4th Quarter 2011
The volatility that has dominated equity markets in recent years did not abate during the fourth quarter of 2011. The market oscillated between fear and greed, declining each time the perceived liquidity or solvency risk in Europe grew, only to rebound after each intervention by the European Central Bank. By year end, the trailing 100-day volatility of the broad-market S&P 500 Index was at a level only seen three times (1987, 2002, and 2009) since the 1930s. Looking at the Dow Jones Industrial Average, there were 12 downward corrections of at least 5% in 2011, nearly double the long-term average of seven per year.
Despite a double-digit surge during the fourth quarter, there was little to show for all the market volatility in 2011. The Fund’s Russell 3000 Value Index benchmark ended almost at exactly the same point it started in posting a slight loss. For the year, there was a clear preference for stable cash flows as the Utilities and Health Care sectors dominated. The ongoing turmoil in European financial markets played a clear role in the massive underperformance of the Financials sector.
Overall, 2011 marked the first year since 2007 that large-cap stocks (represented by the Russell 1000 Index) outperformed small-caps (Russell 2000 Index). Growth outperformed value in both large-caps and small-caps among the component Russell style indices. The highest yielding stocks in the S&P 500 outperformed the lowest yielding by nearly seven percentage points per Ned Davis Research.
According to BofA/Merrill Lynch, high-quality stocks outperformed low-quality stocks by more than 11 percentage points in 2011, with fundamental-driven strategies the clear winners. Cash return strategies, including dividend yield, return-on-capital, and stock repurchase significantly led the more risky high-beta (volatility), low-price, and high earnings per share estimate dispersion strategies.
Dividend performance for 2011 was supported by a strong fundamental backdrop. During the year, 298 companies in the S&P 500 initiated or raised their dividends at an aggregate rate of more than 19%, the fastest growth rate since 1977. At the same time, rapid earnings growth has driven the estimated payout ratio down to a near-historic low.
Fourth Quarter Rally
Interestingly, results during the fourth quarter were almost the exact opposite of the full year trends. The Russell 3000 Value surged more than 13% as cyclical sectors such as Energy and Industrials significantly outperformed more defensive oriented Telecommunication Services and Utilities sectors. Leadership shifted as small-caps outpaced large-caps. Small-cap value led the way during the quarter, countering the dominance of large-cap growth during the full year. In addition, the lowest yielding companies outperformed the highest yielding by nearly six percentage points. There was no clear pattern in the relative performance of high- or low-quality, while the relative performance of fundamental- and momentum-driven strategies was mixed.
The Fund lagged the benchmark during the fourth quarter, though those results didn’t dent by much its substantial outperformance for the year. Both sector allocation and stock selection had a negative impact on relative performance during the quarter. Stock selection within Energy and Industrials subtracted the most, primarily driven by positions in Ship Finance International and Nordic American Tankers in Energy and Waste Management, Iron Mountain, and United Technologies in Industrials.
Shipping companies Ship Finance and Nordic American were also the two biggest individual detractors to relative performance. Ship Finance charters out 61 marine vessels under long-term contracts that provide stable cash flows outside of the volatile day-rate spot market. We trimmed the position significantly in August due to accumulated unrealized losses and the risk defaults by its charterers posed to the dividend. The shares continued to decline as the downturn in the shipping industry intensified during the quarter. Some classes of ships operated at cash flow negative rates for a significant part of the quarter, triggering the bankruptcies of some highly levered operators. This prompted an additional reduction in the position in November. In December, the firm’s second largest charterer announced a financial restructuring and recapitalization. Our concern that Ship Finance would be forced to reduce charter rates and cut its dividend came to fruition. We immediately exited the small position that remained.
Similar industry challenges pressured Nordic American’s profitability, leaving investors questioning the sustainability of its quarterly dividend. In October, we significantly reduced the position due to accumulated unrealized losses. In November, the company reported a difficult third quarter, as average gross spot rates dropped more than 50% and operating cash flow turned negative. Unlike its shipping industry peers, however, the management of Nordic American has not employed significant amounts of leverage. This allows the company to deploy its balance sheet in a counter-cyclical manner to support the dividend and opportunistically acquire vessels. The Board of Directors elected to maintain the dividend, using its credit facility to support the payout. Even after acquiring three ships in recent months, net debt per vessel remains relatively low. Although we are confident that the firm will survive the downturn and reward shareholders when industry conditions improve, the October trim prudently reduces the risk if we are wrong.
Strong stock selection and an underweight position in Financials provided the most significant boost to relative performance during the quarter. The portfolio benefited from limited exposure to the largest U.S. financial institutions and strong contributions from third quarter additions BlackRock and PNC Financial Services Group.
