Market Commentary as of 9/30/08
Financials, Financials, Financials
The third quarter of 2008 was certainly noteworthy. The threat of a global recession appears to have ended the bull market in commodities, at least temporarily, as oil prices peaked at the beginning of the quarter before dropping nearly $40 by the end of September. After precipitous declines in June and the first two weeks of July, Financial stocks rebounded sharply following Wells Fargo's announcement of a 10% dividend increase. But more dramatic changes to the sector would follow as AIG, Fannie Mae, and Freddie Mac were effectively nationalized, Lehman Brothers filed for bankruptcy, Merrill Lynch, Wachovia, and Washington Mutual were forced into mergers at distressed prices, and Goldman Sachs and Morgan Stanley survived the scare of the credit crisis by converting into commercial banks. Amid this volatile environment, it was surprising that the Financials sector in the Russell 3000 Value Index gained 5.2% during the period.
Small-cap stocks performed significantly better than large-caps, and value outgained growth during the quarter. The reconstitution of the Russell benchmarks in June resulted in a large increase in the representation of Financials in the Russell 2000 Index, aiding its performance significantly. In a reverse from the second quarter, the strong performance of Financials also resulted in the broad outperformance of value versus growth stocks across the market capitalization spectrum. The Fund's Russell 3000 Value Index benchmark posted a loss of less than half that of its growth index counterpart, a difference that was even more pronounced among the small-cap indices.
High-yield stocks continued to lag owing to turbulence in the Financials sector and a decline in dividend growth. The highest yielding quartile of companies in the S&P 500 Index continued to underperform all other quartiles by a wide margin. The index's overall dividend growth rate dropped again during the third quarter as some large financial institutions reduced payments. For the first time since the dividend income tax cut in 2003, the broad market is posting below average nominal dividend growth and negative real growth. Despite the anemic growth, market declines have resulted in a steady increase in the yield of the market to just above its 25-year average—the highest it has been since the mid-1990s. In addition, dividend-increasing companies still outperformed firms that did not increase their dividends and those that reduced or eliminated their dividend during the last 12 months, the latter by a wide margin.
Winners
Although it's been a difficult period overall in the market, the Fund has substantially outperformed its benchmark and peer group for the quarter, year-to-date, and since its June 28, 2005 inception. Indeed, through the end of the recent quarter, the Fund ranked in the top decile of the Morningstar Mid-Cap Value Category (Morningstar does not have an equity-income category) for the trailing three-year period. (Ranking based on total returns through September 30, 2008, versus 328 similarly styled funds).*
During the third quarter, Financials and Consumer Staples contributed the most to absolute returns, while holdings within the Utilities and Consumer Staples sectors were the key to the positive relative performance. The portfolio moved from slightly overweight to slightly underweight in the Financials, though the group remained the largest in the Fund with an average weight of 25.5% of assets.
The three holdings with the greatest positive return during the quarter were all from the banking industry—BB&T Corp., US Bancorp, and Bank of America. In mid-July, BB&T reported strong second quarter results. The company's pension plan purchased 2.45 million shares of its own stock for around $22 per share, establishing the bottom of the decline. The firm followed up with a 2.2% dividend increase in late August. Following the announcement of the government bailout plan, the firm began trading at a premium to our assessed absolute value in September and we exited the position. US Bancorp's stock price also spiked on the announcement of the government bailout plan, allowing us to reduce meaningfully the position at a significant premium to our assessed absolute value. With Bank of America's recent acquisition of Merrill Lynch and Countrywide Financial, we believe it is acquiring risky assets at the appropriate time—when they are cheap. We became concerned, however, with the firm's ability to grow the dividend in the future and significantly reduced the position, and subsequently were disappointed to learn of plans to cut the dividend payment 50%.
Energy Drain
The sectors with the largest negative contribution to total return were Energy and Materials. The dramatic drop in the price of oil during the quarter affected most Energy firms, even those that stand to benefit from lower prices—such as those in the oil and gas pipeline industry, where revenue is based upon the volume of oil or gas shipped, not the price of the underlying commodity.
