2nd Quarter 2013 Commentary - ASTON/River Road Small Cap Value Fund
2nd Quarter 2013
It was a volatile and somewhat confusing quarter for investors, with stocks ending the period higher despite a surge in interest rates. Stocks rose early in the quarter as investors saw tepid earnings growth and weak economic data as support for continued stimulus from the Federal Reserve. The fireworks began on May 22 when a mix of cryptic (and seemingly conflicting) comments from Fed Chairman Ben Bernanke, taken in the context of just released Fed meeting minutes, spooked investors. Just hours after the broad market S&P 500 Index set a new all-time high, stocks dropped sharply and the interest rate on 10-year US Treasuries rose above 2.0% to nearly a percentage point above its May 2 low of 1.63%. During the final days of the quarter, equities reversed yet again as various Fed officials made public statements aimed at calming the markets.
Rising volatility and widening credit spreads do not typically favor the relative performance of small-cap stocks. With both factors well below their long-term averages and small-cap earnings expected to grow faster than large-cap earnings, however, small-caps maintained their performance advantage. Interestingly, a large portion of the small-cap earnings advantage comes from the booming housing sector, which according to Bank of America/Merrill Lynch now represents more than 18% of small-cap earnings compared with just 5% for large-caps.
Low-quality/high-beta (volatility) stocks typically do not outperform during a period of rising market volatility. During the second quarter, however, investors rejected high-quality, low-beta, and dividend paying stocks in favor of cyclical growth stocks. Within the Fund’s benchmark Russell 2000 Value Index, the highest quintile stocks based on return-on-equity (ROE—a measure of quality) returned -0.24% versus a whopping 8.15% for stocks with the lowest ROE (fifth quintile). Similarly, the lowest-beta stocks lagged the highest-beta stocks by more than five percentage points, with dividend stocks lagging non-dividend payers by four percentage points.
Active small-value managers performed reasonably well during the quarter with 61% outperforming the benchmark, fueled by the underperformance of real estate investment trusts (REITs). Most institutional small-cap managers (including our team) avoid investing in REITs, treating them as real estate assets rather than equities. REITs comprise roughly 13% of the benchmark, however, and have significantly outperformed the past few years. With the sharp rise in interest rates, REITs plummeted more than 7%. This drop boosted the Fund’s relative performance during the quarter owing to its sizeable underweight position in REITs.
Overall, the Fund posted positive returns despite the market turmoil in extending its lead over the benchmark since the beginning of the year. The sectors with the highest contribution to relative return in were Financials and Industrials, with Financials primarily benefitting from the weakness in REITs while Industrials benefited from strong stock performance across a range of holdings.
A continuing catalyst for both the market and the portfolio has been the rise in merger and acquisition (M&A) activity. Heightened M&A activity has historically been a positive factor for the Fund. We attribute this to the alignment of our critical investment characteristics with that of private and strategic acquirers. Recent results appear consistent with that trend with holdings involved in M&A contributing about 40% of the portfolio’s year-to-date outperformance. Since late December, the portfolio has experienced a total of five takeovers and two major asset sales—a record level of activity. Three transactions took place during the second quarter, including the buyout of True Religion Apparel and Buckeye Technologies, with Harris Teeter Supermarkets occurring shortly after quarter-end.
Top-holding Harris Teeter was the Fund’s biggest individual contributor to performance during the quarter after Bloomberg reported that private equity firm Cerberus Capital Management made a bid to acquire the company. The firm subsequently signed a deal to be acquired by Kroger in early July at a substantial premium to its February closing price when the company announced that it had hired an investment banker to explore strategic alternatives. The bid came in below our calculated Absolute Value, we think largely due to the fact that Harris Teeter would be a stand-alone entity of Kroger, limiting potential synergies. Industrials firm Buckeye was among the top performers as well after it reached an agreement to be acquired by Georgia-Pacific in April. We sold the position after the announcement.
ICU Medical, another top contributor, reportedly hired an investment bank on May 8 to explore a sale (though the company did not confirm the rumors). Given ICU's abundant free cash flow generation, high returns on invested capital, unique product line, and pristine balance sheet, we believe it would be an attractive target for either a strategic acquirer or a financial sponsor. With the higher probability of a sale, we raised our valuation multiple. When the stock rallied to our new and higher Absolute Value, we began selling the position.