The largest individual contributor was Genuine Parts, distributor of NAPA brand replacement auto parts, industrial parts, office products, and electrical supplies. The firm reported a record third quarter on solid contributions from all four segments. Management also gave strong guidance for the remainder of the year and noted favorable fundamentals for the auto aftermarket, which represents approximately 50% of its sales and operating profits. On the strong results, we increased our Absolute Value target and maintained the Fund’s position.
Other top contributors during the quarter included railroad company Norfolk Southern and offshore drilling company Seadrill. Norfolk reported solid results for the third quarter, including all-time quarterly highs for both operating income and earnings. In early December, all but one of its outstanding labor contracts was resolved, ending the threat of a major rail strike. We increased our Absolute Value for the stock and maintained the position. Seadrill management offered a positive outlook and announced a dividend increase. The firm’s Board of Directors decided to integrate this year’s quarterly special dividend into the regular payout and increase it, its seventh increase in the past eight quarters. Given Seadrill’s strong fundamentals, growing payout, and favorable outlook, we maintained the position.
The Fund’s outperformance for the year was broadly distributed. Both sector allocation and stock selection had a positive impact on relative performance, with allocation positive in six sectors and stock selection in seven. Financials had the most significant impact due to both positive stock selection and the underweight position. Although it was the worst performing sector in both the portfolio and the benchmark on an absolute basis, the Fund’s holdings bested the index by more than seven percentage points. This strong relative result was almost entirely attributable to the lack of exposure to four companies—Bank of America, Citigroup, Goldman Sachs, and JPMorgan Chase.
The top individual contributors for the year were Genuine Parts, Duke Energy, and McDonald’s. As the market declined in August 2011, Duke and other utility stocks rose as investors sought the relative safety of regulated utilities. Shareholders approved the proposed merger of Duke with Progress Energy during the third quarter, but the merger did not close in 2011 due to delays in obtaining regulatory approvals. The combination would increase the regulated earnings from under 75% to more than 85% of the total, increasing the predictability of future cash flows and creating the largest utility in the U.S. We trimmed the portfolio’s stake in Duke in December as it traded above our Absolute Value despite the indication that the merger would be delayed.
McDonald’s posted strong mid-single digit same store sales growth every quarter during the year, balancing targeted value promotions (e.g. McNuggets, Sweet Tea) and highly successful menu additions (new smoothie flavors, oatmeal) to drive higher traffic. The company also managed margin pressures well, selectively increasing prices to limit the impact of inflation in the cost of its grocery bill. The company’s Board of Directors authorized a sizeable dividend increase in November and the company continues to execute its share repurchase plan announced in September 2009. We reduced the position during the latter part of the year on multiple occasions as the stock traded at a significant premium to our Absolute Value calculation.
Only two sectors, Healthcare and Energy, had a negative total effect on the relative results of the portfolio. An underweight position and stock selection in Healthcare both had an adverse impact on performance, with only one of seven holdings in the portfolio outperforming the overall sector. The modest underperformance in the Energy sector was attributable to the previously mentioned holdings in the shipping industry, with Nordic American Tankers and Ship Finance International among the biggest individual detractors for the year as well as the fourth quarter.
In addition, institutional asset manager Federated Investors detracted from performance owing to its significant share in money market funds. The Federal Reserve’s announcement of its intention to hold the federal funds rate at effectively 0% until at least mid-2013 impaired our investment thesis. It became clear that, over 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. Moreover, some of the firm’s money 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 third quarter.
A Bottom-Up Perspective
Our strategy employs a true bottom-up approach to allocations among sectors and market-capitalization groups, letting individual stock selection dictate overall portfolio positioning. Since 2009, a significant shift has occurred in the portfolio. The weighting of small-cap stocks declined as we incrementally found more opportunities among mid- and large-cap companies. This shift was a significant contributor to relative results in 2011, as the Fund’s large-cap holdings dramatically outgained its small-caps. In addition, attribution highlights the strong outperformance of our large-cap dividend payers in outperforming the benchmark’s large-caps.
The low interest-rate environment in 2011 made it increasingly difficult to find companies with yields in excess of 5% that met our investment criteria and were not already trading at a premium to our calculated Absolute Value, causing exposure to those types of holding to drop well below the Fund’s historical range. In our view, the near frantic demand for alternative sources of income has resulted in MLPs and REITs trading more on a relative value basis, rather than an Absolute Value basis.
There were only modest changes in the relative positioning of the Fund during the quarter, with turnover relatively low. The portfolio weighting in Energy decreased primarily as a result of the sale of Ship Finance and Spectra Energy, along with the reduction in Nordic American Tanker, more than doubling the relative underweight in the sector. The Fund’s overweight to Industrials increased owing to the introduction of Republic Services to the portfolio and an increase to the position in Lockheed Martin.
