3rd Quarter 2011 Commentary - ASTON/Cornerstone Large Cap Value Fund
3rd Quarter 2011
Market: Worst Quarter Since 2008
Equity markets entered the third quarter of 2011 positive for the year and on pace for an above average annualized equity return. The period closed with the worst three-month performance since the end of 2008 and the “Great Recession”, as the market’s sell-off approached bear-market territory. The reasons were varied but carried a similar theme of global economic malaise and debt, beginning with the U.S. economy slowing and Congress taking the country to the brink of default over the debt ceiling. Concerns about the economic slowdown were not just limited to the U.S., however, as global data showed a slowdown across the board—including in the previously bulletproof emerging economies. European indices were down more than 20%, led by the French and German bourses. Debt concerns were also not just the province of the U.S., as the Euro zone continued to play chicken with Greece’s debt restructuring as possible default looms in the coming months.
Volatility was a common factor throughout the quarter as investors tried to guess which way the economic and bailout winds would blow. The Chicago Board Options Exchange Market Volatility Index (“VIX”) doubled during the period to twice its historical average, the biggest quarterly jump on record. In August and September alone the market moved 1% or more on 29 days and 2% or more on 15 days. Nearly 1-in-4 stocks in the Fund’s Russell 1000 Value Index benchmark declined more than 30%, while the yield on the 10-year US Treasury bond bottomed at levels not seen since the 1940s.
With this as a backdrop, U.S. large-cap equities fared significantly better than their small-cap peers. The Russell 1000 Index dropped 14.7% during the third quarter compared with a loss of nearly 22% for the small-cap Russell 2000 Index. More defensive areas of the market took leadership positions given the slowdown in economic activity. Utilities was the only area of the market in positive territory during the quarter, as investors gravitated toward regulated cash flows and higher yields in the face of plunging Treasury yields. The sector still faces headwinds though, as it is the only sector expected to see a drop in earnings for the full year and with what we consider to be valuations at a slight premium to the market. Consumer Staple and Telecommunications also outperformed the broad market, the former as investors rotated out of economically sensitive sectors and into more defensive, consistent earning sectors and the latter as industry dominant companies with strong cash flows fared better than their smaller, less-entrenched peers.
Three sectors during the quarter were down more than 20%—Materials, Financials, and Energy. Materials lagged significantly as commodity prices tumbled on news of a global economic slowdown, including fast growing emerging markets. Financials were lower as financial institutions struggled to calm the fears of investors worried about exposure to the European debt crisis through derivatives and counterparty risk. Energy sold off as leading indicators and economic reports cautioned of a global economic slowdown, hampering those stocks dependent on economic growth.
Strong Consumer Picks
The Fund outperformed the Russell 1000 Value by a considerable margin during the third quarter largely due to stock selection. Holdings within Consumer Discretionary, such as VF Corp and GameStop, led the way in delivering strong relative outperformance. Technology enjoyed relative strength on the back of solid performances out of industry-leading, strong cash-flow generating companies such as IBM, Microsoft, Apple and Oracle. Strong stock selection within integrated oil firms and the avoidance of oilfield services led to outperformance in Energy.
VF Corp continued to deliver strong relative returns since its announced acquisition of Timberland in June. Analysts raised price targets and upgraded the stock, as immediate and meaningful earnings per share accretion from the deal became incorporated into estimates for the company. A shift towards Outdoor and Action Sports (up to 50% of revenues) should allow for faster, more-stable growth. Furthermore, future growth could be fueled by expanding internationally with VF’s international exposure low relative to its domestic share.
Bristol-Myers Squibb was another top individual performer in the portfolio during the quarter. Investors overly focused on the upcoming patent expiration of the company’s largest drug, Plavix, have been forced to re-examine their thesis as the firm’s previously underappreciated pipeline came to the forefront of attention amid a slew of positive data points and approvals. Questions about second quarter results were dominated by the recently approved cancer drug, Yervoy, which has posted impressive sales since its launch. In addition, Bristol-Myers reported impressive results in efficacy and side effects for blood thinner Apixaban against not only existing drugs, but also other competitor drugs recently brought to market or in development.
Hard Hit Financials
Underweight stakes in both the Consumer Staples and Utilities sectors were the biggest drags on Fund performance as investors flocked to more defensive areas of the market despite what we consider more expensive valuations and lower growth prospects. Several stocks within Financials also hurt relative returns on concerns about exposure to the Eurozone debt crisis noted earlier as well as regulatory and capital concerns.
