2nd Quarter 2011 Commentary - ASTON/River Road Dividend All Cap Value Fund
Stocks Flat as Economy Weakens
It was a volatile quarter for equity markets with stocks gyrating on robust earnings early in the period followed by weak economic data. Although management comments provided advance warning of a contraction in growth, the pivot point occurred on April 29 when the slowdown officially appeared in the U.S. Gross Domestic Product (GDP) numbers. A stream of disappointing economic news continued through May, particularly in housing and labor, which weighed on equities. In June, the fiscal crisis in Greece added to the turbulence, with investors initially fearing a broader debt contagion and later celebrating the passage of austerity measures. Toss into the mix the end of the second round of quantitative easing (QE2), more economic braking in China, and the deficit stalemate in Congress and investors were given considerable reason to reduce risk exposure during the period.
Despite the macroeconomic uncertainty, equity markets delivered solid results. Both the S&P 500 and Russell 1000 Indices ended the quarter with positive performance. The performance of small-cap stocks, however, reflected the market’s heightened volatility and investor risk aversion. After rallying to an all-time high in late April, the Russell 2000 Index plunged 10% through mid-June before rebounding in the final week of trading to end the quarter with a 1.61% loss. Mid-cap stocks were the best performing market-cap group overall. Among style categories, growth led value across all market-caps as growth-oriented indices benefitted from their larger relative weighting in the Consumer Discretionary sector and smaller relative weighting in the lagging Financials sector.
The performance of high-dividend stocks was strong. According to Ned Davis Research, the highest yielding companies in the S&P 500 outperformed the lowest yielding by more than four percentage points during the quarter. Although high-dividend stocks lagged following the initiation of a second round of quantitative easing in 2010, they outperformed as the program approached completion and uncertainty increased. This coincided with the fading of the high-beta (volatility) theme which had dominated equity performance since the start of the recovery.
Rising macroeconomic concerns led high-quality stocks to regain a leadership position as well, significantly outperforming low-quality stocks. According to BofA/Merrill Lynch, fundamental-driven approaches substantially outperformed as the dividend yield and return-on-equity (ROE) strategies led the more risky high-beta and low-price strategies. Interestingly, the dividend-yield strategy continues to be a swing factor, turning in the best results during the second quarter after having been the worst performer in the first quarter.
Consumer Staples Stands Out
The Fund outperformed its Russell 3000 Value Index benchmark during the quarter, posting positive returns versus a decline in the index. The portfolio outperformed in each of the market-capitalization tiers, with the returns of large-cap stocks particularly strong. The greatest contribution to absolute returns came from the Consumer Staples and Healthcare sectors, while relative performance benefited from stock selection in Financials and an overweight position in Consumer Staples. Financials was the worst performing sector in the benchmark, but the portfolio’s lack of exposure to the largest money center banks—which underperformed significantly during the period—noticeably boosted results over that of the index.
The top contributing holding during the second quarter was Telecomunicacoes de Sao Paulo. Commonly referred to as Telesp, the firm is Brazil’s largest telecommunications company following a merger with Vivo Participacoes S/A. Fears that the parent company of both firms, Telefonica, might force an unattractive share exchange ratio were unfounded, and the shares continued to rise following orderly and equitable merger negotiations. As the merger was completed and our conviction increased, we added to the Fund’s position.
Other notable performers included Sysco, PepsiCo, and Johnson & Johnson. Food distributor Sysco traded down in March following storms and freezes that devastated crops in the U.S. and Mexico, leaving the company with limited supplies of produce to sell to their customers. We increased the portfolio’s position as the discount became attractive. The company managed through the challenges extremely well, reporting results in-line with our expectations and that exceeded Wall Street projections. Pepsi reported strong first quarter results as volume growth in North America surpassed expectations, reflecting the benefits of its continued investment in brand building and innovation. In May, the company announced a sizeable boost to its dividend, marking its 39th consecutive annual dividend increase.