A total of five new positions were established during the quarter, the largest being Dr Pepper Snapple Group. Dr Pepper is number three in the North American liquid refreshment beverage business behind Coca-Cola and Pepsi. The Dr Pepper and 7UP brands are iconic leaders in their categories and the company has cobbled together commanding leadership positions in other flavored soda categories, including ginger ales (Canada Dry & Schweppes), orange sodas (Sunkist, Crush, Orangina), and root beers (A&W, IBC, Stewart’s, and Hires). Since being spun out of Cadbury in 2008, management has used the company’s significant cash flow to initiate and increase the dividend, repurchase shares, and pay down debt. Most recently, in May 2011, its Board of Directors announced a sizeable dividend increase. At the time of initial purchase, the stock was trading at a 10% discount to our assessed Absolute Value and had a 3.4% yield.
Our macroeconomic outlook has changed very little in recent months and, unfortunately, there is no reason to expect that the volatility that dominated 2011 will decline in 2012. Solvency issues in Europe remain largely unresolved and austerity efforts are having a negative impact on economic activity in the region. Saber rattling with Iran is intensifying, which threatens to add volatility to oil prices and could ultimately pressure the ongoing recovery in the U.S. In addition, just as we could not have anticipated the Japanese tsunami or Arab Spring, there are likely some surprises in store for the markets in 2012.
Almost unnoticed amid all the focus on Europe, the U.S. economy ended the year with surprisingly strong momentum. Unemployment claims remained below the critical 400k level, consumer sentiment rebounded, inflation declined, railcar loadings and steel production increased, and lastly, inventories reportedly surged providing an unexpected boost. The strength of the recent U.S. economic reports suggests the growth is more robust than in the past. This stands in stark contrast to the emerging recessionary pressures throughout much of Europe. It is unclear if this “decoupling” will continue in the coming year. For now, management teams of the companies we follow noted that visibility has declined but, to date, the actual impact on business has been minor.
We think the fundamental outlook for dividend-focused strategies remains very strong. As noted at the beginning of this commentary, dividend growth accelerated during the fourth quarter at the fastest growth rate since 1977 and the payout ratio for the S&P 500 remained at historic lows. We expect dividend growth will continue to be robust in 2012 due to the low payout ratio and increased investor demand for dividends. We continue to see significant press coverage and investor interest in dividend strategies due to strong performance and increasing demand for income in a zero interest rate environment.
That said, a number of articles in the press have begun to urge caution, noting that overly focusing on a stock’s dividend yield may lead to a poor outcome. We agree with this view. An investor whose sole concern is the relative yield of a relatively safe and predictable asset could end up taking on considerable interest-rate risk and may not be prepared for the capital losses that could occur. Buying an overvalued stock for yield is similar to buying a bond at a premium just because it has a higher coupon. The income stream may be attractive but there is a risk of capital loss that must be evaluated. This is why we employ a process that seeks to balance both valuation and yield. We believe demanding a discount at the time of purchase not only reduces downside risk, but also the Fund’s exposure to interest-rate risk and short-term investment fads.
At the end of the third quarter, we noted that the discount-to-value in the portfolio after the summer pullback was attractive but not as compelling as in our other long-only strategies. Thus, we were not surprised that the Fund underperformed modestly as the market rallied sharply in October. By the end of 2011, the average discount-to-value was back to its second quarter level of 91% of our calculated Absolute Value. This is at the high end of its historical range and has been a good indicator that the portfolio is fairly valued.
In recent quarters we have noted that our focus remains on quality, stock selection, and risk management and this has not changed. Given our expectation that 2012 will be volatile, we see no reason to alter that focus in the near future. We view market pullbacks as opportunities to establish positions in companies previously not trading at steep enough discounts. We remain steadfast in concentrating on stocks with high and growing dividends, healthy balance sheets, and attractive valuations.
River Road Asset Management
14 January 2012
As of December 31, 2011, Ship Finance International comprised 0.00% of the portfolio's assets, Nordic American Tankers – 0.38%, Waste Management – 1.90%, Iron Mountain – 0.94%, United Technologies – 1.12%, BlackRock – 1.34%, PNC Financial Services Group – 0.79%, Genuine Parts – 2.29%, Norfolk Southern – 2.32%, Seadrill – 1.72%, Duke Energy – 1.53%, McDonald’s – 1.17%, Federated Investors – 0.00%, Republic Services – 0.96%, Lockheed Martin – 1.55%, and Dr Pepper Snapple Group – 0.98%.
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.