2nd Quarter 2012
Stocks Finish Lower Despite Late Quarter Surge
Following a near record first quarter performance, the broad market S&P 500 Index declined 10% from April through May as investors responded to the spreading financial crisis in Europe and a marked slowdown in global economic growth. On both sides of the Atlantic, the lack of a strong policy response weighed heavily on risk assets. The market rallied yet again during June, however, as comments from various Fed officials raised the expectation (once again) of additional quantitative easing.
We stated in our first quarter commentary that high-beta (volatility) stock leadership had faded in March in a possible sign that maybe the QE-fueled risk trade had run its course. This was indeed the case. During the second quarter, the lowest beta stocks (first quintile) outperformed the highest beta stocks (fifth quintile) within the S&P 500 by more than 15 percentage points—an extraordinary gap. In addition, according to Ned Davis Research, the highest yielding companies in the S&P 500 outperformed non-payers by five and a half percentage points. All told, 310 companies in the S&P 500 have initiated or increased their dividends during the past 12 months. As earnings growth has slowed, the payout ratio has finally begun to climb, but still remains well below its long-term average.
Value outperformed growth across all market-capitalizations during the quarter, with the gap wider among large-cap stocks among the various Russell indices. Dispersion of returns by market-cap itself, however, was minimal. Within the Fund’s Russell 3000 Value Index benchmark, seven of 10 sectors delivered a negative total return. The outperformance of low-beta strategies was apparent as cyclical sectors like Technology, Materials, and Energy posted the lowest total returns, while defensive areas like Telecommunications, Utilities, and Healthcare generated the highest.
Despite a small absolute loss, the Fund outperformed its benchmark during the second quarter. Both sector allocation and stock selection had a significant effect as eight of 10 sectors within the portfolio generated positive relative results. Strong stock selection and an underweight position in Financials provided the most significant impact on a sector level.
The top individual contributor was Kimberly-Clark, which reported quarterly results that topped analyst estimates on organic revenue growth and strong sales in its international division. The maker of global health and hygiene products benefited from earlier cost reduction efforts to increase earnings year-over-year. In addition, management announced a significant stock plan funded from operating cash flow and raised its dividend.
Telecom provider Verizon Communications and Railroad operator Norfolk Southern were also among the top performers during the quarter. Verizon beat expectations as it reaped the rewards of a record number of smart phone activations. The transition to smart phones, now 47% of postpaid subscribers, contributed to an increase in revenues and margins in its Wireless division. Management continues to utilize the company’s superior network quality to drive higher growth and margins, rewarding investors with share price performance as well as an attractive dividend yield. Norfolk Southern reported record results as demand for intermodal and automotive freight more than offset weak thermal coal volume. Despite losing highly profitable coal freight, the company managed to improve margins by increasing network efficiency through faster average train speed and personnel utilization. The company repurchased 1.7% of its shares during the period, and we increased our calculated Absolute Value on the stock.
Other notable positive contributors included Wal-Mart Stores and Bermuda-based reinsurer PartnerRe. Wal-Mart reported quarterly earnings above the top end of their guidance and ahead of Wall Street estimates on higher comparable sales at its U.S.-based stores, marking its best quarterly performance in three years. PartnerRe reported strong results in May, benefitting from a quiet quarter with regard to catastrophes. As with the previously mentioned holdings, we maintained the Fund’s position in each stock during the quarter.
… and Losers
Only two sectors had a negative total effect on relative performance, Telecom and Healthcare, with Telecom providing the largest negative impact due to weak stock selection. Underweight stakes in Healthcare and Utilities, among the best performing sectors in the benchmark, also detracted from relative results.
Among the biggest individual detractors during the quarter were Telefonica Brasil, Hillenbrand, and ABM Industries. Telefonica Brasil is Brazil’s leading wireless telecom company. Despite solid fundamentals, the stock declined due to concerns about parent company Telefonica S.A. and weakness in the Brazilian real. Investors have become increasingly concerned about the parent’s debt burden and have begun to speculate whether it might have to sell all or part of its healthy, growing Latin American operations. Our view is that Telefonica needs the dividends from Telefonica Brasil’s strong cash production and modest debt to reduce its own leverage, and to support operations. Speculation about the parent company may create short-term distractions, but we believe Telefonica Brasil’s merits stand on their own and maintained the Fund’s position.
Hillenbrand reported disappointing fiscal second quarter results driven by weakness in its casket manufacturing business. Management indicated full year 2012 results would be near the low end of previous guidance as the number of deaths in the U.S. declined 3% to the lowest level since 1982, resulting in fewer burials. We maintained the Fund’s position as the firm’s process equipment platform continues to exceed expectations. Facility services contractor ABM Industries reported disappointing results in June with delayed start dates for awarded contracts combined with early termination of some government contracts. ABM used its strong free cash flow to reduce net debt during the quarter, however, and we maintained the portfolio’s position.
Rounding out the bottom five performers were asset manager BlackRock and oil and gas producer BreitBurn Energy Partners LP. BlackRock’s stock fell as Barclays, a major shareholder, decided to exit its stake in the company in order to raise capital. Given that Barclays’s decision appeared to be motivated by forced, rather than opportunistic, selling and that our long-term optimism for the company’s fundamentals has not changed, we used the opportunity to increase the position. BreitBurn traded down with the price of oil and from increased balance sheet risk from acquisitions of producing properties in the Permian and Big Horn Basins.
