always lurking around the economy and equity markets. When we see them face to face, we are frequently more concerned with them than what the passing of time suggest they warrant. In these uncertain times, which I posit are more the reality and the norm than many might suggest, we also see some rays of hope.
Fundamentals are definitely improving. Unemployment is moving down. Interest-rates, viewed as a sign of better fundamentals and associated potential inflation, are moving up. The stock market after an initial decline has risen quite significantly since President Obama was inaugurated on January 20, 2009.
We do have a concern as to whether the stock market has risen too far too fast and possibly has eclipsed the level of fundamental improvement. If the prospects in the future justify it, the market has been correct. But, we do not know if that will be the case. Instead of hoping and guessing, we seek value creating opportunities at the individual stock level, which also drive the portfolio’s sector allocations. By doing so, we tend to find ourselves moving contrary to the market’s enthusiasm, as well as its pessimism.
Would we be surprised to see the market pull back? No. Are we predicting it will? No. But, we think that the current environment of optimism should give investors a reason to step back and reassess.
Our process has led to a portfolio overweight in Energy, Consumer Staples, Materials, Technology, and Healthcare. Similarly, we have lowered its exposure to some of the areas that have been recent darlings of the market, such as Energy and Materials, while increasing exposure to other areas mentioned above. We cannot predict whether these recent changes will result in immediate outperformance. We can confidently share that we believe we are moving in the right direction long-term, even if we may be out of step with the market in the short run.
Randell A. Cain, CFA
Principal and Portfolio Manager
Herndon Capital Management
April 4, 2011
As of March 31, 2011, Marathon Oil comprised 2.38% of the portfolio's assets, Exxon Mobil – 3.69%, Kinetic Concepts – 2.92%, Copa Holdings – 2.63%, Coach – 2.44%, Windstream – 1.53%, Strayer Education – 0.80%, Gilead Sciences – 1.08%, and Annaly Capital Management – 1.90%.
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.