1st Quarter 2011 Commentary
Equity markets showed remarkable resilience during the first quarter of 2011, rallying in the face of sharply rising oil prices and a devastating earthquake and tsunami in Japan. Even the release of weak economic data in early March failed to have a lasting impact on stocks. Small-cap stocks performed especially well, with the Russell 2000 Index gaining nearly 8% versus a little more than 6% for the larger-cap Russell 1000 Index. Style performance was mixed across the market-cap spectrum, with no clear leadership between value and growth stocks among mid- and large-cap stocks.
High dividend stocks continued to lag the broader market. Since the beginning of the year, 117 companies in the S&P 500 Index initiated or raised their dividend by a record $16.6 billion. Financials accounted for 42% of the increase following the completion of another round of stress tests by the Federal Reserve. Despite the year-over-year increase in S&P 500 dividends, however, the highest yielding companies in the index continued to underperform the lowest yielding according to Ned Davis Research. The performance gap has been substantially in favor of the lowest yielders as high-dividend stocks have lagged the broader market since the Federal Reserve announced a second round of quantitative easing in August 2010.
The dominant performance theme for stocks during 2010 was volatility (as measured by beta). Although the outperformance of high-beta stocks is common in the early stages of a market recovery, the current trend is unusually elongated. As discussed in last quarter’s commentary, we believe the primary factor driving this trend is the extraordinary liquidity being provided to markets by the Federal Reserve. As the market looks ahead to the end of the Fed’s latest round of quantitative easing (QE2) in June, however, there are signs that the beta theme is beginning to fade. High-quality stocks regained their leadership position, modestly outperforming low-quality stocks during the first quarter. According to Bank of America/Merrill Lynch, fundamental-driven strategies substantially outperformed as low price/earnings to growth ratio (PEG) and high earnings-yield strategies led more risky high-beta and small-size strategies. Interestingly, the dividend-yield strategy was the worst performing during both the first quarter and the previous six months.
The Fund underperformed its Russell 3000 Value Index benchmark during the first quarter as both sector allocation and stock selection had a negative effect on relative results. The portfolio also underperformed in all three market-capitalization groups. Four of the five lowest contributors to performance were small-cap stocks, resulting in the portfolio’s small-cap holdings lagging its benchmark peers by nearly six percentage points. Although the Fund’s underweight in large-caps and overweight in mid-caps was positive, it was insufficent to offset the negative impact of stock selection in both groups.
Holdings in the Financials and Materials sectors contributed the least to the Fund’s absolute returns, while stock selection within Financials and an overweight position in Consumer Staples were the biggest detractors versus the index. Consumer Staples, largest overweight position in the portfolio, was the worst performing sector in the benchmark due to concerns about rising input costs. The adverse stock selection in Financials was primarily the result of two positions, Compass Diversified Holdings and Sabra Healthcare REIT.
Compass is a trust that acquires and develops middle-market businesses. Its current portfolio of eight companies spans a variety of sectors from medical devices to temporary employment staffing services. The company underperformed following the announcement that CEO Joseph Massoud is temporarily stepping down due to an informal regulatory inquiry unrelated to the company. In conversations, neither Mr. Massoud nor his temporary replacement, Allen Offenberg, would disclose the exact nature of the regulatory matter. Instead, we focused our discussion with Mr. Offenberg on his strategy as the new CEO, and do not expect any impact on Compass’ current portfolio or process for sourcing new deals. Solid fourth quarter revenues and earnings helped confirm our expectations as the firm announced a dividend increase. (Update: On April 12, Compass announced plans to pursue an initial public offering of its Staffmark Holdings subsidiary. We expect this transaction will be positive for the stock as it unlocks value not currently reflected in the market.)
Other notable detractors from performance during the quarter included Cracker Barrel Old Country Store and Microsoft. Restaurant operator Cracker Barrel reported soft second quarter revenues as snow storms in the Southeast negatively affected store traffic. Margins came in slightly lower due to higher food costs, a trend that was anticipated by the market and is expected to continue for the rest of the fiscal year. The company maintained its revenue and earnings guidance for fiscal 2011, however. In anticipation that Wall Street would grow increasingly concerned about the firm’s prospects in the face of rising gasoline and input prices, we substantially reduced the position in the portfolio during the period.
