3rd Quarter 2011
The U.S. equity market declined sharply over the course of the third quarter. In July, fears that deadlock in Washington D.C. would result in a debt default or credit downgrade pressured the market. Despite the last minute deal that averted a technical default, Standard & Poor’s downgraded the rating on U.S. sovereign debt. For the remainder of the quarter, concerns about the health of European banks and economic weakness in the U.S. led to further risk aversion. The Federal Reserve tried to stem the tide by initiating “Operation Twist,” an effort to extend the average maturity of its security holdings, but the plan did not include an expansion of the Fed’s balance sheet and the market reacted negatively.
Defensive Strategies Dominate
The broad market S&P 500 Index declined nearly 14% during the quarter, its biggest drop since the fourth quarter of 2008 and the second worst calendar third quarter since 1928. As would be expected in any market correction, defensive, high-quality strategies held up better than most. Defensive sectors such as Utilities and Consumer Staples dramatically outpaced the more cyclical Materials and Financials sectors as investors sought out a relatively safe source of income in a low-yield environment.
High-quality stocks maintained their leadership position, significantly outperforming low-quality stocks during the quarter. According to BofA/Merrill Lynch, fundamental-driven strategies like dividend yield and return-on-capital (ROE) substantially outperformed more-risky high-beta (volatility) and low-price strategies. Despite the poor relative performance during the first quarter, the dividend yield strategy was the top performer by a wide margin for the year-to-date through the end of September. As concerns of another financial crisis and global recession grew, investors also fled to the relative safety of large, growing firms. The Russell Top 200 Index substantially outpaced the smaller-sized Russell Midcap and Russell 2000 indices. Among the largest companies, growth outshined value in the Russell Top 200 as growth benefited from minimal exposure to Financials and a heavy emphasis on Technology.
Similarly, the highest yielding companies in the S&P 500 outperformed the lowest yielding during the third quarter (per Ned Davis Research). High-yield stocks lagged as markets advanced following the mid-2010 announcement of the second round of the Fed’s quantitative easing (QE2) program, but have remained resilient as markets have declined. The price performance continues to be supported by a strong fundamental backdrop for dividends. During the past year, 287 companies in the S&P 500 initiated or raised their dividend, while rapid earnings growth has driven the payout ratio down to 28.6%—the lowest rate since measurement began in 1926—indicating that there's plenty of room for dividend expansion if earnings hold.
Strong Staples Picks
The Fund substantially outperformed its Russell 3000 Value Index benchmark during the quarter, outperforming in each of the market-capitalization tiers with the performance of large-cap stocks particularly strong. Although the Fund’s small-cap holdings lagged the rest of the portfolio, it bested its respective area of the index by a wide margin.
The Utilities sector was the only area to post a positive absolute return in either the Fund or the benchmark. Both sector allocation and stock selection had a positive impact on relative returns, with the largest contributors being stock selection in Financials and a large overweight to the Consumer Staples sector. Financials was among the worst performing sectors in the benchmark, but the portfolio holdings in the sector nearly beat the broader benchmark return.
Among Consumer Staples holdings, Kimberly-Clark and Clorox were top contributors during the quarter. Kimberly-Clark reported second quarter results that topped analysts’ estimates and included a gain in organic sales. Management also raised sales guidance and increased cost reduction estimates for the year. Commodity inflation has been a significant headwind for the firm, but its strong brands and ongoing product innovation supported price increases. As this headwind abates, the firm is positioned for further margin expansion. Clorox has grown beyond the bleach business and now owns a portfolio of consumer products including Burt’s Bees, Brita, Glad, S.O.S., Formula 409, and Kingsford. In July, activist investor Carl Icahn made an unsolicited offer to buy the remaining shares in the company, boosting the stock. We sold the Fund’s position on the day of the announcement.
Other top individual performers included two utility companies, Duke Energy and Southern.
Duke Energy and Progress Energy shareholders approved the proposed merger between the two companies during the quarter. Duke is still waiting on final approvals from FERC, the North and South Carolina utility commissions, and the NRC, but the merger is still expected to close by the end of the year. The transaction will increase Duke’s regulated earnings to more than 85% of total earnings and create the largest utility in the U.S. Southern reported a better than expected second quarter, with weather-normalized sales increasing year-over-year driven by an increase in sales to industrial customers. The economic recovery in the Southeast, combined with Southern’s favorable regulatory relationships, has allowed the company to continue earning industry leading returns.
Only two out of 10 economic sectors had a negative total effect on relative results, with an underweight stake in Healthcare offsetting marginally positive stock selection. Unlike with Healthcare, strong stock selection in poor performing Industrials mostly offset the negative effects of an overweight position in the sector.
Among the biggest individual detractors from performance during the quarter were transporation-related holdings Norfolk Southern and Nordic American Tankers. Railroad stocks plummeted on fears of an economic slowdown or possible recession, sending Norfolk Southern lower despite reporting strong second quarter operating results. During the quarter, the firm repurchased its own shares and raised its dividend for the second time in 2011. Crude oil shipping company Nordic American traded down as the tanker industry continued to deteriorate. Day-rates have been weak since the middle of 2010 driven by an oversupply of new ships that were ordered when rates were peaking in 2007-2008. Unlike much of the rest of the industry, Nordic American has a conservative balance sheet, and we believe this financial strength gives them the ability to survive the downturn while making opportunistic acquisitions. Despite our optimism, we reduced the position in accordance with our sell discipline due to accumulated unrealized losses and the increased risk of slowing global economic growth.