Investors had become increasingly critical of Johnson & Johnson due to a string of recalls resulting from quality issues at three production facilities in North America. News turned more positive during the second quarter as the firm and Merck announced a settlement of their dispute over two large drugs, Remicade and Simponi. Merck ceded sales territories, adjusted the profit split in favor of Johnson & Johnson, and made a one-time payment to the firm. The stock continued to rally when the company announced an agreement to acquire Swiss orthopedics device-maker Synthes—creating a dominant player in the global orthopedics market. Although the manufacturing issues led us to conclude that the stock’s multiple should be reduced in calculating our valuation to reflect the increased risk, the Fund has maintained its position owing to the company’s strong financial position, limited patent expiration risk, and long history of dividend increases.
The sectors with the lowest contribution to total return were Energy and Financials. Healthcare was the best performing area in both the portfolio and the benchmark in absolute terms, but a significant underweight position and lackluster overall stock-picking in the sector hurt relative performance despite the boost from Johnson & Johnson. Outside of Healthcare, the largest negative impact on relative performance was from stock selection in Materials. Steel manufacturer Nucor, the only holding in the sector for much of the quarter, dramatically underperformed the sector, though it modestly outperformed its peers in the Metals & Mining industry.
The weakest performer during the quarter was Bermuda-based reinsurer PartnerRe. Results from the company were negatively affected by losses primarily resulting from the Tohoku earthquake and tsunami in Japan. Subsequent loss estimates reduced the firm’s tangible book value significantly. Looking forward, the surge in catastrophic events should result in improved reinsurance pricing as the industry looks to rebuild capital levels. Our calculated Absolute Value declined as a result of the losses, but we maintained the position as the stock now trades below our new estimate of tangible book value.
Two other underperforming Financials stocks detracted from performance as well. Property & casualty insurer Cincinnati Financial deliberately expanded outside of the Midwest region in part to diversify against catastrophe risk. Unfortunately, they were still exposed to the unusual level of tornado and flooding damage that occurred during the second quarter. The extent of the underwriting losses has yet to be determined but they likely will reduce the insurer's book value and impact our assessed Absolute Value, which is currently under review. Money manager Federated Investors, with a large presence in the money market space, continued to tread water in a sub-optimal operating environment. A near zero federal funds rate requires that the company continue to subsidize its money market funds, offering fee waivers to maintain a positive, or zero, net yield. Management’s credibility with investors also took a hit when they offered an outlook for a rate hike by year-end. As economic data suggested U.S. growth was slowing and the probability of an interest rate hike decreased, the stock price declined.
Finally, BreitBurn Energy Partners, an oil & gas exploration and production Master Limited Partnership declined along with oil prices during the quarter. We think the fundamentals remain strong as the partnership raised its quarterly distribution for the fourth consecutive time. There was no change to our assessed Absolute Value during the period.
Three new holdings were purchased and one was sold from the Portfolio during the quarter. Turnover remained below the Fund’s historic average and changes in the relative positioning of the portfolio were driven by both trading and the June 24 reconstitution of the Russell benchmark. Notable shifts occurred within the Technology, Telecomm, and Consumer Staples sectors.
A number of changes boosted the benchmark weight in Technology from 5.7% to 8.9%. Thus, despite adding to the Fund’s position in Intel and the stock’s strong performance, the portfolio moved from a slight overweight versus the benchmark at the beginning of the quarter to a more than two percentage point underweight by the end of the period. Additions to current positions within Telecomm and a reduction in the benchmark weight contributed to an increase in the Fund’s overweight stake in that sector.
Reductions to several positions, including McCormick & Co. and Sara Lee Corp, at prices above our calculated Absolute Values led to a decrease in the weighting within Consumer Staples in the portfolio. Still, an even more substantial reduction to the benchmark that removed PepsiCo, Coca-Cola, and other constituents from the value index caused the Fund’s relative weighting to increase overall, and it remains the portfolio’s most significant overweight position.