Microsoft drifted lower despite reporting earnings that exceeded consensus estimates in late January. The adverse impact of tablet and smart phone growth on PC shipments remains an overhang. Technology market research firm, Gartner, again lowered its forecast for PC growth in 2011 and 2012, and many Wall Street analysts are forecasting even greater declines. Despite significant effort, Microsoft has yet to gain meaningful market share on either the rapidly growing tablet or smart phone platforms. That said, we think the firm’s dominant position in the PC segment drives a very attractive risk-reward scenario.
Energy Stands Out
Holdings in Energy and Industrials were the biggest contributors to performance on an absolute basis, as they were also the best performing areas of the benchmark. The largest positive contributors to relative performance were from an underweight in Financials and stock selection in Telecommunications. Strong results from Vivo Participacoes, Brazil’s largest wireless company, drove much of the outperformance in the Telecom space.
Of the Fund’s 72 holdings at quarter end, 24 increased their dividend payments during the period. As expected, US Bancorp announced a large dividend increase following the completion of a stress test by the U.S. Federal Reserve. In addition, two holdings—Raytheon and General Dynamics—already announced increases in dividends payable during the second quarter.
Three Energy-related stocks—ConocoPhillips, Chevron, and BreitBurn Energy Partners—stood out on the upside during the quarter. ConocoPhillips completed a $15 billion divestiture plan in 2010 which supported a substantial dividend increase, debt reduction, and a share buyback. In March, management announced plans to increase non-core asset sales in 2011 and return the proceeds to shareholders via additional dividend increases and share repurchases. As oil prices surged and the stock began trading at a significant premium to our calculated Absolute Value, we trimmed the position within the portfolio. Rising oil prices and turmoil in North Africa provided a tailwind for many energy stocks during the period, but Chevron also reported strong international production growth from properties in Brazil, China, Kazakhstan, and Thailand. Unlike with ConocoPhillips, the strong performance did not lead Chevron to trade at a significant premium, and the position remains among the Fund’s top holdings. Master Limited Partnership BreitBurn rose during the quarter after the company reported solid reserve and production growth. Despite the partnership’s conservative hedging policy, rising energy prices also had a positive impact as the hedges employed allow some upside participation.
Elsewhere, shares of HR outsourcing provider Automatic Data Processing reacted positively after reporting strong fiscal second quarter results. Improving employment and marginal increases in business spending led to strong top-line growth and an upbeat outlook. The company also raised its dividend, marking its 36th consecutive annual increase. Railroad company Norfolk Southern capped off an exceptional year by reporting solid results, with revenue increases driven by higher volumes and pricing. In January, the firm announced it had won an exclusive contract for FedEx’s eastern intermodal business. This contract marks the first time in more than 40 years FedEx has regularly employed rail, demonstrating the great strides Norfolk Southern has made in improving the reliability of rail transport. In addition, the firm repurchased stock and raised its dividend during the quarter, and market weakness in February gave us an opportunity to add to the Fund’s position.
Turnover during the quarter was relatively low, with only modest changes in the relative positioning of the portfolio. An overweight position in Consumer Discretionary was reduced noticeably, primarily as a result of the elimination of positions in VF Corp and PetMed Express, and the reduction to holdings in Cracker Barrel and PetSmart. VF was sold at a significant premium to our assessed Absolute Value, while PetMed was eliminated due to accumulated unrealized losses and growing fundamental concerns. PetSmart was trimmed as the firm approached our Absolute Value and the yield became less attractive.
Conversely, the weighting in Telecommunication and Industrials rose during the period. Additions to current positions in Vivo Participacoes, Vodafone, and Atlantic Tele-Network boosted the portfolio from underweight to slightly overweight the sector versus the benchmark.
The purchase of Iron Mountain and additions to current stakes in Norfolk Southern, Lockheed Martin, and Raytheon offset the reduction to Waste Management after that stock reached our Absolute Value, nearly doubling the overweight in Industrials by quarter end.
Data storage firm Iron Mountain was the largest of six new purchases during the quarter. The firm focuses on three core business services: record management services, data protection & recovery, and information destruction. Approximately 95% of the Fortune 1000 uses the firm’s services, with customers typically adding more storage boxes than they destroy over time in creating internal recurring revenue growth at minimal incremental costs. As the business has matured, revenue growth prospects have declined to approximately that of the overall economy, but strong operating leverage and ample free cash-flow can drive attractive results provided capital is allocated properly. In February 2010, the Board initiated a dividend, and followed it up by announcing a huge dividend hike in December. The stock was trading at a 12% discount to our assessed Absolute Value at the time of initial purchase.
