3rd Quarter 2013 Commentary - ASTON/River Road Small Cap Value Fund
3rd Quarter 2013
Focus on the Fed
Stocks delivered robust returns during the third quarter of 2013 as investors remained focused on the Federal Reserve rather than a steady stream of negative news events. That focus was particularly evident early in the quarter when, despite a disappointing employment report, weak housing data, and anemic second quarter earnings growth, the small-cap oriented Russell 2000 Index registered its third best July on record. The Fed noted the negative change in outlook in their July 31 statement, downgrading their assessment of the recovery.
Stocks retreated in August amid growing tension with Syria over chemical weapon attacks and concern that the Fed was leaning toward reducing the size of its current bond purchase program. By early September, however, those concerns diminished and stocks again traded sharply higher. On September 18, in the defining moment of the quarter, the Fed chose not to reduce the pace of its quantitative easing (QE) bond-buying program. Although stocks traded modestly lower in the final days of the month on concerns about the budget debate in Washington, September ended with strong returns, particularly for small-cap stocks.
For the fourth consecutive quarter, small-caps (Russell 2000) outperformed large-cap stocks (Russell 1000 and S&P 500 Indices), this time by a sizeable margin. The breadth of outperformance among small-caps was also strong. Every sector within the small-cap S&P 600 Index outperformed its S&P 500 counterpart during the third quarter for only the third time since 1995. The S&P 500 is experiencing its best first three quarters of a calendar year since 1997, while small-cap returns year-to-date rank among the top-20 since 1940.
Growth led value across all market-caps. Among small-caps, the Russell 2000 Growth Index outpaced its value counterpart by more than five percentage points, increasing its year-to-date lead through the end of September to more than nine percentage points. High-beta (volatility) stocks dominated during the third quarter by an enormous margin. In terms of quality, the picture was mixed with low quality (based on a company’s return-on-equity) generally outperforming. Stocks with a dividend yield lagged those with no yield by a hefty margin as well.
Active small-value managers continued to perform well overall, especially relative to core and growth managers. As discussed last quarter, active small-value managers continued to benefit from the underperformance of bond-like stocks, such as REITs (real estate investment trusts) and Utilities. Collectively, these two groups represented 18% of the Fund’s Russell 2000 Value Index benchmark and continued to underperform the broader market. As we’ve stated before, we typically avoid investing in REITs, seeing these securities as real estate assets rather than equities.
Tough Quarter Amid Solid Year
The Fund underperformed the benchmark for the quarter, though it still maintains a slight edge for the year-to-date through the end of September. Given the strong small-cap returns in 2013, high valuations, and high-beta leadership, we are pleased that the portfolio (which ranks among the least volatile strategies within its peer group) has outperformed year-to-date. The portfolio benefited from high merger and acquisition (M&A) activity through the end of the second quarter and underweight positions in REITs and Utilities, the performance of which was a significant headwind the previous two years.
All 10 economic sectors in the index posted positive total returns during the quarter, with Healthcare the best performing area and Utilities the worst. The sectors in the Fund with the lowest contribution to relative returns were Materials and Financials, both of which suffered from poor relative stock performance.
Bermuda-based property and casualty insurer Tower Group was the largest individual detractor after it postponed the release of second quarter earnings in August because it needed more time to review its loss reserves. In September, it further delayed their release without any additional guidance. Following the second delay, investors became concerned that the charge to loss reserves would be higher than previous guidance, possibly forcing Tower to raise capital or sell the company in a distressed state. We trimmed the position by nearly half during the quarter.
Materials stock Intrepid Potash fell sharply after Russian potash producer, Uralkali, announced plans to maximize its future production after exiting its marketing partnership with a Belarusian potash producer. Prior to this announcement, roughly 70% of the global potash export market was controlled by two cartel-like partnerships, the other being Canpotex, a group of Canadian producers. These groups have historically exercised supply discipline by reducing production to maintain high prices in periods of slow demand. Uralkali’s decision to sacrifice pricing power weakens the bargaining positions of producers, and could lure competitors to run at full capacity in order to lower unit cost. We trimmed the Fund’s position.
