Market Commentary as of 3/31/08
Rough Start
A rough start to 2008 had the market picking up right where 2007 left off. All but one sector in the Fund's Russell 1000 Value Index benchmark finished the quarter in negative territory. Dislocations in the credit markets continued unabated, leaving the balance sheets of many financial services companies in significantly worse shape. The US Federal Reserve Board took steps to alleviate many of the problems by acting aggressively to provide additional liquidity, most notably by opening up its discount window to the broker-dealers for the first time since the Great Depression in the 1930s. As of the end of the quarter, however, the credit market dislocations remained mostly unresolved, and questions loomed large about the state of the US economy. The uncertainty and increased volatility that began to plague the market three quarters ago continues.
Although we don't cheer the reasons behind the increased volatility, as active investors we certainly welcome the increased opportunities created amid such an environment. While the market's appetite for risk has declined from the very high levels of a year ago—as evidenced by the significant widening of corporate debt spreads during that time—we think investors are still underestimating the long-term value of high-quality companies. If the Fund can add even higher-quality, slightly faster growing than the market, companies to the portfolio without paying too much of a premium, then we think that's a great value proposition for shareholders over a three- to five-year time horizon.
Healthcare Struggles
The Aston Value Fund portfolio underperformed the benchmark during the first quarter of 2008. Stock selection in the Healthcare, Financials, and Industrials sectors were the main detractors. Shares of all HMOs, including Fund holdings WellPoint and UnitedHealth, declined significantly on investor concerns about a cyclical economic downturn and rising medical loss costs. WellPoint was particularly hard hit after it made negative earnings pre-announcements indicating worse-than-expected trends for medical loss costs. In addition, Merck fell on concerns about the impact of a study released during the quarter that demonstrated no greater efficacy for its cholesterol drug Vytorin compared with other, lower-cost statins. The negative press, as well as calls by some medical experts to reduce usage of the compound, led to a 15 percent decline in scripts during in the quarter. Vytorin represents approximately 15 percent of Merck’s sales and earnings, yet caused a loss of more than a third of the company's market-capitalization.
Within Financials, greater-than-expected losses at UBS led to sizeable book value write-downs and a substantial issuance of dilutive equity to raise capital in an effort to shore up its balance sheet. Despite the attractiveness of its global wealth management franchise, the value destruction from the company's credit exposures have been larger than anticipated, resulting in a significant loss. Fannie Mae also suffered during the quarter as continued weakness in the credit environment and the increased likelihood that it will have to raise additional capital offset any potential positives resulting from a government reduction in its capital requirements and an increase in the maximum loan value the company can purchase. Furthermore, not owning General Electric in the Industrials arena detracted from relative performance during the first quarter, exacerbated by its sizeable position—nearly 5%--within the benchmark.
Overweight positions and stock selection within Consumer Staples and Consumer Discretionary, as well as positive stock picking in Technology aided performance. Nestle reported better-than-expected 2007 results due to strong organic growth and increasing margins, leading to impressive overall earnings for the company. Noteworthy quarterly results at Nike—including revenue growth of 16% and earnings growth of more than 30%—demonstrated the firm's geographic and product diversity.
The Fund's avoidance of AIG, Wachovia, and Motorola also contributed positively to relative performance. Credit Default Swap (CDS) losses of nearly $14 billion, and questions raised by auditors about how it values this portfolio, weakened management's credibility and put significant pressure on AIG. Wachovia's ill-timed acquisition of lender Golden West in 2006 led to outsized exposure to deteriorating mortgage assets and continued to put pressure on the stock. Weaker-than-expected performance at Motorola's core handset division led to speculation about the company’s ability to compete effectively in the market, driving its shares lower.
Favoring Tech and Energy
We’ve noted for some time that our investment universe has broadened during the course of the last several years as valuations have compressed across industries and sectors. As a result, relative sector exposure within the portfolio is about as close as it has ever been to that of the Russell 1000 Value. Even in absolute terms, exposure to some sectors is at historical extremes. Weightings in Technology and Energy are at or near all-time highs. Conversely, the percentage of assets devoted to Financials has never been lower.
The biggest change to our portfolio during the quarter was the Fund's decreased exposure to Financials. This is in part due to depreciation, but we have also actively reduced exposure in a number of names. Note though that the Fund's overall positioning within the sector—underweight regional/credit sensitive banks and REITs in favor of insurance companies, trust processing banks and brokers, and asset managers—is largely unchanged from 2007. Although we are actively looking for opportunities to add to the portfolio in this sector, it has been quite a challenge to find new ideas among the hardest hit companies. As of now, our lack of comfort with the sustainability and durability of many franchises has kept the Fund largely on the sideline.
In regards to Technology, it's rare that we can remember a time where tech companies have stacked up so attractively. Unlike during previous periods, we think the prospects for firms the Fund owns within the sector are much more certain, yet the valuations are at the low end of historical ranges. Therefore, we increased the Fund's exposure to several stocks during the quarter as each company's valuation became increasingly attractive relative to other opportunities in the market.
MFS Investment Management
Boston, MA
Note: Value investing involves buying company stocks that are out of favor and/or undervalued. Depending on market conditions, a fund's return may be adversely affected during market downturns.
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.
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.