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Oct 18 2012

3rd Quarter 2012 Commentary - ASTON/Cornerstone Large Cap Value Fund

3rd Quarter 2012

The third quarter of 2012 proved to be as confusing in the equity markets as the full year has been. Despite investor skepticism, decelerating earnings growth, weak global economic reports and an unresolved debt situation within Europe, the Fund’s Russell 1000 Value Index benchmark gained more than 6%. During the second quarter, short-term factors such as earnings momentum and earnings growth drove the market while valuation seemed to simply not matter. The third quarter was a complete reversal as valuation came back to the forefront. Many of the sectors and stocks that were the biggest detractors to the Fund’s performance during the second quarter were the biggest winners during the past three months. Although there were some positive macroeconomic events—the U.S. housing market began to show signs of stabilization and the Federal Reserve launched its third round of quantitative easing—to spur the markets higher, the recognition of what we considered attractive values was encouraging.

Within the Russell 1000 Value, Telecomm, Consumer Discretionary, and Energy were the top performing sectors. Investors concerned about troubles around the globe rewarded telecom companies given their strong dividends and exposure to the U.S. economy. Attractive valuations, strong balance sheets, and an improved outlook for the U.S. consumer led to the strong performance in Consumer Discretionary. Energy rebounded after being one of the biggest laggards the previous quarter as investors refocused on the sector’s attractive valuation, strong free cash flows, and global growth opportunities while riding oil prices higher.

Utilities, Technology, and Industrials were the worst performing sectors in the index. Investors shunned utility stocks and their strong dividends after valuations appeared stretched following the group’s big run up during the second quarter. Concerns about the global macroeconomic slowdown and fear that global demand for PCs may be weakening weighed on Technology. Industrials suffered from a global slowdown in construction and an outlook for slower earnings growth.

Strong Tech and Healthcare Picks

The Fund outperformed its benchmark by more than two percentage points during the quarter, powered by stock selection in Technology and Healthcare and our avoidance of the lagging Utilities sector. Based on Cornerstone’s Fair Value Model, valuations within Utilities remain unattractive. While an overweight stake in Healthcare aided performance, stock selection was the primary driver as the portfolio’s holdings consist predominantly of large-cap, multinational pharmaceutical companies that followed up a strong second quarter with more positive results.

Western Digital and Google were the big winners within Technology, with Western rebounding from being the biggest detractor during the second quarter to the top performer during the third. The stock had sold off on fears of peak pricing and demand given concerns about global PC demand.  We had added to the portfolio’s position on that weakness and were rewarded as the company provided increased earnings guidance that drove the stock price considerably higher. Our investment thesis on Google continues to play out and many of the negatives are dissipating.  Specifically, there have been major concerns about the competitive risks associated with Facebook and Bing and the threat that they pose to Google’s social search dominance. These concerns appear to have diminished as time has passed.

Other notable individual contributors included Hess and Eaton. Integrated oil producer Hess bounced back from lackluster second quarter production results in the Bakken region to produce better results in the Bakken during the third quarter along with the announcement of several asset sales that should help overall funding going forward. The market appears to approve of the planned acquisition of Cooper Industries by power management solutions provider Eaton given that it positions the historically cyclical company to be a more diversified industrial firm.

Stock selection within Materials and the total lack of exposure to Telecomm detracted the most from relative performance. Vale SA, the world’s largest iron ore producer and second biggest nickel miner, was weaker on concerns pertaining to China and overall global demand for steel. The Brazilian government’s influence over the company has also led some investors to question whose interest company management is trying to serve—shareholders or the Brazilian government.

Intel, Hewlett-Packard, and Staples were among the biggest individual detractors. Intel retrenched during the period over concerns relating to weak global PC and microprocessor demand.  The company also lowered its outlook based on macroeconomic concerns. The market reacted negatively to an earnings report in August from Hewlett-Packard in which management provided a muted outlook for the remainder of 2012. Investors remain concerned about how quickly management can implement needed changes at the company. Office supply company Staples is a new name added during the quarter that underperformed after reporting a disappointing quarter. The market is concerned about weakness in domestic and international operations as it pertains to declining secular trends in ink, paper and toner.

Portfolio Positioning

Despite the strong market rebound during the third quarter, we think that valuations remain compelling, both on traditional measures and Cornerstone’s proprietary valuation work. Our Fair Value Model now indicates that 73% of the 800 stocks in our universe are undervalued relative to their normalized earnings, with the average stock trading at roughly 69.2% of fair value.

During the quarter, we added two new names to the portfolio and exited two others. In addition to previously mentioned Staples—purchased based on an attractive valuation, a healthy dividend yield, and management’s global turnaround plan—we also initiated a position in leading medical device company Stryker. We believe the fundamentals look favorable at Stryker into the near future, and we view the recent appointment of a new CEO as a positive.

We sold both Bristol-Myers and VF Corporation based on current valuations after delivering solid returns. Our investment thesis has played out at Bristol as the company brought three new major drugs to the market. Although an excellent stock for the portfolio, current valuation does not warrant further ownership. Clothing manufacturer VF also appears fairly valued after its recent strong run of performance.

Concluding Comments

We continue to think that the market remains attractive for equities. In addition to our valuation model, traditional valuation metrics such as price/earnings and price/book ratios also show the portfolio trading at a significant discount to the market—this despite the near total reversal during the third quarter from what we experienced during the second quarter. As was the case then, and is now, we continue to find a lot of value in the market. We are enthusiastic about the portfolio’s positioning and our ability to improve the quality of the holdings through the addition of market leading, cash-flow rich, and attractively priced companies. We cannot be swayed by the whims of the market, however, which appear to be changing quarter to quarter. Although there may continue to be periods of strength and weakness, we will not stray from our time-tested process that has proved sensibly focused on long term results.

Cornerstone Investment Partners

As of September 30, 2012, Western Digital comprised 3.47% of the portfolio’s assets, Google  – 4.33%, Hess – 3.60%, Eaton – 3.39%, Vale SA – 2.16%, Intel – 1.95%, Hewlett-Packard – 2.14%, Staples – 2.27%, and Stryker – 3.02%.

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.


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