Subsequent to establishing the Fund’s initial position, activist hedge fund Elliott Associates launched a public proxy battle with Iron Mountain’s management. Their stated goal is to unlock value by reducing the capital allocated toward poor performing segments and converting the firm into a REIT. One of Iron Mountain’s largest shareholders, Davis Advisors, has publically supported the effort. We carefully compared Elliott’s proposal against our own analysis and concluded that there is a strong likelihood that certain aspects of the plan would be enacted and create value for shareholders. Other aspects, such as the REIT conversion, offer substantial upside but appear less likely at this juncture. We made positive adjustments to our estimates and our calculated Absolute Value increased by nearly 17%.
During the first quarter of 2011, equity markets continued to advance even in the face of sharply higher oil prices and a devastating natural disaster. We have seen the operating environment for many of the portfolio’s companies continue to improve over the past six months. Thanks to healthy balance sheets, easy credit, and a host of fresh tax incentives, there has been a rebound in capital spending, especially in areas focused on improving productivity and reducing labor costs. Our calculated discount-to-value for the portfolio continues to reflect that stocks are fully valued, but also supports the conclusion that the market performance during the period generally reflects the improving fundamentals. In such an environment, earnings will be a primary focus as any moderation in expected growth is likely to prompt a corresponding correction.
But risks are increasing and momentum is fading. During the past six weeks, the trend in markets, economic data, and management commentary has become more uneven. In March, more Wall Street analyst estimates were revised down than up. Company management teams are increasingly focusing their comments on inflationary pressures, margin compression and, in some cases, weakening sales as a result of higher energy costs. Many are also clearly concerned about the strength of the recovery—the second weakest economic expansion in the post-war period thus far. With the recovery in stocks one of the strongest on record, investors face the enormous risk of extrapolating recent corporate and market performance into the future. Not only have margins likely peaked for this stage of the cycle, valuations are full. Additionally, the stimulus that has fueled the market rally during the past seven months is winding down. Unemployment remains high and housing has yet to show any signs of a material rebound. In other words, we are likely transitioning into a period of modest earnings growth and heightened market volatility.
Still, the fundamental outlook for dividend-focused strategies continues to improve. Not only did we see robust dividend increases in the portfolio’s holdings during the quarter, but the aggregate dividends for the S&P 500 Index increased substantially year-over-year. Despite their rapid growth, dividends are still lagging earnings. This has contributed to a surge in cash on corporate balance sheets, which should support further dividend increases even as earnings growth slows in the coming year. Mounting concerns about rising inflation and interest-rates have highlighted the relative attractiveness of high-yielding stocks for income-oriented investors.
Regardless of what happens in the broader market we are pleased with the quality and positioning of the Fund. We remain steadfastly focused on stocks with high and growing dividends, healthy balance sheets, attractive valuations, and stable growth. The market advance has allowed us to reduce or eliminate positions at substantial premiums to our assessed Absolute Values. At the same time, heightened volatility presented us with new value opportunities. We believe that as earnings growth slows, the high-correlation, high-beta trend that has dominated the market during the past two years will fade, creating excellent opportunities for our Absolute Value style of investing.
River Road Asset Management
20 April 2011
As of March 31, 2011, Compass Diversified Holdings comprised 0.68% of the portfolio's assets, Sabra Healthcare REIT – 0.99%, Cracker Barrel Old Country Store – 0.48%, Microsoft – 0.92%, Vivo Participacoes – 1.07%, US Bancorp – 0.60%, Raytheon – 1.07%, General Dynamics – 0.98%, ConocoPhillips – 1.87%, Chevron – 2.07%, BreitBurn Energy Partners – 2.34%, Automatic Data Processing – 2.41%, Norfolk Southern – 2.30%, FedEx – 0.00%, PetSmart – 0.93%, Vodafone – 1.77%, Atlantic Tele-Network – 0.56%, Lockheed Martin – 1.06%,Waste Management – 2.73%, and Iron Mountain – 0.99%.
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.