4th Quarter 2012 Commentary - ASTON/River Road Long-Short Fund
4th Quarter 2012
The fourth quarter provided a fitting end to what was a volatile, yet successful year for equity investors. Stocks traveled almost 8% between their highs and lows during the quarter, but ended the period virtually flat. Several positive catalysts supported equity returns for the full year. Among the strongest were a significant improvement in the housing market, an extension of the Federal Reserve’s hyper-aggressive monetary policies, and the extraordinary actions by the European Central Bank, which prevented the most severe downside scenarios related to the European debt crisis. New leadership and a re-acceleration of growth allayed fears of a hard landing in China and the associated global impact.
Both long-short mutual funds and private hedge funds, on average, continued to underperform the broader equity market in 2012. We suspect that the increasing impact of global macroeconomic events has made managing net equity exposure particularly difficult in recent years. Large flows into index funds and exchange-trade funds (ETFs) have also likely driven increasing equity correlations.
Strong Long Performance
Relative to a market (represented by the Fund’s Russell 3000 Index benchmark) that barely budged during the quarter, the portfolio outperformed for two primary reasons. First, we added value by effectively managing net long equity exposure. The market declined to its low on November 16, and we gradually increased net long equity exposure from 48% to 65% (exposure peaked the same day the market troughed) by adding to more attractive long positions and trimming less attractive short positions. We designed our “normal” net long equity exposure range (50% to 70%) to be wide enough to make a meaningful contribution for markets like that seen during the quarter, which fluctuated widely between its high and low, but ended near the same place it started.
Second, strong stock selection in the long portfolio offset weaker performance from the short portion of portfolio. We had identified three opportunities in our third quarter commentary—Consumer Discretionary stocks, economically-sensitive stocks, and ADT, the largest new position in the portfolio. ADT quickly worked out and was the largest positive contributor during the fourth quarter. Four of the quarter’s top-five contributors were economically sensitive stocks.
The performance of the Fund’s Consumer Discretionary holdings highlighted the importance of expectations. More than 90% of the portfolio’s long positions in Consumer Discretionary were positive contributors, benefiting from sector strength and low expectations. Conversely, each of the top five individual short contributors were also from the Consumer Discretionary sector, underscoring that shorting stocks with unrealistic expectations can be profitable despite even in the face of strong sector performance.
In the short portfolio, we poorly timed the initiation of a basket of iron ore and metallurgical coal short positions. This basket accounted for three of the Fund’s top-10 losing short positions during the quarter. An uptick in Chinese infrastructure spending and an extremely cold Chinese winter limited iron ore supply, resulting in iron ore prices nearly doubling from their September lows. Still, we think our fundamental short thesis for the group remains intact long-term. The volatility-driven rally also pushed some the portfolio’s more leveraged short positions higher, dragging down returns.
The three holdings with the highest contribution to returns during the quarter were ADT (long), General Motors (long), and BlackRock (long). Home security firm ADT was quickly “discovered” after being spun off from Tyco by activist investor Corvex Management. The company also announced its intention to repurchase $2 billion worth of stock (more than 20% of its market cap) over the next three years and initiate a quarterly dividend.
General Motors is the largest auto manufacturer in the U.S. with nearly a 20% market share. Pre-bankruptcy, the “old” GM broke even during periods of average automobile demand (historically between 15 and 19 million cars), earned a profit at the peak, and burned through massive sums of cash at the trough (less than 10 million cars). Having dramatically reduced debt and labor costs through bankruptcy, the “new” GM emerged as a more efficient global competitor that should be profitable at the bottom of the demand cycle in its core North American market. Its most pressing overhang was addressed during the quarter when the U.S. government announced its intent to sell back 40% of its shares to the company immediately and its remaining shares in the open market over the following 12 to 15 months.
Asset manager BlackRock rallied as lingering market concerns about the possibility of Chairman and CEO Larry Fink departing for the U.S. Treasury abated. We appreciate the asset-light economics of the money management business and admire the firm’s evolution into the most diversified asset manager in a volatile industry. Sticky institutional customers that account for more than 80% of total assets provide further stability, while BlackRock’s ownership of ETF provider iShares represents a primary growth driver.
For the full year, top contributors included Madison Square Garden (long), Big Lots (long), and SEI Investments (long). Long-time holding, Madison Square Garden posted strong results as both the New York Knicks and New York Rangers made the playoffs, the facility renovation progressed smoothly, and rising affiliate fees and ticket prices boosted bottom-line results. Despite the stock dropping more than 25% during the year, closeout retailer Big Lots was a top contributor as we traded the position well. SEI Investments, a provider of middle- and back-office functions for the investment industry, made steady progress throughout the year by adding Global Wealth Platform clients, improving private banking margins, and repurchasing shares at a discount to our assessed Absolute Value.
