4th Quarter 2012 Commentary - ASTON/River Road Small Cap Value Fund
4th Quarter 2012
Mixed Fourth Quarter Amid Strong 2012
The fourth quarter provided a fitting end to what was a volatile, yet successful year for equity investors. Stocks traded modestly higher in October before experiencing a sharp, post-election decline. Surprisingly positive employment data later led to a reverse of the slump with stocks propelled by rising optimism for a resolution of the fiscal cliff. The final surge arrived on December 31, as news emerged that lawmakers had finally cobbled together the framework for a deal.
Small-cap stocks led for the quarter, as the Russell 2000 Index gained 1.85%, nearly two percentage points more than the large-cap oriented Russell 1000 and S&P 500 Indices. For 2012, large and small-cap stocks delivered equally robust returns, with all three indices returning roughly 16%. Mid-caps were the best performing segment, with the Russell Midcap Index gaining more than 17%.
With Financials posting stellar returns and Technology stocks lagging, value stocks handily outperformed growth across the market-capitalization spectrum (as represented by the Russell indices) for both the quarter and 2012. Indeed, among small-caps, the Fund’s Russell 2000 Value Index benchmark outpaced its small-cap growth index rival for the first time in three years.
High-beta (volatility) stocks fueled the fourth quarter rally as risk aversion fell. The highest beta stocks (fifth quintile) in the benchmark outgained the lowest beta (first quintile) by more than four percentage points. High-beta stocks in the benchmark also led for all of 2012. Extended high-beta leadership this late in an economic recovery is unusual and, in our opinion, is a direct consequence of the Federal Reserve’s aggressive monetary policies. Fortunately, high-beta leadership has not coincided with low-quality outperformance, as higher-quality stocks led the benchmark during the first three quarters of the year before falling off during the fourth quarter rally. This is likely due to slowing profit growth, which encourages investors to bid up stocks with strong earnings metrics
Active Managers Disappoint in 2012
Active small-value managers performed well during the fourth quarter in general, with 66% outperforming the benchmark, but they struggled in 2012 as just 35% outperformed. Since early 2011, we have commented on the unusually large percentage of small-value managers that have outperformed during recent periods of high-beta leadership—a trend that is counter to our long-term observations. Small-cap managers lagged in 2012, however, despite high-beta leadership. We believe the reason was the significant underperformance managers experienced during the second quarter, when low-beta stocks significantly outperformed and just 12% of small-value managers beat the benchmark. (Note: The second quarter was a particularly strong quarter for our low-volatility, high-quality style of investing.)
Active managers across the size and style spectrum have struggled against their benchmarks the past few years. Large-caps have been a particularly challenging segment, though small-caps have not performed well either. Small-cap managers posted their worst relative performance since 2008, and fewer than half of all active small-value managers have now outperformed since 2000.
As active managers have struggled, fund flows have shifted dramatically toward index funds and exchange-traded funds (ETFs) dedicated to U.S. stocks. Unfortunately, large flows into index funds and ETFs typically leads to higher equity correlations and a more challenging performance hurdle for active fundamental managers. Long-term, however, these flows result in crowded trades that can create inefficiencies for active managers to exploit.
It is difficult to say exactly why managers have struggled against the benchmark recently. Certainly, high equity correlations related to global macroeconomic events and strong ETF flows have been contributors. Within the small-cap space, value managers have suffered from outperformance in the Financials sector, particularly in real estate investment trusts (REITs)—where managers have generally been underweight.
The Fund underperformed the Russell 2000 Value during the quarter, and substantially underperformed for the year. As noted in previous commentaries, the most challenging phase of the market cycle for our style is the early, high-beta/low-quality stage, which we believe ended in February 2011. Since that time, the Portfolio has performed reasonably well in outperforming the benchmark. During this period, stock selection has been strong and volatility and turnover have remained consistently low. The biggest challenge by far has been the Financials sector, including the lack of any REITs in the portfolio.
