1st Quarter 2012 Commentary - ASTON/Cornerstone Large Cap Value Fund
1st Quarter 2012
Best First Quarter for Stocks Since 1998
Despite the continued overhang of European sovereign debt, slowing emerging economies, and political uncertainty in the U.S., the first three months of 2012 was the best first quarter for stocks since 1998. For the second straight quarter, equity markets posted double-digit gains, with the Fund’s Russell 1000 Value Index benchmark up more than 11%. Attractive valuations coupled with improved economic reports from the U.S. drove investors to equities, though growth companies outperformed their value counterparts by nearly 350 basis points.
Nine out of 10 benchmark sectors were positive during the period, with five sectors posting double-digit returns. Given the improving sentiment and uptick in economic activity, more cyclical areas of the market took leadership positions. Financials and Consumer Discretionary led the market higher as both gained more than 15%. Financials were aided by the recovery in banks as they continue to work through bad loans and improve their capital position, while economic optimism led investors to bid up Consumer Discretionary companies with attractive valuations. More defensive areas of the market trailed as investors flocked to companies poised to take advantage of improved economic conditions. The Utilities and Telecom sectors significantly trailed, posting negative and only slightly positive returns respectively, as investors demanded higher growth prospects.
The Fund outperformed its benchmark during the quarter fueled by enthusiasm for potential economic improvement that drove investors towards more economically sensitive companies and sectors. A substantial overweight stake in Technology was the largest contributor to performance as we have thought that valuations and fundamentals within the space have long justified significant ownership. Stock selection within Financials and a zero weight in Utilities were also major contributors to relative performance. The results of the Federal Reserve’s bank “stress tests”, improving news on the European sovereign debt front, and improved capital positions further boosted banking holdings.
Apple was the best individual performer during the quarter as the company continues to drive sales through their Ipad, Ipod, and Mac product lines. Results at the company were particularly positive as the company announced that it would begin paying a dividend while also initiating a share repurchase program.
Western Digital and Citigroup were the two other standout performers. The FTC gave Western approval to proceed with its acquisition of Hitachi Global Storage Technology pending asset sales to Toshiba. The company also recovered faster than expected after flooding in Thailand that interrupted production of its hard drives, which helped to raise expectations for revenue, earnings, and market share. Citigroup’s stock was higher as the company reported earnings that showed improvement in lending and a reduction in losses on bad loans. The company also continues its slow but steady recovery, reporting net income 6% higher than in 2011.
Stock selection detracted from performance on the whole, however, as holdings in Healthcare and Consumer Discretionary trailed the overall market. Pharmaceutical stocks were notable detractors as Eli Lilly, Bristol Myers, and Merck all dealt with significant patent issues. Bristol Myers is navigating the loss of Avapro and Plavix this year, with more patent expirations expected in the near future. The company also suffered a setback when the FDA failed to approve a new class of diabetes drug the company was jointly developing, asking for more information before they could reach agreement. Bristol did acquire Inhibitex during the quarter to help bolster the company’s pipeline, but it came at a sizable premium.
Within Consumer Discretionary, Gamestop hurt performance as the video game retailer’s business model continued to come under attack. The company reported in-line earnings but softness in its used-game business. Concerns continue to surround the viability of the used-game business as game makers look to digital downloads and restrictions around used-game sales to protect new game sales.
Elsewhere, new holding Hewlett-Packard was the biggest individual detractor as the company reported earnings that were sharply lower from a year ago and warned of continued weakness going forward. The company also announced plans to combine its personal computing and printing divisions in an effort to improve sales.
Valuations Remain Compelling
Despite the strong positive results from stocks during the first quarter, we believe valuations remain compelling based on both traditional measures and Cornerstone’s proprietary valuation work. Cornerstone’s Fair Value Model now indicates that 71% of the stocks in its 800 stock universe are undervalued relative to their normalized value. Using normalized earnings, we now calculate the average discount of that universe to be 68% of fair value. The current equity risk premium (the projected excess equity return over a risk-free rate) for the Model is now at 9% versus an historical average of 3%. Along with valuation, other positives factors for stocks include accommodative central banks, record low interest-rates, and record corporate earnings.
Aside from normal additions and trims, we added two new positions to the portfolio during the quarter—eBay and Hewlett-Packard. Following a series of missteps and management turnover, HP is now one of the most attractive stocks in the portfolio based on our valuation work. The stock is valued as though it were a broken company in perpetual decline. It is rare for a large-cap, industry-leading firm in good financial condition like HP to look this attractive. We believe that the opportunity lies within the gap between the perception of it as a broken company and the current reality of it being a market-leader in three of its business units (PCs, printers, and x86 servers). It has a relatively clean balance sheet with operating cash flow of more than $12 billion for the most recently completed fiscal year. Furthermore, a renewed focus on operational excellence and disciplined capital allocation under new CEO, Meg Whitman, is consistent with our investment thesis. That is, our valuation work suggests a very low bar has been set for HP, and the company does not need to do anything heroic for the stock to work.
Ebay is transforming its business model from an online auction marketplace for unique items to a provider of technology driven e-commerce services to retailers. The company retains a large user base, global reach, and brand awareness, and has a strong balance sheet as well as very compelling valuation. As the parent company of Paypal, it also operates a global payments platform that enables secure and quick payments that is attractive to online retailers.
We sold two positions from the portfolio during the quarter—Chubb and Flextronics. Both relative and absolute valuations for high-quality insurer Chubb now appear more in-line with historic averages. The market seems to be pricing in considerable pricing improvement due to catastrophic losses that typically drive premiums higher. Electronics manufacturer Flextronics faces rising pressure due to higher input costs and increased competition.
As the market has produced double-digit returns in each of the past two quarters, investors could be forgiven for thinking stocks are due for a breather. A number of issues still overhang the economic and market environment with looming elections in the U.S. and abroad, slowing emerging economies, and the indebtedness of troubled European governments. Cornerstone does not attempt to forecast these macroeconomic events or when their conclusions will be realized. Rather, we attempt to identify successful companies trading at attractive valuations given low expectations in an effort to protect capital. We think there are a significant number of industry-leading, strong cash-flow generating companies trading at reasonable valuations that offer compelling opportunities for patient and disciplined investors.
Cornerstone Investment Partners
As of March 31, 2012, Apple comprised 4.99% of the portfolio’s assets, Western Digital – 3.61%, Citigroup – 4.20%, Eli Lilly – 3.23%, Bristol Myers – 2.20%, Merck – 3.82%, Gamestop – 1.28%, Hewlett-Packard – 2.65%, and eBay – 2.03%
Note: Value investing often involves buying the stocks of companies that are currently out of favor that may decline further.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.