Other notably detractors included Orthofix International and Abercrombie & Fitch. Orthofix is a global medical device company that produces hardware/implants and other regenerative solutions for the spine and orthopedic markets. The company postponed its earnings release to review its revenue recognition for prior periods. Our valuation already assumed significant year-over-year declines in revenue and cash flow. We trimmed the portfolio’s position by roughly 25%. Specialty clothing retailer Abercrombie reported second quarter results that were below expectations due to a highly promotional operating environment and removed full year guidance citing a lack of visibility. On a positive note, a strategic review should conclude during the fourth quarter and management has already identified significant annual cost savings. The company’s balance sheet is healthy and it has an authorization to repurchase more than 20% of its outstanding shares. After trimming the position earlier in the year at prices near our calculated Absolute Value, we added back to the position during the quarter on the recent weakness.
The sectors with the highest contribution to relative return during the quarter were Utilities and Industrials. The Fund benefited from an underweight allocation to the struggling Utilities area, while Industrials benefited from strong stock performance in names such as Insperity. The professional employment firm provides Human Resource services to small- and medium-sized businesses. Insperity reported strong revenue and margin growth during the period due to the upcoming implementation of the Affordable Care Act as its product offerings are able to help clients handle the regulatory and cost burdens of the new law.
Other top contributors to the portfolio included Miller Energy Resources, Bob Evans Farms, and Big Lots. Independent oil and gas exploration and production company Miller Energy announced positive production results from two key offshore oil wells. The results not only significantly increase its cash flow and strengthened its financial position, but also suggested an improved long-term outlook on the quality of the firm’s reserve base. Our analysis indicates that Miller’s reserves, acquired in a highly opportunistic bankruptcy process, are likely booked at conservative levels. This quarter’s production data supports that view. We increased the portfolio’s position and our assessed Absolute Value after the favorable production announcement.
Bob Evans increased its dividend—the eighth consecutive annual increase—and the company plans to complete a significant share repurchase by year-end. The company also attracted additional attention after a large institutional investor wrote a letter to the Board suggesting various methods to unlock shareholder value. As the stock rose near our Absolute Value, we trimmed the position significantly. Closeout retailer Big Lots continued to refine its merchandising approach to create more sourcing consistency. It is also testing smaller sized stores for urban locations and is evaluating using a third party to provide new financing options in its furniture segment. We expect these new initiatives will generate more customer traffic and create more stability in operating results.
Unattractive valuations within the small-cap universe has led to a steady decrease in the number of holdings in the portfolio since the beginning of the year (82 to 74). Similarly, cash in the portfolio at quarter end was 8.8%, reflecting a steady increase from 4.7% at the beginning of the year.
Seven stocks were purchased and seven sold from the portfolio during the quarter. Six of the sales were holdings that had achieved our Absolute Value price targets, while Pan American Silver was sold due to accumulated losses and a decline in fundamentals. The new positions were largely concentrated in consumer- and transportation-related industries, with Air Transport Services Group, Marten Transport, and Werner Enterprises comprising the latter group.
On a sector level, exposure to Consumer Staples decreased after exiting what was the largest holding in the portfolio, Harris Teeter Supermarkets, following its acquisition by Kroger. We also decreased Materials exposure as we trimmed precious metals holdings. The majority of the sales proceeds were held in cash and, as previously described, reinvested within the transportation industry of the Industrials sector.
The largest new position added during the quarter was rent-to-own operator Aaron’s. The firm essentially has a duopoly with competitor Rent-A-Center (another portfolio holding), as the remainder of the industry is extremely fragmented—the next largest competitor having only 5% as many locations. The industry serves the “under-banked” consumer with household incomes between $15k and $50k. Rent-A-Center has typically served the low-end of the range (offering weekly payment options) while Aaron’s has catered toward the higher end (offering monthly payment options). The Great Recession resulted in fewer retailers offering credit to low/middle income consumers, strengthening the market opportunity. Regulatory risk is a concern, as the industry is regularly accused of charging usurious implied interest rates by consumer advocacy groups. There is no pending litigation or active legislation targeting the industry, but we are carefully monitoring this risk as it could affect the company’s business model. We calculated the stock as trading at a 22% discount to our assessed Absolute Value at the time of initial purchase.
