3rd Quarter 2013 Commentary - ASTON/River Road Long-Short Fund
3rd Quarter 2013
Stocks delivered robust returns during the third quarter as investors remained focused on the Federal Reserve rather than a steady stream of negative news, including weak economic and earnings growth, the conflict with Syria, and a vicious budget debate in Washington. On September 18, in the defining moment of the quarter, the Federal Reserve 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’s market performance remained strong, particularly for smaller cap stocks.
Alternative Strategies Underperformed
The Fund posted solid gains but lagged its long-only Russell 3000 Index benchmark during the quarter, while modestly outperforming its long-short peers. The portfolio did well given that it maintained an average net long exposure of half that of the benchmark during a period of generally rising returns for the market. Both the long and short portfolios performed well. The maximum drawdown from the Fund’s “high-water mark” during the quarter was -1.53%, just 35% of the market’s -4.36% drawdown.
Recent data indicates that stocks may be transitioning from a “risk on/risk off” headline-dominated market to one more focused on bottom-up fundamentals. At the end of July, stock correlations to the large-cap oriented Russell 1000 Index were at their lowest reading since 2007, down significantly from a year ago. We hope this trend continues as it increases the probability of finding excellent companies trading at compelling prices on the long side and overvalued, challenged businesses with low momentum on the short side.
Lower correlations were evident in the portfolio results. For example, interest rates continued to rise from their May lows and negatively affected the Telecommunications Services and Utilities sectors, the only two sectors with a negative price return in the broad market S&P 500 Index during the quarter. Two of the Fund’s top-four long contributors came from these sectors, however, and each of the top-five long contributors came from distinct sectors. The same dynamic held on the short side. The top-three performing sectors in the S&P 500 this quarter were Materials, Industrials, and Consumer Discretionary. Three of the portfolio’s top-four short contributors came from these sectors.
The short portfolio outperformed despite the fact that lower quality and riskier stocks, which typically account for the majority of the short portfolio, led the market advance. Performance benefited from our decision earlier in the year to move aggressively into Utilities and Telecom short positions as high dividend-yielding stocks traded at century-high valuations. We never short on valuation alone, however, but were able to find challenged businesses in these sectors that exhibited low momentum. Unlike some short sellers, we are willing to assume the cost of dividends on the short side if the opportunity is greater than the carrying cost.
The top-five individual contributors to performance returns were all long positions, however, including Apple, FedEx, and Vodafone Group. Apple rebounded after concerns about slowing growth, margin compression, and capital allocation decimated the stock from September 2012 to June 2013. At its lows, the stock was trading for less than six times recent levels of free cash flow, clearly cheap on almost any metric given the firm’s exceptional products, fortress-like balance sheet, and explosive growth.
FedEx reported solid quarterly numbers during the period. The express business at FedEx has struggled even though its ground segment has increased its market share for 54 consecutive quarters in doubling to nearly 30% of the market. The Street remains focused on the express segment, which had a good quarter, but we think it’s the ground segment’s exceptional operating performance that continues to make the stock attractive and increasingly deserving of a UPS multiple. Global wireless firm Vodafone agreed to sell its 45% stake in Verizon Wireless to Verizon Communications for $130 billion during the quarter, with 70% of the deal proceeds to be returned to Vodafone shareholders, thus reducing the risk that the company will return to its historically poor deal-making roots. Without Verizon Wireless, the firm will have low leverage and may be an interesting takeover target.
Holdings with the lowest contribution to returns during the quarter were a long position in Intrepid Potash and shorts in Mercury General and AmTrust Financial Services. Potash is one of only three essential nutrients needed for plant growth and has no known substitutes. Potash is concentrated in two remarkably small areas that are both cartel-controlled—Russia/Belarus and Canada. Intrepid Potash fell sharply after Russian potash producer, Uralkali, announced in July plans to maximize its future production after exiting its marketing partnership with a Belarusian potash producer. (To highlight the extraordinary context of this action, Belarus has since imprisoned the leading Russian potash CEO.) In light of this fundamental change, we lowered our assessed Absolute Value on Intrepid. With the stock price then trading above this level, we eliminated the position and it subsequently dropped even further. Although the stock rallied off its lows and ended the quarter trading higher than our exit price, we will always happily pay the risk management premium to protect against catastrophic losses that can inflict serious damage on the portfolio.
