4th Quarter 2011
Full of Sound and Fury
The stock market in 2011 will best be remembered as a market “full of sound and fury, signifying nothing.” A year that began with promise retreated mid-year before rebounding sharply during the fourth quarter, with the late surge helping to secure modest returns for the calendar year. Macroeconomic events whipsawed the markets throughout the year as the European debt crisis, Asian natural disasters, and U.S. political wrangling drove investors into seemingly all or nothing mode as the “risk on/risk off” theme dominated the markets. Correlations remained high throughout, with 90% or more of stocks moving in the same direction on 69 trading days (27% of the time) during the year. Daily volatility was also a common factor as investors tried to gauge the extent to which macro events would drive the overall market and economy. The market closed up or down more than 2% 35 times in 2011, nearly 14% of all trading sessions.
The Fund’s Russell 1000 Value Index benchmark gained 13.1% during the fourth quarter, as improved economic reports in the U.S. overshadowed the European debt crisis that has been ongoing for nearly two years. All 10 benchmark sectors were positive, with eight sectors posting double-digit returns. Given the improvement in sentiment and uptick in economic activity, more cyclical areas assumed leadership of the market. Energy led all sectors with an 18.4% return, as better than expected economic growth drove a 25% increase in crude oil prices. The Industrials and Materials sectors followed close behind, boosted by newfound economic optimism despite retreating commodity prices, persistent weakness in developed market demand, and mounting signs of Chinese real estate softness.
More defensive areas of the market trailed as investors flocked to companies poised to take advantage of improved economic conditions. Telecommunication stocks trailed the broader market as AT&T recovered from their failed acquisition of T-Mobile, while Verizon suffered through 4G network outages denting their reputation for reliability. Utilities and Consumer Staples were the next worst performing sectors in the Russell 1000 Value as investors sought faster growing companies with better prospects for expanding earnings in an economic upturn.
Winners and Losers
The Fund underperformed the benchmark during the quarter (though it beat the index handily for the year) as enthusiasm about potential economic improvement drove investors towards more economically sensitive companies and sectors. Stock selection within Technology, Consumer Discretionary, and Materials was the largest reason for the underperformance. Indeed, holdings in Technology were responsible for nearly half of the relative underperformance as Oracle and Flextronics International suffered from a disappointing earnings report and negative forecast, respectively.
Oracle was the biggest detractor as the company reported earnings below guidance on softness across business lines and geographies and numerous deals were pushed into future quarters. Tech equipment manufacturer Flextronics was essentially flat as the company experienced softness in sales as the quarter progressed, largely in semi-cap equipment, but spreading into networking and telecom from client capital expenditures being delayed due to economic uncertainty. The company also took a one-time charge to accelerate its departure from the PC ODM business.
An underweight stake in the Materials sector, along with stock selection, also hurt relative performance as investors rushed to own more economically sensitive positions regardless of valuation. Vale SA, the world’s largest iron ore producer, traded lower as the company continues to deal with project delays and capital expenditure inflation despite a positive cycle for iron ore. Weakness in China, slowing output, and lack of product diversification also continued to weigh on the shares, though we think the attractive valuation and low consumer iron ore inventory make it a compelling story.
Stock selection and an underweight position in Consumer Staples was the largest contributor to relative performance during the quarter, while positioning within the Healthcare sector and a lack of exposure to Utilities also aided returns. Among the top individual contributors were Google, Western Digital, and Royal Dutch Shell.
Google was the best relative performer as the company reported strong third quarter results on the back of strong search growth (especially paid clicks), significant net revenue growth both in the U.S. and abroad, improved operating margins for the first time in a year, notable mobile growth, and impressive product launches including Google+ (40 million members). The strong results and momentum have led to raised guidance for revenues and earnings in 2012.
Western Digital recovered faster than expected after flooding in Thailand interrupted production of its hard drives, which helped raise expectations for revenue, earnings, and market share. Despite weakness in the integrated oil area that was a detractor from performance in the Energy sector for the Fund overall, Royal Dutch Shell was higher as the company reported earnings above expectations. The company benefitted from higher oil prices and strong downstream results, and remains one of the more attractive names in the space with one of the highest yields.
Despite strong absolute returns during the quarter, valuations remain compelling in our view, both on traditional measures and Cornerstone’s proprietary valuation work. Cornerstone’s Fair Value Model now indicates that 78% of the stocks in our 800-stock universe are undervalued. Using normalized earnings, we calculate the average price for the universe at 70% of fair value.
Aside from normal additions and trims, we added one new position (Parker Hannifin) to the portfolio and exited one (Life Technologies) during the quarter. Parker Hannifin manufactures a full line of diversified motion and control technologies and systems, including fluid power systems, electromechanical controls and related components-hydraulics, pneumatics, and vacuums. This is a cyclical company, but it has a history of pricing power due to the value-add and high tech nature of their products. The firm has been focusing on rationalizing and controlling costs at some of their more expensive manufacturing plants in the EU in addition to a great deal of cost cutting in the past years. These actions should put them in a better position to weather further storms and/or benefit from an economic upturn. The company has historically retained its engineering talent through downturns to maintain their technology base. Although it has a history of acquisitions, most are only in the $50 to $200 million range. The lack of transformative acquisitions and its historical ability to integrate acquisitions alleviates the risk of overpaying for growth or suffering from massive integration issues.
Biotech equipment developer Life Technologies was sold as a lesser idea in the portfolio to be replaced by a higher-quality, more-diversified name that had been punished during the quarter. We see a lot of Industrial stocks “on sale” at this time, so while there wasn’t a tremendous amount of new information at Life Technologies, it no longer was one of our 30 best ideas given the dip in valuation elsewhere.
The turning of the calendar has historically been a time for the so-called “experts” to prognosticate about the direction of markets in an attempt to predict an unpredictable future. Cornerstone does not attempt to forecast macroeconomic events. Rather, Cornerstone attempts to identify those successful companies trading at attractive valuations because of low expectations in an effort to protect capital. The past 12 months have seen earnings among benchmark companies rising to record levels, yet opportunities remain compelling throughout our investable universe as investors fret over macro concerns. Recent volatility offers an opportunity to own large, well-known, market-leading companies with strong cash-flow generation and clean balance sheets at valuations rarely seen. Certainly there are concerns surrounding the equity market, but as history has demonstrated these challenges create buying opportunities for patient investors. As these concerns abate over time, we believe discipline and patience are likely to pay off as the prices of these companies revert closer to fair value.
Cornerstone Investment Partners
As of December 31, 2011, AT&T comprised 2.34% of the portfolio’s assets, T-Mobile – 0.00%, Verizon – 0.00%, Oracle – 3.81%, Flextronics International – 2.34%, Vale SA – 1.81%, Google – 4.40%, Western Digital – 3.49%, Royal Dutch Shell – 3.73%, Parker Hannifin – 2.04%, and Life Technologies – 0.00%.
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.