The Fund does not invest in REITs, as we take a more institutional approach that treats real estate as a separate asset class. Historically, the lack of REIT exposure has had a negligible impact on the relative performance of the strategy. The recent, extraordinarily low interest-rate environment, however, has fueled strong REIT performance resulting in a significant negative impact on relative performance for the year. REITs gained a stunning 27% in 2012, accounting for roughly about half of the portfolio’s underperformance in the Financials sector. If yields on U.S. government bonds should rise, as they have in the beginning of 2013, REITs are likely to underperform given the strong correlation between the two asset classes.
The remaining underperformance in Financials was largely the result of limited (and more conservative) exposure to Banks and Thrifts. Banks have been an underperforming sector in the portfolio for much of the recovery as the more leveraged, and lower-quality, institutions have bounced back sharply from the financial collapse of 2008. We continue to see few opportunities in the commercial bank and thrift industries that meet our investment criteria, preferring instead more transparent and less-volatile investments.
Poor stock selection within Energy, including two of the Fund’s five biggest individual detractors, hurt fourth quarter returns. Despite being of the better performing sectors for the Fund historically, smaller, event-driven investments in Energy have lagged the benchmark during the past two years. Oil and gas exploration/production firms Miller Energy Resources and Endeavor International each suffered from company specific issues.
Miller faced an unexpected temporary shutdown on an important producing oil well and missed management’s stated timetable to restore another gas well, while Endeavor failed to close two previously announced acquisitions of attractive North Sea assets. Miller possesses valuable offshore, onshore, and midstream assets but has a limited number of them, which increases the need for strong operational execution on each well. Despite the setbacks, the management team has a record of increasing production each year and we expect this trend to continue into 2013 with the recent purchase of a high-powered drilling rig. The operational setbacks at Endeavor combined with increased balance sheet leverage significantly reduced our margin for error and impaired our investment thesis. We sold most of the position just prior to year-end as the situation deteriorated.
The biggest individual detractor during the quarter, however, was Ascena Retail Group. Specialty apparel store operator Ascena (dressbarn, maurices, Lane Bryant, Catherines, and Justice) sold off when the company reported results that were above expectations, but management failed to raise full-year guidance. They were also conservative in their estimates for synergies from the Charming Shoppes acquisition completed in June. The company expects to reduce overhead during the next three years to improve profitability and solid sales and earnings growth. We took no action on the position.
Laggards for the full year 2012 were a mixed bag. Closeout retailer Big Lots lowered earnings expectations and guided toward its first negative annual comparisons in more than 10 years. Discretionary sales have been weak and management is working on various initiatives to address its merchandising issues. We eliminated the position in The Dolan Company, a provider of mortgage default processing and litigation services. The “robo-signing” scandal prompted mortgage servicers to delay processing foreclosures, which we believed would be temporary. Non-foreclosure solutions like short sales appear to have successfully resolved many delinquent mortgages, however. Finally, energy services firm Tetra Technologies re-deployed legacy assets into offshore acquisitions that have disappointed thus far. Interestingly, multiple insiders made several open market share purchases in November. We trimmed the position to manage losses.
The sector with the highest contribution to relative return for both the fourth quarter and all of 2012 was Industrials. Stock selection drove performance led by the Fund’s top-performing stock for both periods, Geo Group. In 2012, Utilities and Technology also provided strong relative performance, with Utilities benefitting from a significant underweight position and Technology driven primarily by stock selection.
Shares of private prison operator Geo Group rallied when its Board of Directors announced the company would be converting into a REIT on January 1, 2013. To conform to the REIT rules of the Internal Revenue Code, the company paid a special dividend during the fourth quarter. The REIT conversion will improve the company’s tax efficiency, lower its cost of capital, and provide additional flexibility for growth opportunities. It should also increase the price investors give the stock as REITs are trading at a significant premium in the current low interest-rate environment. Although we do not typically invest in REITs, we do not feel compelled to sell a portfolio holding that converts into a REIT as long as our calculated discount-to-Absolute Value is compelling. Thus, we maintained the position in Geo during the quarter.