Although we build the portfolio using our bottom-up investment process, we remain cognizant of the position of the Fund relative to the Russell 3000 Value. On June 22, Russell reconstituted its indexes contributing to two significant changes in the relative position of the portfolio.
Primarily driven by an increase in Exxon Mobil, the benchmark’s weighting in Energy increased more than four and a half percentage points to 15.8%. Despite the addition of two MLPs (see below), the portfolio’s underweight position relative to the benchmark nearly doubled due to the reconstitution. We are not bearish on the sector, but have had trouble finding good value. This has begun to change recently as over the past few months we have worked on numerous investment ideas in the sector and expect that this underweight will decline as we identify attractive investment opportunities.
The Fund established new positions in some master limited partnerships (MLPs) for the first time since March 2010. These securities had experienced a broad move up and become richly valued. We have diligently watched the group waiting for valuations to return to attractive levels, and that patience was finally rewarded. After evaluating 10 MLPs, some of which we have owned in the past, we established initial positions in Transmontaigne Partners LP and Amerigas Partners LP in the portfolio.
The addition of j2 Global boosted the Fund’s stake in Technology during the quarter as the benchmark weighting decreased. Of note is that the drop in the index rebalance was largely due to a sharp decrease in the weighting of Intel, the top holding in the Fund. Thus, the portfolio’s position in Technology went from a slight underweight to a nearly two-percentage point overweight. j2 Global provides flexible global messaging and communications services, and has a dominant position in electronic fax with a highly scalable and asset-light business model that generates significant free cash flow. Despite strong fundamentals and a recently initiated dividend, the company is widely disliked by investors due to concerns about the viability of the fax market. We believe that the company’s subscription-based model and efforts to continually reinvent core offerings with new features will continue to drive consistent, growing revenues, and steady free cash flow. The customer base is growing organically, the cancel rate is at historical lows, and fax pages per user are increasing.
Thus far this year, global markets are eerily echoing the path charted in 2010 and 2011. Buoyed by massive quantitative easing, global markets surged during the first quarter only to decline in the second as the temporary stimulus wore off and issues in Europe moved into the headlines. Looking at the volatility the last two summers, it is no surprise that a sense of déjà vu has overcome investors, policymakers, and management teams.
The global economy is caught in a tug-of-war between the ongoing eurozone debt crisis plus weak global growth on one side and aggressive monetary policies on the other. The two sides have thus far been evenly matched and as they battle we have experienced a series of short, powerful cycles. As economic growth wanes and policymakers inject massive amounts of liquidity, markets surge and the economy advances only to slow again as the injection is completed. Until another factor (like fiscal policy) grows strong enough to upset the balance, this pattern will likely continue. At this point, it is impossible to determine what that factor will be or when it will come, but it will likely dictate the ultimate direction the market takes.
Fiscal policy in the U.S., like much of the developed world, is a mess. Since the 2010 election, the political process has been deadlocked and both parties have allowed the resolution of important issues to be deferred until after the November 2012 elections. This has contributed to the creation of a “fiscal cliff” in 2013, a collection of spending cuts and tax increases that is expected to contribute to a 3% to 4% falloff in Gross Domestic Product (GDP). To date, this deadlock has also prevented the replacement of blunt, short-term monetary stimulus with sound, supportive long-term fiscal policy, without which the U.S. economy may not be able to move forward.
That said, policymakers realize that market participants have been trained to expect that economic or financial weakness will prompt supportive actions. If the economic situation deteriorates significantly in the coming months, it is highly likely that, yet again, central bankers will be compelled to rush in and save the day. As the November election nears, however, the freedom and willingness of the Federal Reserve to act may decline. It is possible that growing political pressure will prevent the decisive action the market has come to expect.
Despite the uncertainty, we continue to believe that markets will deliver attractive returns in 2012. Looking out over the next six months, earnings expectations from the portfolio’s holdings remain positive, corporate balance sheets are well positioned, and declining energy prices should help consumers and offset adverse currency impacts for businesses. Conditions also remain ripe for a continued increase in mergers and acquisitions, which should favor the Fund’s small-cap holdings and our Absolute Value style of investing.
The current interest rate environment demands that we carefully balance current yield and valuations. Persistent, low interest rates have increased the demand for high-yield equity and valuations among the highest yielding companies remain stretched. As such, the portfolio’s exposure in this area remains low. We will continue to look for opportunities in this group, but we believe that a patient, value-oriented process is central to long-term success. We remain focused on companies with growing dividends, healthy balance sheets, attractive valuations, and other characteristics we believe the market will reward in the months ahead, including the ability to thrive in a low growth environment.
River Road Asset Management
17 July 2012
As of June 30, 2012, Kimberly-Clark comprised 2.38% of the portfolio's assets, Verizon Communications – 1.87%, Norfolk Southern – 2.21%, Wal-Mart Stores – 1.37%, PartnerRe – 1.57%, Telefonica Brasil SA – 1.34%, Hillenbrand – 1.18%, ABM Industries – 0.90%, BlackRock – 1.76%, BreitBurn Energy Partners LP – 1.67%, Exxon Mobile – 0.00%, Transmontaigne Partners LP – 0.39%, Amerigas Partners LP – 0.51%, j2 Global – 0.51%, and Intel – 2.72%.
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, 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.