Holdings with the lowest contribution to portfolio returns during the quarter were Western Union (long), MSCI (long), and Devon Energy (long). Western Union lowered guidance for fiscal year 2012 and provided a disappointing outlook for 2013 in late October that sank the stock. A combination of agent defections in Mexico, increased competition from traditional competitors, and new entrants required the company to cut prices in several key channels, initiate a cost savings plan, and accelerate investments in the business. We overestimated the power and sustainability of the firm’s network, while growing competitive issues suggest the near-to-medium term future may not resemble the past. Our loss of fundamental conviction prompted the elimination of the position from the portfolio.
Investment index provider MSCI dropped on news that Vanguard would transition 22 ETFs, comprising $131 billion in assets, from MSCI benchmarks to another provider in search of lower fees. The news fueled worries that other large clients might follow suit and/or pricing pressure would ultimately affect MSCI’s core business. We were less troubled about the core subscription business as we were management’s unwillingness to consider share repurchases at attractive prices after the stock decline. Confirming our initial concern, management noted its intention to pursue growth over share repurchases even at depressed levels. Given this frustration and that MSCI accounted for nearly 10% of the portfolio’s unrealized losses, we eliminated the position. Subsequently, ValueAct Capital, a leading activist investor, established a 5% position in MSCI and the company announced a major share repurchase plan (comprising 8% of its market capitalization) in December. The improvement in shareholder orientation has us eager to consider the stock again. However, we typically avoid analyzing a losing stock for three months after a sale to ensure a fresh perspective when we revisit the position.
We think Devon Energy has sensibly battled the perfect storm of falling natural gas/natural gas liquid prices and widening spreads (the discount it receives from quoted benchmark prices) over the last few years. The company completed two joint ventures with foreign production companies in 2012 to lighten the financial burden of developing the firm’s massive undeveloped resources. The company has raised its dividend annually and repurchased approximately 20% of its shares since 2004. Despite it being one of the Fund’s biggest losers during the quarter, we took no action as there was no change in our fundamental conviction and the stock remained cheap by our work at year-end.
For 2012, each of the Fund’s major detractors exposed the primary weakness with our risk control framework—stocks that “gap” the wrong way. It is easier to contain gradual losers than those that move violently against us. The three largest losers gapped an average of 34% on just one trading day. There is no single, foolproof method to deal with such stocks, so we rely on several tools to minimize “gap” risk, starting with solid fundamental analysis. Holdings with more operational and/or financial risk are more likely to gap, so they typically encompass smaller position sizes. Finally, we do not average down into losing positions.
Apart from a hedge in the SPDR S&P 500 ETF, the Fund’s three worst performers for the year were AOL (short), Western Union (long), and Hill-Rom Holdings (long). AOL appeared to be the perfect “value trap” (a stock that appears cheap but can continue to fall because of a deteriorating business model or fundamentals), a source of our favorite short opportunities. Shareholder activism and the monetization of its patent portfolio, however, drove the stock past our pre-determined stop-loss price. The stock proceeded to rally another 73% after our stop-loss discipline forced us to close the short position, avoiding further losses. This served as an example of how we would rather stop losing money than accept the risk of waiting to be proven right. Hospital bed manufacturer Hill-Rom chose to pursue questionable acquisitions rather than buy back stock at bargain prices during the year. If a management team prefers to buy presumably “better” companies than increase its stake in its own core business, we thought it made sense to follow suit—and sold the position.
The Portfolio entered the fourth quarter with its net long equity exposure below our normal range (50% to 70%) at 44%. Our proactive discount-to-Absolute Value indicator for the portfolio flashed “extremely overvalued” the same day that Chairman Bernanke announced quantitative easing (QE) “infinity” during the third quarter. That announcement also established the market’s high for 2012 and prepared the portfolio for the market’s nearly 8% sell-off through mid-November. We subsequently increased net long equity exposure in the Fund more than 20 percentage points through mid-November as the market declined and long opportunities became more attractive.
One of our primary drivers in positioning the portfolio is to reduce volatility through management of its net long equity exposure. The Fund was, on average, only 55% exposed to the equities during the fourth quarter as valuations remained extended for most of the period. Our calculated discount-to-Absolute Value indicator averaged 76% (relatively close to our “extremely overvalued” level at 80%). The long portfolio ended the year with close to 20% in cash, and we believe was well positioned in the event of a market correction.
The opportunities that we discovered in the long portfolio throughout the year—riskier positions trading at a discount—remained available at year-end. We added to each of the Fund’s long Energy holdings as that sector lagged. The portfolio holds a diverse group of Energy stocks, each with an investment grade balance sheet that we think is essential to long-term value creation in a volatile industry.
We typically limit the percentage of the long portfolio we devote to riskier stocks. For example, we set specific caps for retailers, commodity-based stocks, and special situations. The long portfolio seeks to present a balance between more opportunistic (and riskier) positions, such as the current energy bet, and favorite core holdings (steady and predictable) that comprise larger position sizes. Each of the top-five long holdings at year-end are what we consider to be consistent, repeatable, and recurring business models.