ENI S.p.A. and Alliance Resource Partners L.P. were the two biggest disappointments. An international producer of oil and natural gas, ENI suffered from the falling price of oil, despite actually boosting production by 3% year-over-year. The Fund continues to hold the stock as the company raised its dividend by 8.3% year-over-year and repurchased close to 8 million shares at around $75/share. Coal producer Alliance Resource Partners has a conservative growth policy and we believe the recent decline in coal prices should not affect cash flows significantly given the firm's long-term contracts.
The biggest disappointment for the Fund this quarter was Nucor, one of North America's largest steel producers. The company produces a wide variety of steel products in an attempt to reduce cyclicality and dependency on any one steel market. The firm is a high-quality, low-cost producer, but remains sensitive to the changing price of raw materials and energy prices, which in turn have affected its production costs. We trimmed the position in the portfolio during the period to reduce accumulated unrealized losses in accordance with our sell discipline.
Outlook
We are witnessing unprecedented events and actions in the economy and securities markets. The credit market is paralyzed, with the impact felt well beyond Wall Street. Businesses around the globe are feeling the effects of tightening bank credit standards. Expansion plans are being put on hold, inventories are being reduced, and growth opportunities are going unmet. Pressure is also coming to bear on US consumers, and they are adjusting accordingly. Jobless claims are rapidly climbing and the longer this credit crunch continues the worse it is likely to get.
Wall Street was not alone in its drive to increase leverage during the past decade, as the average US household also steadily increased its use of debt and stopped saving. Since the beginning of 2008, this trend has reversed dramatically. During the second quarter of 2008, US mortgage equity withdrawals were negative for the first time since 1992, a marked decrease from the nearly $900 billion in wealth taken out of homes and used for consumption in 2006. While this current frugality will be positive for household balance sheets in the long run, that spending was an important driver of economic growth.
The continuous stream of bad news has created a powerful downward spiral in stock prices. The volatility among equities suggests that the only certainty is a high level of uncertainty. In some cases, there is a clear disconnect between prices and the underlying fundamentals (for Master Limited Partnerships, MLPs, in particular). What gives us some level of comfort is that the stocks we own represent companies whose businesses engage largely in functions that are critical to the continued operation of the economy. Looking at the Fund's top holdings, you will find garbage collection companies, electric utilities, snack food manufacturers, and companies that make kitty litter, cleaning products, and personal care products. It's hard to imagine a situation in which these firms won't continue to have a market for their products.
Despite the massive uncertainty, we are actually more optimistic than we have been in a long time. While the economy appeared to be in good order in 2006, few realized at the time that the systemic risks were significantly greater than they are today. After a series of failed band-aid solutions during the past year, we are finally seeing a massive, coordinated, global policy response. Given the proper amount of time, it is likely government will succeed in its goal to stabilize the system.
The Fund itself also provides us with reason to be optimistic. We track the weighted average discount to our assessed absolute value of the Fund's top-20 holdings. During the past 12 months, this indicator has remained steady at 78% to 82% of the assessed absolute value. Considering we target a minimum discount of 85% to 90% of absolute value for a new investment, this range represents an attractive discount. As of Thursday, October 9, 2008, this measure declined to 69%, the first time on record that it had fallen below 70%—using what we consider conservative assumptions on our Absolute Values. In the past, we have refrained from making statements about the relative attractiveness of investing in the Fund, but we truly believe that given an appropriate time horizon, it now represents a compelling investment opportunity.
River Road Asset Management
As of September 30, 2008, US Bancorp comprised 1.52% of the portfolio's assets, Bank of America – 1.28%, ENI S.p.A. – 2.26%, Alliance Resource Partners – 1.26%, and Nucor – 0.87%.
* The Aston/River Road Dividend All Cap Fund (formerly the Aston/River Road Dynamic Equity Income Fund), was ranked by Morningstar as of 9-30-08 based on Total Return within the Mid-Cap Value category. The Fund received a percentile Ranking of 11% and 6% among 437 and 328 funds for the one- and three-year periods, respectively. Morningstar ranks funds from 1 (being the highest percentile rank) to 100 (the lowest percentile rank). A top-performing fund will receive a rank of 1 in its category. Rankings are subject to change. Past performance is no guarantee of future results.
Note: Mid-cap stocks are generally riskier than large-cap stocks due to greater volatility and less liquidity.
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.