What Happened to the Economic Surge?
Earlier this year, as stock prices soared and growth rates began to decline, it was the consensus opinion on Wall Street that the economy would re-accelerate during the second half of 2013. As we suspected, that surge in growth is not materializing. We based our opinion on the comments of companies we follow, none of which indicated they believed the economy would experience a surge during the second half. Although Wall Street would have you believe that the shutdown is responsible for the disappointing growth trends, the slowdown was actually evident long before the budget debate heated up. Fortunately, CEO skepticism about a second half surge should help to support margins in a slow growth environment.
The real surprise is that investors do not seem to care about the widening disconnect between earnings growth and stock prices. According to FactSet, the forward price/earnings (P/E) ratio on the Russell 2000 has gone from 16.6 on December 28, 2012 to an astonishing 21.1 on September 27, despite actual earnings (and forward guidance) coming in well below initial expectations. Furthermore, according to Ned Davis Research, it has now been more than 490 days since the S&P 500 has experienced a -10% correction. This is more than three times the mean average of 161 days going back to 1927. We described this last quarter as a case of ‘acute monetary fever’, which as third quarter performance demonstrated now borders on an epidemic.
In addition to Fed stimulus, there is another related catalyst propelling stocks higher—outflows from government bonds. In our fourth quarter 2012 commentary, we stated that, “the biggest potential catalyst for stocks in 2013…is 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.” Although we would not classify current outflows in the Treasury Bond market as a rout (that title belongs to precious metals), outflows from the overall government bond market, including Treasuries, as well as TIPS and Municipal bonds, have been significant. This is a trend that we see continuing, possibly helping to extend the rally in stocks.
While we enjoy a strong rally as much as any investor, we feel it is our obligation to inform shareholders when we believe market risks are high. This typically occurs when valuations are over-extended. Whether you employ our discount-to-Absolute Value model, which remains at the high end of its historical range, or other measures of valuation, the small-cap market appears very expensive. According to Bank of America/Merrill Lynch Small Cap Strategist Steven G. DeSanctis, who accurately forecasted the huge rally small-caps this year, “Valuations have reached extreme levels based on an absolute as well as a relative basis.”
It is difficult to explain the rise in market multiples using fundamental company analysis. Growth in earnings and the economy are declining, M&A multiples are well below peak, and a key economic bright spot, housing, has slowed in the face of higher interest rates. It is impossible to say precisely when the monetary fever will break. The Fed and other central banks have proven remarkably committed to inflating financial assets—a strategy that the new Fed Chair nominee, Janet Yellen, will likely continue. This disconnect between tepid earnings growth and soaring stock prices cannot go on indefinitely.
Despite our concern about valuations in the broader market, we think the Fund’s relative fundamental metrics look attractive. From a quality perspective, the five-year average return-on-equity (ROE) for the holdings in portfolio is more than twice that of the benchmark. We think the portfolio can benefit from any potential increase in M&A activity or further pullback in bond-like equities, including REITs and Utilities, should interest rates rise again. Combined with the portfolio’s historically low-volatility Absolute Value approach, we think it is also positioned well should the market experience a significant correction.
River Road Asset Management
As of September 30, 2013, Tower Group International comprised 0.31% of the portfolio’s assets, Intrepid Potash – 0.56%, Orthofix International – 0.52%, Abercrombie & Fitch – 0.95%, Insperity – 1.97%, Miller Energy Resources – 1.63%, Bob Evans Farms – 1.75%, Big Lots – 3.06%, Air Transport Services Group – 0.95%, Marten Transport – 0.80%, Werner Enterprises – 1.31%, Aaron’s – 1.30%, and Rent-A-Center – 1.84%..
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.