Morgan Stanley dropped sharply as investors worried about the more traditional business model of trading and brokerage, fears related to Europe, the slowing global economy, and a trading downturn. Despite the fears, we calculate that the company is trading at roughly half of its tangible book value and is in better financial shape than it was during the 2008 financial crisis. Citigroup also lagged severely owing to regulatory issues (Dodd-Frank) and Moody’s downgrade of short-term credit. Light information and spotty disclosure has left investors somewhat uncomfortable with Citi’s exposure to Europe, and the stock has traded down in response.
Despite the extreme volatility (or perhaps because of it), we think valuations have become even more compelling—both by traditional measures and Cornerstone’s proprietary valuation work. Our Fair Value Model now indicates that 84% of the stocks in the Fund’s 800-stock universe are undervalued relative to normalized earnings, with the universe overall priced at 54% of fair value. On an absolute basis, stocks are trading at 10.2 times 2012 earnings estimates, even as the growth of those earnings estimates is slowing. Other positive factors for stocks include an accommodative and creative Federal Reserve, record low interest rates, and solid, growing corporate earnings.
Aside from normal additions and trims to current holdings, we took advantage of the volatility during the quarter to purchase four new positions—Hess Corporation, Life Technologies, Lockheed Martin, and Mattel. Hess extracts oil and gas through drilling and processes it into a variety of products, including gasoline, lubricants and heating oil. We think the company is currently one of the cheapest integrated oil companies due to its poor track record within exploration (although recent data suggests otherwise) and one money losing refinery. Global life sciences company Life Technologies is diversified in clients, product offerings, and geographic dispersion of its highly recurring revenues. The company possesses a rich pipeline and has more than 3,900 patents. The stock has been weak thus far year-to-date, which offered an attractive buying opportunity for the Fund.
Defense contractor Lockheed Martin’s share price has been hindered recently as budgetary pressures surrounding defense spending are likely to result in significant reductions to its revenue. Despite questions about the health of its F-35 fighter plane program and its underfunded pension plan, which is likely to force the firm to earmark more free cash to funding requirements, the company is in strong financial shape. It has earned an average of nearly $3 billion in free cash during the past five years, has stable margins, and a huge backlog of new business. We think the valuation looks attractive, with the stock trading at a meaningful discount to our fair value.
Mattel, the world’s largest toymaker, features a broad portfolio of products that includes Barbie, Hot Wheels, Matchbox, Fisher Price and American Girl brands. We think it is an attractively valued industry leader with good growth prospects globally, a financially sound balance sheet with strong cash flows, and a solid dividend yield.
The Fund exited four positions during the period—Advance Auto Parts, ConocoPhillips, McGraw Hill, and St. Jude Medical. Advance Auto Parts reported better-than-expected earnings in large part due to more aggressive cost cutting and stronger do-it-yourself sales. The stock responded accordingly, but after such a strong performance no longer represents one of our best ideas. ConocoPhillips was sold on strength after the company announced it was splitting into two separate divisions, which will also see the resignation of the CEO directly after the separation is complete. This corporate action calls into question the relevance of the firm’s past history and, hence, our ability to assess valuation. McGraw Hill was sold during the month as the stock had performed well and our investment thesis had played itself out.
St Jude Medical was sold as the stock had performed relatively well on the back of a new product, Quadra. The valuation of the stock became no longer compelling enough for the Fund to warrant holding, however. Our past valuation work was also based on a high growth rate that looks difficult to maintain given the company’s exposure to the slow growing ICD market, a US Department of Justice investigation into excessive ICD use, and a medical device tax.
Given all of the concerns surrounding the global economy, any short-term moves in the markets are largely unpredictable. Cornerstone does not attempt to forecast macroeconomic directions, interest rates, Gross Domestic Product (GDP), or any other unforecastable event. Rather we attempt to identify successful companies trading at attractive valuations with low expectations in an effort to protect capital. The recent sell-off in equity markets has allowed us to focus on highly successful franchises trading at attractive valuations, and we think the recent volatility has allowed for an upgrade in the quality of the companies in the portfolio. As macroeconomic concerns abate over time, we believe the discipline and patience shown now is likely to pay off as the prices of stocks revert closer to fair value.
Cornerstone Investment Partners
As of September 30, 2011, VF Corporation comprised 3.28% on the portfolio’s assets, GameStop – 4.51%, IBM – 3.52%, Microsoft – 3.27%, Apple – 3.70%, Oracle – 4.15%, Bristol-Myers Squibb– 3.32%, Morgan Stanley – 2.72%, Citigroup – 2.47%, Hess – 2.34%, Life Technologies – 2.31%, Lockheed Martin – 1.05%, and Mattel – 2.55%.
Note: Value investing often involves buying the stocks of companies that are currently out of favor that may decline further.
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.