The largest new position added during the quarter was global packaging manufacturer Bemis Company. Unlike packaged food companies, the firm is not affected by consumer trade-downs as both branded and private-label products use their packaging and pricing is the same. Together these factors have allowed the firm to deliver consistent free cash flow. Management has a history of strong shareholder orientation and that free cash flow is devoted to growing the dividend, share repurchases, strategic acquisitions, and debt reduction. The company has paid a dividend since 1922 and the latest dividend increase in February 2011 marked the company’s 28th consecutive annual increase.
Although contracts provide for regular price adjustments, rapidly rising prices for resin and other raw materials remains the greatest risk. Longer pass-throughs resulting from a recent acquisition was the focus in first quarter results as resin prices surged more than 15%. The firm is working to shorten the contract adjustment time frame on inherited contracts as they come up for renewal. At the time of purchase the stock was trading at a 16% discount to our calculated Absolute Value.
Since the beginning of 2011, we anticipated that as the end of QE2 approached the following two events would occur: 1) investors would begin to de-risk their portfolios and, thus, low beta/high quality stocks would begin to outperform; and 2) given stretched valuations, the small-cap market would experience at least a modest correction. We further believed the correction would signal the market’s entry into the mid-stage of the recovery, where earnings (and stock price gains) moderate. Finally, we stated that a sustained rise in oil prices would pose the greatest threat to what we continue to believe is a very fragile recovery.
Looking back at the first half of 2011, investors have been de-risking their portfolios since late February and the market did experience a modest correction between late April and mid-June. Earnings began to moderate and higher oil prices contributed to a slowdown. The end of QE2, however, appears to have been more coincident than a major catalyst to these events.
The market appears to be entering the mid-cycle stage of the recovery. As organic growth has become more challenging, merger & acquisition activity is picking up, especially among small-cap stocks, and is beginning to have a positive impact on the portfolio. So called “Tail risk” remains high, but even if economic growth continues to slow and we do re-enter a recession, we believe the portfolio is well positioned.
We believe the fundamental outlook for dividend-focused strategies remains very strong. Dividend growth continued to accelerate during the period and the aggregate dividend payment for the S&P 500 Index is significantly higher than last year. Despite their rapid growth, dividends are lagging earnings, which should support further dividend increases even if earnings growth slows in the coming year.
Looking out over the next two or three years, we are also modestly positive on equities. The economy appears poised to continue growing (albeit at a sluggish pace) and should continue to look favorable relative to most other developed nations. The Federal Reserve indicated it will remain supportive, broad inflation appears subdued, and companies are well capitalized. Corporate margins will likely compress, but thanks to low wage inflation they should remain reasonably attractive. The White House is likely to do whatever it can to keep oil prices low and boost employment prior to the 2012 election. If the Republicans win, we can expect a favorable reaction from Wall Street on the assumption of greater tax relief. While austerity measures will ultimately need to be adopted in the U.S. public sector, the really tough choices are likely to be addressed well after the 2012 election.
In summary, we believe that while there are clear structural issues that will weigh on U.S. equities longer-term and a sustained rise in oil prices remains a huge risk, in the intermediate-term the U.S. is one of the more attractive equity markets in the developed world.
River Road Asset Management
15 July 2011
As of June 30, 2011, Telecomunicacoes de Sao Paulo comprised 1.69% of the portfolio's assets, Sysco – 2.15%, PepsiCo – 2.15%, Johnson & Johnson – 1.58%, Merck – 0.00%, Nucor – 1.45%, PartnerRe – 1.51%, Cincinnati Financial – 1.70%, Federated Investors – 1.52%, BreitBurn Energy Partners – 2.07%, Intel – 2.18%, McCormick & Co. – 1.05%, Sara Lee – 1.56%, Coca-Cola – 0.00%, and Bemis Company – 0.75%.
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.