Another notable detractor was asset manager Federated Investors, a major player in the money market funds space. The Federal Reserve’s announced intention to hold the federal funds rate at effectively 0% until at least mid-2013 impaired our investment thesis on the stock. It became clear that given our investment horizon the firm would have to maintain the fee waivers offered to its investors in order to keep money market fund yields at zero or slightly positive. In addition, some of Federated’s funds were invested in the certificates of deposit of troubled European banks. This increased our concerns about the credit quality of the funds as they stretched for yield. Given these factors, plus the accumulated unrealized losses, we eliminated the position from the portfolio during the quarter.
Turnover picked up during the quarter as the market decline created opportunities to establish new positions at attractive discounts. In addition, the market decline resulted in the portfolio exceeding our unrealized loss threshold, requiring the management team to reduce losing positions. In terms of sector positioning, the portfolio’s stake in Healthcare and Consumer Discretionary increased, while the position in Financials decreased. Four stocks were sold during the quarter, one of which was sold as it traded at a premium to our assessed Absolute Value.
A total of six new positions were established, including Healthcare stocks Landauer and Medtronic and Consumer Discretionary name National CineMedia. The largest of the new positions was in global investment manager BlackRock. The firm’s five-year annualized dividend growth rate through June 30, 2011 has been significant. Considering senior management’s large stake in the firm, the company’s dividend policy represents a significant, stable, and rapidly growing income to them. We were able to take advantage of the August market correction to establish a position in this market leader, which we calculated was trading at a 20% discount to our assessed Absolute Value.
Since the beginning of 2011, much of our outlook has been focused on how we believed the market would react to the expiration of QE2. From our perspective, the extraordinary liquidity provided by QE2 effectively extended the risk trade from April 2010 through February 2011. Since QE2 did little to stimulate actual demand for anything other than financial assets and commodities, equity markets became increasingly disconnected to the underlying economy. Such gaps eventually close. This is why we communicated our belief at the beginning of 2011 that the following two events would occur as the Federal Reserve began to wind down QE2: 1) investors would begin to de-risk their portfolios and 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 anticipated the correction would signal the market’s entry into the mid-stage of the recovery, where earnings (and investor expectations) begin to moderate, and that the Fund’s relative performance would improve substantially as these events unfolded.
We did not foresee the Arab Spring, the natural disasters in Japan, the European financial crisis, or the debt ceiling debate in Washington. Thus, although our outlook for 2011 was bearish relative to most of Wall Street, we did not anticipate the severe contraction in economic growth or the depth of the correction in equity markets. We simply knew speculative froth was high and the Fed had few remaining effective options. It was a time for caution.
We believe the persistent global financial problems we face, including the sovereign debt issues in Europe, are residual effects of a multi-decade global debt explosion that will require many years to unwind. Historically, hangovers from financial events are long and painful, accompanied by slow economic growth, plenty of market volatility, social upheaval (e.g., Occupy Wall Street, Tea Party, Arab Spring), and policy mistakes. From our perspective, however, earnings have held up reasonably well. Many companies never unwound their austerity measures from the 2008 recession as they recognized, and subsequently learned how to manage in, a slow-growth world. Unlike 2008, corporate balance sheets are also in excellent condition.
We continue to think macroeconomic risks remain elevated. Since the end of June, the likelihood of a recession in Europe and the U.S. has increased substantially. The odds of a financial crisis (and associated contagion) emanating from Europe have also increased. Large U.S. banks remain weak, growth in key markets like China has slowed appreciably, and the political environment in Washington remains unstable and unpredictable. Still, we believe that many of these risks have already been discounted in equity prices.
As expectations have downshifted dividends are finally getting the attention they deserve. Dividend growth has rebounded to historic highs, payout ratios are at historic lows, interest-rates on bonds are low, cash is accumulating on corporate balance sheets, performance has been relatively strong, new funds are being launched, and there has been an explosion in both media and investor interest. Every day we hear or read commentators and professionals extolling the virtues of investing in large-cap dividend stocks. While everything appears to be primed for the long-term secular shift that we have long expected, we think it proper to diligently watch for signs of investor euphoria. What gives us confidence that this renewed focus on dividends is more than just another investment fad is the recent growth in interest from large institutional investors and consultants. In the past 12 months we have seen investors with large pools of capital readdress their allocation models and open up to dividend-focused strategies. This indicates that a second, much larger, wave of investors could be building which would fuel a secular shift toward a more balanced focus on both income and capital gains.
We wanted to take a moment to note that dividend-focused investment strategies do not all share the same risk/reward profile. As many investors learned to their detriment in 2008 and 2009, buying or holding onto a position just because the yield is attractive can be a recipe for disaster. We believe a successful investment outcome requires a process that balances the need for a high and growing income stream with the strong underlying business fundamentals that are necessary to support it. We think that River Road’s core Absolute Value philosophy and investment process, coupled with a dividend focus, strikes this balance effectively.
River Road Asset Management
14 October 2011
As of September 30, 2011, Kimberly-Clark Group comprised 2.28% of the portfolio's assets, Clorox – 0.00%, Duke Energy – 1.93%, Southern – 1.34%, Norfolk Southern – 2.13%, Nordic American Tankers – 0.77%, Federated Investors – 0.00%, Landauer – 0.81%, Medtronic – 0.83%, National CineMedia – 0.56%, and BlackRock – 0.95%.
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.