Other top individual performers during the quarter were Insperity and Madison Square Garden. Insperity provides full-service human resources to small and medium-sized businesses, and reported strong results with higher gross profit due to lower benefit costs. In addition, the company announced a special dividend and a Dutch auction share repurchase plan that cost it little as its stock rallied past the high end of the tender offer. Media and sports conglomerate Madison Square Garden reported solid quarterly results driven by their content deal with Time Warner and increased sales associated with Phase I of the Garden renovation. It helped that the New York Knicks had a fantastic start to their 2012-2013 basketball season. The National Hockey League (NHL) also finally reached a tentative agreement with the players union to end its league-wide lockout, which should eliminate a short-term risk for the company. We trimmed the Fund’s position as the stock approached our assessed Absolute Value.
For the full year, the best contributors were generally the portfolio’s largest holdings, including fourth quarter standouts Geo Group and Madison Square Garden. DST Systems was another top holding with strong performance, largely attributable to its new CEO Stephen Hooley monetizing non-core assets and using the proceeds to pay down debt. DST is the largest third-party provider of mutual fund shareholder accounting services and remains a high conviction position.
Five new holdings were purchased and seven sold from the Fund during the quarter. Among the five new positions, two were in the Industrials sector (Layne Christensen and Kelly Services). The new positions also tended toward the smaller end of the market-cap spectrum, with three having market-caps less than $600 million. Among the companies sold, four achieved our Absolute Value price targets and three were sold due to either accumulated losses and/or a negative change in our fundamental outlook for the firm. Overall, turnover for the year was among the lowest in the Fund’s history.
We have been comfortable with the portfolio’s positions and sector weights (excluding Financials) during the past two years and looking ahead do not foresee any major shifts in allocation. Industry and sector allocations are driven almost exclusively by company-specific opportunities. Perhaps one key difference from 2012 is that multinationals look a bit more attractive as estimates have been slashed along with their stock prices. We are also increasingly concerned about consumer stocks given tax increases and other fiscal headwinds, and will continue to monitor closely.
The largest new position added during the quarter was WMS Industries, one of three major manufacturers and distributors of slot machines and video lottery terminals. WMS has the scale and financial strength necessary to license attractive brands and navigate the labyrinth of regulations across hundreds of jurisdictions. The company is viewed as an innovator within the industry, a position that has led to significant share gains but also increased product risk. WMS struggled in 2011 to commercialize several new products because the complex nature of their latest technologies caused operational and regulatory delays, resulting in competitors regaining market share lost to the company in prior years. After gaining regulatory approvals and rationalizing its pipeline, the firm appears to be back on track.
We previously purchased WMS for the Fund in July 2011 and eliminated the position as a loser in July 2012. The stock subsequently dropped even lower. When we first purchased the stock, the leveraged balance sheets of casino operators were causing a delay in the replacement cycle. We believed that the company’s strong balance sheet would help them weather that type of operating environment. We did not expect the regulatory delays that caused the market share losses. We repurchased WMS at an attractive discount to our previous sale with the belief that the company’s operating momentum is now on an upswing.
Reflecting on the past decade, it is typical for us to underestimate market returns in the early stages of the profit cycle, be on target in the middle, and then hit or miss in the late stages depending on how overextended valuations become. That has been the case with this current cycle as we underestimated the market recovery during the first two years and were largely in-sync the past two years. As mentioned in our last outlook, the recent slowdown in profit growth may indicate markets are entering the late stage of the cycle. Thus, you may rightfully sense that our conviction in our outlook for this year is a bit more tempered than that of the last two years.
Although our outlook is not a forecast, our perspective of the economic and market environment can affect our stock valuations and portfolio positioning. Valuations are the primary driver of our outlook. When stocks are cheap we get excited, when they are expensive we become more cautious. We would categorize current valuations as approaching full value. In other words, we are more cautious than excited, but not yet sounding the alarm. Employing our proprietary discount-to-Absolute Value measure, valuations were slightly below their historical peak at year-end, but with the market appreciating about 4% since year-end the indicator is now at 81%—uncomfortable territory for us. External measures show small-cap stocks being fairly valued, not grossly overvalued. That said, our proprietary measure has proven to be far more useful in predicting near- to intermediate-term corrections than any external measure we monitor.