Although the broader market was essentially flat during the fourth quarter, we added to the Fund’s individual short portfolio as high-beta (volatility) and “crowded” stocks led the market, pushing some challenged business models to what we considered over-valued prices. The short portfolio remained defensively positioned as of year-end, with a diversified list of 36 holdings positioned and an average position size of 0.64%.
The largest new position added during the quarter was DirectTV (long), one of the world’s largest pay-TV companies and the largest satellite television provider in the United States.
The domestic satellite market is a duopoly between DirectTV and DISH Network, with DirectTV relying on customer service and differentiated content offering to become the second largest multichannel video distributor in the U.S. Its domestic business is now focused on maintaining the subscriber base and maximizing cash flow, with growth coming from its Latin American segment. The company has repurchased 55% of its shares outstanding since 2005, and we expect more share buybacks to come.
The two biggest risks facing the company remain cable’s “triple play” threat (TV, internet, phone) and rising programming (particularly sports) costs. Triple play still has yet to catch on in five years, evident by DirecTV posting subscriber growth during the financial crisis, unlike its cable competition. The firm has been able to offset rising programming costs through effective cost controls and raising prices. Thus, we think the stock represents an attractive opportunity.
Annual Review and Objective Update
We were slightly disappointed with the Fund’s return in 2012. Although we outperformed a majority of our peers, we had hoped to participate to a greater degree in a strongly rising market such as that seen in 2012. The portfolio’s relatively low average net long equity exposure of 53% during the year overwhelmed solid stock selection in the long portfolio. We were pleased that the long portfolio outperformed the short portfolio, however, in a market driven by high-volatility stocks.
Businesses with steady and predictable cash flows trading at discount prices were in short supply during the year. Despite maintaining the Fund’s net long equity exposure at the lower end of our “normal” range, it was significantly higher than the typical hedge fund. According to Bank of America Merrill Lynch, the average hedge fund kept its net market exposure between 25% and 35% during 2012. We designed our strategy to participate in bull markets like 2012 by establishing our normal net long equity exposure range relatively high at 50% to 70% (the average hedge fund net market exposure has been approximately 40% according to Bank of America).
Protecting capital was not difficult in 2012. The market never had a daily close below the closing level of 2011, which has happened only the seven times before since 1928 (the last occurrence was in 1979). The market’s biggest drawdown (peak-to-trough decline) during the year was 10%, in-line with the market’s median calendar-year drawdown since 1950. The portfolio’s maximum drawdown was only 4.9%.
We believe the primary difference between successful and unsuccessful asset managers is that successful managers make small mistakes instead of big mistakes. We leverage a robust set of risk controls—not averaging down on target positions, setting stop-losses, monitoring unrealized losses at the portfolio level, and avoiding momentum in the short portfolio—to help limit the damage individual positions can cause the portfolio. Given the significant market gains in 2012, it’s not surprising that the short portfolio remained the focus of our risk controls at year end. We actively reduced the momentum of the short portfolio during the quarter by trimming higher momentum short positions. If the market grinds even higher in 2013, we expect more risk control action will be necessary as several short positions approached our stop-loss limits near year-end.
It may be easy for investors to grow complacent after such a smooth ride in 2012, but we designed the strategy for the inevitable bumps in the road. We do not know if sluggish earnings growth, rising interest rates, the debt ceiling debate, or other factors will force the market to consider risk in 2013. We do believe that both our proactive discount-to-Absolute Value indicator and reactive Drawdown Plan are proven tools to help protect capital in challenging environments. Like many of the great money managers of the past—Jesse Livermore, Bernard Baruch, Gerald Loeb, Roy Neuberger—we are uncomfortable losing more than 10% of capital, and thus, have created capital protection tools with potential downside mitigation in mind.
River Road Asset Management
16 January 2013
As of December 31, 2012, ADT comprised 2.52% of the portfolio's assets, General Motors – 2.70%, BlackRock – 0.00%, Madison Square Garden – 0.00%, Big Lots – 1.25%, SEI Investments – 0.00%, Western Union – 0.00%, MSCI – 0.00%, Devon Energy – 3.00%, SPDR S&P 500 – 0.00%, AOL – 0.00%, Hill-Rom Holdings – 0.00%, and DirecTV – 3.80%.
Note: Short sales may involve the risk that the Fund will incur a loss by subsequently buying a security at a higher price than which it was previously sold short. A loss incurred on a short sale results from increases in the value of the security, thus losses on a short sale are theoretically unlimited. Value investing often involves buying the stocks of companies that are currently out-of-favor that may decline further. Investing in exchange traded and closed end funds are subject to additional risk that shares of the underlying fund may trade at a premium or discount to their net asset value.
Parameters set by the Subadviser are not a fundamental policy of the Fund and are subject to change at any time.
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.