2nd Quarter 2011 Commentary - ASTON/Herndon Large Cap Value
The Fund outperformed its Russell 1000 Value Index benchmark during the second quarter. Stock selection and sector allocation were both positive with stock selection contributing 66% of the outperformance and sector allocation 34%. Holdings in eight of 10 sectors in the portfolio bested their respective sector and/or the overall index during the period. The two areas of the portfolio that lagged were Materials and Utilities.
Performance for the index itself was fairly broad with five sectors—Healthcare, Utilities, Consumer Staples, Telecom, and Consumer Discretionary—outperforming the overall index. Unlike the first quarter, which had more of a cyclical tilt, the second quarter saw the outperformance of more defensive sectors and the index finishing with a negative return as asset and capital preservation became clearly paramount.
The three sectors with the highest contribution to relative returns for the quarter were Consumer Staples, Consumer Discretionary, and Financials. The first two sectors benefitted from the defensive orientation of the market. Solid performances from multinational companies such as Herbalife, Pepsico, and Colgate-Palmolive aided returns within Consumer Staples. Consumer Discretionary rose with a wide variety of price point demographics represented by companies such as Coach, YUM Brands, and TJX Companies. Financials continued to help returns on a relative basis due to the Fund’s underweight exposure and a focus on specific industry groups. These groups included asset management, consumer credit, and capital market players, with the avoidance of most major banks.
The three top individual contributors to performance were Herbalife, Copa Holdings, and Coach. It should be noted that Copa Holdings and Coach were two of the worst performers in the Fund last quarter. The reversal in performance illustrates one of the key principles to our investment philosophy, “We cannot predict the timing, magnitude, or duration of returns. All we can do is fill the portfolio with what we think are the best value creating opportunities available.”
The lack of value creating opportunities led to underweight stakes in the Utilities and Telecom sectors, which were two of the lowest contributing sectors in the portfolio. In addition, a poor perception of the outlook for Owens-Illinois resulted in that stock declining, which contributed to the lagging performance within Materials. Other individual holdings with the greatest negative contribution to returns were Babcock & Wilcox and Waddell & Reed. All three stocks remain holdings in the portfolio.
At the end of the quarter, the Fund was overweight Consumer Staples, Materials, Consumer Discretionary, Energy, and Health Care, having increased exposure to both consumer areas and Energy during the period. Within this exposure are some defensive oriented sectors as well as those with a correlation to economic growth. We added to the portfolio’s stake in Industrials in bringing it up to close to neutral with the benchmark. Financials, Utilities, Telecom, and Technology remain underweight relative to the index despite the addition of new names in Financials and Telecom. We decreased our exposure to Utilities. Sector over- and underweights should not be taken as signaling a certain perspective on the market, but as a reflection of where we are finding the most value creating opportunities through our bottom-up analysis.
We eliminated 15 stocks from the portfolio during the quarter due to sector adjustments and/or valuation or fundamental issues. These sales included Goldman Sachs, SLM Corporation, Marathon Oil, Johnson & Johnson, AES Corporation, Garmin, and Energizer. The level of turnover was higher than usual as stock fundamentals appear to have eclipsed what we deemed to be relatively attractive valuation levels. Once again, as part of our investment philosophy, “We have a core process but no core holdings.” If a stock no longer appears to be a value creating opportunity, we sell.
With the increased number of stocks sold, we initiated positions in YUM Brands, Coca-Cola Enterprises, Frontier Oil, Kimberly-Clark, Lockheed Martin, Ross Stores, and Best Buy among others. These stocks were added to increase exposure in the areas noted above after first being identified as a value creating opportunity followed by fundamental analysis to vet out each company's potential as a portfolio holding.
From an economic and political perspective, it appears that as one storm subsides, another begins. Japan’s tumultuous natural disaster proved to be the short-lived disaster du jour as the European debt crisis continues to gain headlines. As if the debt across the Atlantic Ocean was not enough to take center stage, the United States appears to be playing a political game of chicken with its own debt as a budget has yet to be passed. The partisan gamesmanship may be a ploy to position one political party against the other as the presidential election begins to gain steam. The market appears more sanguine in expecting a resolution at some point. This balanced perspective is likely a pragmatic and prudent one.
The economic landscape seems to be on a slow boat to China, pun intended. China, along with the other BRIC (Brazil, Russia, India, and China) countries, is gradually becoming the dog that appears to be wagging the U.S. tail. Unlike the U.S., which continues to persist with historically low interest-rates and bond yields (which may actually be negative when adjusted for inflation), China and some of the more forward-looking developed economies are starting to raise interest rates to head off inflation.
Without much evidence that the Federal Reserve is prepared to follow in lock-step, the bond and cash markets continue to look unattractive compared with equity markets. Some investors may seek attractive returns outside of the U.S. For those with more of a domestic orientation, we think stocks appear to be a better place to be.
For the Fund, we are struggling to find as many value creating opportunities as we have in the past. The market is bidding up valuations beyond where we view their fair values should be. We have still been able to stay fully invested, but the number of opportunities allowing us to do so has diminished significantly.
The portfolio is currently most overweight in Consumer Staples, traditionally a defensive sector. We have not waved the proverbial white flag of surrender to the market. We are overweight Consumer Staples because it is an area where we have an above average representation of value creating opportunities. As this sector represents a disproportionate amount of the opportunities that we are finding, it does call into question what might be in store for the rest of the market. Beyond its defensive characteristics, Consumer Staples also offers products which have some of the broadest geographic reach collectively as a sector. Thus, although it has defensive appeal, there are other solid reasons to have exposure to the sector.
In contrast, Financials continue to be the area where we are most challenged to find opportunities. We think that the domestic focus limits a major fundamental catalyst. We also think that the market’s fixation on book value has temporarily limited the stocks correcting to where the fundamentals are leading them, which we believe is lower. The catalyst for the correction may be the day when the Federal Reserve finally decides to raise interest rates.
Randell A. Cain, CFA
Principal and Portfolio Manager
Herndon Capital Management
July 6, 2011
As of June 30, 2011, Herbalife comprised 2.31% of the portfolio's assets, PepsiCo – 2.00%, Colgate-Palmolive – 1.31%, Coach – 2.36%, YUM Brands – 1.74%, TJX Companies – 2.64%, Copa Holdings – 2.62%, Owens-Illinois – 0.92%, Babcock & Wilcox – 1.75%, Waddell & Reed – 1.84%, Coca-Cola Enterprises – 1.65%, Frontier Oil – 1.88%, Kimberly-Clark – 1.60%, Lockheed Martin – 1.68%, Ross Stores – 0.81%, and Best Buy – 0.87%.
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.