Rounding out the top five individual contributors were Monarch Casino & Resort and Motorcar Parts of America. Monarch reported improved quarterly occupancy and daily room rates that indicate its Reno resort may be rebounding from a prolonged slump. More importantly, initial operating results from its recently acquired Black Hawk property suggest that the Monarch management team made a bargain acquisition that has ample opportunities for future cash flow growth. MPAA produces alternators and starters for the largest auto parts retailers in the U.S. and Canada. The stock received a boost when the company announced that subsidiary Fenco filed for bankruptcy. Fenco was a distressed acquisition made in 2011 that made sense strategically but struggled to produce positive investment returns. The liquidation of Fenco should increase investor focus on MPAA’s core business, which is growing at double-digit rates, and allow the company to realize sizeable tax benefits.
The sectors with the lowest contribution to relative return were Technology and Consumer Discretionary, both of which suffered from poor relative stock performance. Materials was the worst performing sector within the benchmark, and the Fund felt the effects of that through its holdings in mining stocks.
Pan American Silver and AuRico Gold were among the biggest negative contributors to performance, with Pan American the portfolio’s worst performer during the quarter. Although it reported solid first quarter results with in-line production and lower than expected production costs, Pan American suffered from the 31% decline in silver prices during the quarter. We trimmed the position due to unrealized losses, but have faith in the company’s strong balance sheet and large net cash holdings. Gold miner AuRico suffered a similar fate as the price of gold fell 22% during the quarter. Like Pan American, it has a very strong balance sheet and is selling at a discount to our Absolute Value.
Big Lots was one of the primary underperformers within Consumer Discretionary. The broadline closeout retailer reported first quarter results that were in line with expectations, but the company issued weak second quarter guidance and lowered its full year outlook for fiscal 2013. Management noted that poor weather dampened discretionary and seasonal categories sales, a trend we observed from several retailers. Fortunately, stores located within the warmer regions of the firm’s footprint have experienced above average sales in those categories. Big Lots’ new CEO emphasized its strong cash flow generation and commitment to reinvest in the business while also returning cash to shareholders each year.
Another negative contributor was Resolute Energy, an independent oil and gas company with properties in Utah, Wyoming, North Dakota, and Texas. The company reported strong production growth, but lower realized commodity pricing and elevated lease operating expenses due to well work-overs affected cash flow. After a string of acquisitions in the Permian Basin in May that increased its balance sheet leverage, the company completed a secondary share secondary offering that was dilutive to our Absolute Value. We maintained the Fund’s position.
We purchased five new holdings and sold nine from the portfolio during the quarter. New positions were diversified across industry groups, with the largest concentration in the Healthcare sector—including Orthofix International and Air Methods. All sales were holdings that achieved our Absolute Value price targets. In addition, we added to 22 existing positions, with the largest increases in Intrepid Potash and Pico Holdings. We trimmed 10 positions, nearly all of which were related to price appreciation.
On a sector level, we continue to decrease our exposure to the Consumer Discretionary as those stocks continued to outperform and trade near our Absolute Values. An increase in the weighting of Financials was primarily the result of relative price appreciation.
The largest new position added during the quarter was bankcard payment processing services firm Heartland Payment Systems. Heartland targets small- to medium-sized merchants where margins are higher due to the lack of purchasing power. The company benefits from the increasing usage of bankcards, while barriers to entry from would-be competitors are strong due to concentration among the top few acquirers, the need for a strong reputation, and required approval from MasterCard/Visa. Management has improved margins and, in 2011, opened its first cloud computing datacenter while consolidating other legacy data centers. These initiatives reduced processing costs dramatically while giving the company more flexibility and scalability.
The primary risk to the company’s business model comes from security breaches. Heartland had such a breach in January 2009, and was removed from both MasterCard and Visa’s published list of compliant service providers. Re-certified in April 2009, the company was placed on probationary status for two years. Although the breach had little operating impact on the business, the company spent roughly $150 million to settle claims and pay legal fees. Any future loss of sensitive data could result in significant fines and sanctions by the card networks or governmental bodies. The stock was trading at a 22% discount to our assessed Absolute Value at the time of initial purchase.