In addition, we believe consensus small-cap profit expectations are too high and likely to fall in the upcoming quarter, just as large-cap expectations have declined in recent months. The current expectation for Russell 2000 median profit growth is in excess of 17%. From our perspective, growth in the range of 8% to 12% for 2013 is more realistic. These factors may imply some level of near-term weakness for small-caps as profit expectations decline, but perhaps solid single-digit stock returns over the course of the coming year, though given that we are in the late stages of the economic recovery cycle our conviction is low.
Despite modest economic growth and firmer employment data, US Federal Reserve monetary policy remains hyper-aggressive. Chairman Bernanke has explicitly expressed his strong preference for higher asset values during periods of deflationary pressure and deleveraging. He also recently declared the Fed would continue to provide extraordinary stimulus until unemployment reached 6.5%. While it is unlikely we will see a 6.5% headline unemployment figure in 2013, 7% is a possibility if growth accelerates. Furthermore, Fed officials Bullard and Plosser have stated that quantitative easing (QE) measures could end at 7%. Either way, we think the Fed continues to stimulate equity prices, but if unemployment drops more quickly than expected, the Fed is likely to begin to withdraw its more extraordinary stimulus measures sooner than the market currently anticipates.
Fiscal policy is poised to be the major headwind as we look ahead, however. Higher taxes, lower federal spending, fewer economic incentives for business, and the upcoming debt ceiling debate collectively represent the greatest risk to our outlook. As recently reported by the New York Times, upper income earners now face the heaviest tax burden in more than 30 years. The debt ceiling debate promises to be highly contentious and, according to ISI Research, spending cuts are highly unlikely to produce the longer-term savings necessary to keep credit rating agencies from further downgrading U.S. debt. If there is one concern that should keep investors up at night, it is the chaos and policies currently emanating from our capitol.
There is a profound and lingering nervousness among businesses, consumers, and investors hanging over this recovery. That is not uncommon following a major financial crisis, especially one resulting in massive credit deleveraging. Fortunately, stocks have thus far successfully climbed the wall of worry. With China averting a hard landing and European tail risks diminishing, we see investors facing fewer global macro concerns in 2013 than in 2012. This should be positive for fundamental stock pickers, as investor focus shifts away from the macro and toward the micro.
A significant improvement in CEO confidence would have an especially positive impact on equity markets and the economy. One possible outcome would be improved merger and acquisition (M&A) activity. M&A activity was reasonably healthy in 2012 (best since 2007), but remains constrained by a lack of CEO confidence to invest in future growth. From our perspective, with record levels of corporate cash on balance sheets and depressed secular growth, even a modest improvement in confidence could result in a surge in M&A activity.
Continued improvement in housing and unemployment are wildcards that have received a lot of attention and could provide upside support in 2013. We believe the biggest potential catalyst for stocks in 2013, however, is a true wildcard—a rout of the government bond market. The bubble in government bonds is so massive that a significant rise in rates has the potential to spark a massive outflow of liquidity into stocks, blowing away any otherwise rational equity valuation or forecast model. We are not predicting this to happen, but the potential is very real.
River Road Asset Management
16 January 2013
As of December 31, 2012, Ascena Retail Group comprised 2.08% of the portfolio’s assets, Miller Energy Resources – 0.75%, Endeavor International – 0.02%, Big Lots – 2.93%, The Dolan Company – 0.00%, Tetra Technologies – 0.34%, Geo Group – 4.28%, Insperity – 1.78%, Madison Square Garden – 2.88%, DST Systems – 3.75%, Layne Christianson – 0.57%, Kelly Services – 0.47%, and WMS Industries – 0.81%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity. 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.