2nd Quarter 2012
Performance of the stock market during the second quarter was driven largely by macroeconomic news as concerns over weak U.S. jobs data, European sovereign woes, and a slowdown in China all contributed to a weak market. The quarter saw investors shift to a shorter time horizon, focusing more on earnings growth and less on valuation. Leading performers consisted primarily of stocks with the most expensive price/earnings ratios and price/book ratios.
As a result, our investment model has worked against us as the least attractive names, in our view, have far outpaced the most attractive names. Put simply, valuation was not a primary driver of returns during the quarter. Indeed, a valuation orientation actually worked against investors. Given this rare occurrence, the Fund underperformed its Russell 1000 Value Index benchmark for the quarter by a significant margin.
Holdings in the Financials, Materials, and Industrials sectors detracted the most from performance. It is interesting to note that Financials were among the top performing sectors during the first quarter of 2012. Stock selection was the main detractor as Morgan Stanley and Citigroup were among the five worst performing stocks in the portfolio. Investor anticipation of a challenging quarter on the back of a tough macro environment, tepid client activity, and a retrenchment in risky asset prices hurt the shares of Morgan Stanley. Specifically, the market seemed concerned about near-term revenue shortfalls in their Institutional Securities business. Citigroup similarly suffered from weak expectations despite the stock already trading at barely 50% of its tangible book value. Stock selection was the principle driver of the underperformance in Materials and Industrials as well.
Among the biggest individual drags on performance were Western Digital and Hess. Western Digital was the worst performer during the second quarter on the heels of being the portfolio’s best relative performer during the first quarter. The hard disk drive maker is suffering from concerns over the weak PC market, with expectations for weaker revenues putting pressure on its share price. Shares of oil company Hess were weak after its quarterly earnings call revealed lackluster production results in the Bakken region. In addition, investors seem focused on near-term capital expenditure costs and assets viewed by some as being too diverse.
The three top contributing sectors for the quarter in the portfolio were Consumer Staples, Healthcare, and Telecommunications as the market rewarded more defensively positioned companies. Results in Consumer Staples were driven by stock selection in the form of top contributor Wal-Mart. The market rewarded the company for regaining its sales momentum in the U.S. The firm’s international business is also seeing improved margins, which could be a bigger contributor to earnings going for forward.
The Fund’s Healthcare holdings consist exclusively of large-cap, multinational pharmaceutical companies which rebounded strongly following a disappointing first quarter performance. An overweight stake in the sector plus three of the portfolio’s top-five individual contributors—Merck, Eli Lilly and Bristol-Myers Squibb—aided returns. Merck combines a mix of low valuation, a proven track record of returning cash to its shareholders, and a pipeline of drug products that has the highest number of Phase III assets of any of the major U.S. pharma firms. In addition, the company has the lowest percent of 2011 revenue exposed to patent cliffs between 2012 and 2016. Eli Lilly was higher as the market has fully digested the Zyprexa patent expiration in October 2011, and begun to focus on Lilly’s outlook going forward. The firm has the highest dividend yield of the major pharma firms and we calculate the stock currently trades at the net present value of its existing drugs alone.
Finally, eBay is a new holding that was added to the portfolio during the first quarter that continued to perform well as we saw positive trends in its Marketplace segment and the long-term Payments opportunity. A big focus for investors is the Offline PayPal business. eBay has a platform in place to help induce large, medium, and small retailers to accept PayPal and to continue growing this high-quality business.
Buys and Sells
Three new names were added to the portfolio during the quarter—Apache, Eaton, and Hasbro, while three positions were sold. The valuation of energy exploration and production company Apache became considerably more attractive recently for a few reasons. The first is concern about civil unrest in Egypt, which is home to about 22% of the firm’s production. Another is the market belief that Apache is not able to grow without making acquisitions, which has been true in the past. Other reasons are more generic to the overall industry such as fluctuations in commodity prices. It is our belief that these concerns are more than reflected in its current valuation.
Eaton is a very attractively valued and well-run multi-industrial company that aspires to be “well balanced across the economic cycle.” Its stock still seems to move with the economic cycle, however. We think recent macroeconomic concerns as well as news of its recent acquisition of Cooper Industries have created a compelling buying opportunity. Hasbro is a well-run, industry-leading toy company with very strong brand recognition and a history of success in capitalizing on this strength. We don’t think recent macroeconomic concerns will detract from the long-term thesis on this attractively valued name.
Gamestop, Lockheed Martin, and AT&T were the three names sold during the period. GameStop detracted meaningfully from performance during the second quarter. Despite a compelling valuation we are starting to see the early signs of deterioration in its core business, as same store sales turned negative for the first time in the company’s history. Lockheed has performed well for the Fund, taking valuation to less compelling levels on a relative basis. In addition, the firm’s future prospects are fairly heavily tied to the success of the Joint Strike Fighter program, which is coming under increasing threat in the midst of the U.S. and European debt crises. The combination of high headline risk, deteriorating fundamentals, and less compelling valuation forced Lockheed out of the 30-stock portfolio. AT&T was sold given strong relative performance and the fact that it appears more fairly valued in our valuation work.
Given the retrenchment that the market experienced during the second quarter, we think valuations remain compelling both by both traditional measures and Cornerstone’s proprietary valuation work. Our Fair Value Model now indicates that 76% of the 800 stocks in our universe are undervalued relative to their normalized value, with the average stock trading at roughly 63.5% of its fair value. The portfolio currently trades at an even greater discount.
We continue to find a lot of value in the market and remain enthusiastic about the portfolio’s positioning given our ability to improve the quality of the holdings while landing market-leading, cash-flow rich, and very attractively priced companies in the process. We cannot be swayed by the whims of the market, which over the short-term seems more concerned with macro factors than the valuation of individual securities (hence the continuation of the so-called “risk-on”/ “risk-off” trades). Although there may continue to be periods of weakness, we will not stray from what we consider a sensible, time-tested process.
Cornerstone Investment Partners
As of June 30, 2012, Morgan Stanley comprised 3.23% of the portfolio’s assets, Citigroup – 3.78%, Western Digital – 3.87%, Hess – 3.11%, Wal-Mart Stores – 4.18%, Merck – 3.83%, Eli Lilly – 3.66%, Bristol-Myers Squibb – 2.67%, eBay – 2.45%, Apache – 2.07%, Eaton – 2.81%, and Hasbro – 1.91%.
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.