Rally Diagnosis – “Acute Monetary Fever”
At the beginning of the year, our outlook for small-cap stocks was for mid to high single-digit returns based on valuation and the assumption of modest stock-price multiple expansion. The assumption of modest multiple expansion is where we got it wrong—at least thus far. Year-to-date through July 15, small-cap stocks (as represented by the Russell 2000 Index) have soared nearly 24% as the forward multiple on stocks have skyrocketed.
It is difficult to explain logically the rise in multiples using fundamental company analysis. Earnings growth for small-caps is tepid, and in the broader economy anemic. In addition, the economy appears to be in the late stage of its current profit cycle, with expectations on both the economic and profit fronts declining. Forward earnings guidance from company management teams has been overwhelmingly negative recently, and we do not expect a material change during the upcoming reporting season.
There have been a few economic bright spots, most notably housing. New and existing home sales, as well as home prices, have experienced significant growth during 2013. That growth is supporting small-cap stock performance. Of course, with interest rates rising sharply over the past two months, mortgage and refinance applications have dropped, as have the stocks of home builders. Although we recognize that volatility, credit spreads, inflation, and interest rates (all of the factors that can work against small-cap performance) are still below their long-term averages, at current valuations it is hard to believe (from a fundamental perspective) that stocks should continue to go up. Yet, the rally persists.
What is driving stock prices? The best answer we can think of is acute monetary fever. Monetary fever is caused when central banks flood the markets with excessive liquidity. Initially, excess liquidity can prove helpful in stabilizing financial markets and raising asset values (the first two instances of quantitative easing by the US Federal Reserve). When intrinsic value is reached, however, and the liquidity continues to flow (as with the current easing program, QE3), bubbles begin to form. Today, we see bubbles beginning to form across a wide range of asset classes.
Acute monetary fever happens when investors appear to lose any sense that policy will ultimately change or asset values are illogical. This appears to have happened with the surge in stocks over the past few weeks, with any economic news (good or bad) now being positive for stocks. This represents a complete disconnect from fundamental reality. We saw a similar liquidity event and then a disconnect in the late stages of the Internet bubble (remember Y2K) and in the late stages of the consumer credit/housing bubble (no money down, teaser loans). QE3 may be remembered in the same context. Cheap money always feels good in the moment (at least for those invested in anything other than CDs), but every bubble ends with a burst.
Precisely when the monetary fever will break is impossible to say. The Fed and other central banks have proven remarkably committed to inflating financial assets. It is possible that the Fed will unwind its current policy in an orderly fashion—that rates will slowly rise and asset values will gradually move back toward their intrinsic value. Unfortunately, history and our collective investing experience do not support that probability.
Then again, the Fed’s statement on June 19 may have been intended to let some of the air out of the bond bubble. If that is the case, it worked. Bond funds and, in particular, high-yield bond funds have seen record redemptions. Of course, these funds are now flowing into stocks. According to Furey Research Partners, the $80 billion differential between stock and bond flows over the past six weeks represents the first major reversal of the longer-term trend favoring bonds in more than five years. In our year-end letter, we stated that a lottery ticket existed for stock investors in the form of the government bond market bubble. Perhaps stock investors have hit the jackpot.
The encouraging news is that the Fund is doing well in a period of elevated returns. Relative fundamental metrics look positive and we think the portfolio will continue to benefit from heightened M&A activity or any continued pullback in bond-like equities, including REITs and Utilities. Collectively, these two groups represent 19% of the benchmark, but just 3% of the portfolio. Finding attractive investments has become more difficult, which is a change from last quarter, but we have been effectively managing our opportunities and cash position. We think the Fund’s current holdings combined with the our historically low volatility Absolute Value approach is positioned well if the market does experience a more significant correction.
River Road Asset Management
As of June 30, 2013, True Religion Apparel comprised 0.00% of the portfolio’s assets, Buckeye Technologies – 0.00%, Harris Teeter Supermarkets – 4.35%, ICU Medical – 1.76%, Monarch Casino & Resort – 0.84%, Motorcar Parts of America – 0.81%, Pan American Silver – 0.54%, AuRico Gold – 0.51%, Big Lots – 2.77%, Resolute Energy – 0.60%, Orthofix International – 0.76%, Air Methods – 0.60%, Intrepid Potash – 1.53%, Pico Holdings – 1.41%, and Heartland Payment Systems – 1.64%.
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.