Leading California-based auto insurer Mercury General wrote more than three-quarters of its policies in California in 2012, a notoriously difficult state for insurance providers (the company has periodically had an adversarial relationship with the California Insurance Department). Increasing competition within California has eroded its market share while poor underwriting results and low interest rates have kept a lid on any meaningful book value growth. A second consecutive quarter of respectable underwriting performance and no unfavorable reserve developments caused the shares to rally. We trimmed the portfolio’s short position as it developed material unrealized losses, though we maintained the smaller position as the quarter ended as the stock traded above our estimate of the company’s takeout value.
Property and casualty insurer AmTrust represents a treasure trove of red flags for us. First, it may be aggressively accounting for its Life Settlement contracts (i.e. a life insurance policy sold to a third party investor), which has contributed almost a quarter of firm profits since 2010. Second, the firm may also be under-reserving for losses. Third, as it has rolled up other agents, acquisition accounting has prevented some costs from hitting the income statement. The stock rose during the quarter along with most crowded shorts (which we seek to limit in the portfolio) and interest rates. We trimmed the position as unrealized losses on the position grew, but our concerns about the fundamentals remained intact.
A relentless rise in the stock market this year—a 21% return with only a minor 5.7% pullback during the first three quarters—has made life difficult for value investors. With most of our favorite businesses trading well above our Absolute Value estimates, it can become frustrating sitting on the sidelines with more than 25% of the long portfolio in cash. The current market reminds us of a quote (also the title of a book we highly recommend on value investor Peter Cundhill, There’s Always Something to Do) by 107-year old (and still investing!) Irving Kahn, “There is always something to do. You just need to look harder, be creative and a little flexible.”
We consistently whittled down our “crowded” short positions throughout the year, which benefited performance. Crowded short positions continued to rise higher during the quarter. The top-50 most shorted stocks in the S&P 500 rose 7.6% versus 4.7% for the index itself. We suspect this was due to short sellers covering their positions, evident by short interest falling to six-year lows. We remain committed to finding “off-the-beaten” path short ideas and the short portfolio grew larger during the quarter.
We initiated two new long positions in newspaper companies Tribune and News Corp during the quarter. We think they represent an excellent example of how we apply our Absolute Value investment philosophy in today’s overheated market. Both positions are “off-the-beaten-path” opportunities (e.g. a post-reorganization bankruptcy and a spin-off) and require a segment-by-segment (“sum-of-the-parts”) valuation methodology. We are well aware of the issues facing the print newspaper business and have been active on the short side in recent years. Slow and steady declines in subscribers has resulted in more severe declines in advertising dollars and wrecked bottom-line results due to the meaningful operating leverage in the business models. The same unavoidable newspaper fundamentals have negatively affected both of these companies, but we purchased them for their non-newspaper assets, which we think the market has overlooked.
The largest new position added during the quarter was diversified holding company Loews, with its ownership interest in three publicly traded stocks and three non-public subsidiaries. For a company with an $18 billion market capitalization, Loews receives very little attention from Wall Street. We can find only one sell-side firm that covers it. A lack of interest has resulted in a challenge to market efficiency, as the company ended the quarter trading below the value of its publicly-traded stock holdings and net cash. This discount seems unwarranted as it does not attribute any value to Loews’ private investments or its strong record of compounding book value per share the past decade. Many conglomerates deservedly trade at a discount to the sum of their parts due to poor records of value creation. We think Loews should trade at a premium.
We believe that the portfolio is well positioned amid a market dominated by concerns about the tapering of quantitative easing, political uncertainty, and sluggish economic growth. When QE unwinds, we suspect individual stock correlations will remain low (we think QE induced all stocks to rise together), which we believe is an excellent backdrop for successful stock selection and the pursuit of equity-like returns.
Intensified squabbling out of Washington D.C. over multiple issues (e.g. debt ceiling, budget, healthcare reform, the Chairmanship of the Federal Reserve, etc.) has the potential to increase volatility in the market. We believe that with just 52% net long equity exposure to the market (and the hefty cash position in the long portfolio), the portfolio is positioned to dampen any potential volatility.
It seems unlikely that the market can continue to rise at 20% annual rates with an economy that only grows 1 - 2%. Thus, we remain prepared for a larger market pullback, which would likely trigger our Drawdown Plan. The Drawdown Plan is our disciplined method for reducing market exposure in an effort to help protect capital, while allowing idle cash to be invested in more interesting opportunities.
River Road Asset Management
As of September 30, 2013, Apple comprised 0.00% of the portfolio's assets, FedEx – 3.03%, Vodafone Group – 1.80%, Intrepid Potash – 0.00%, Mercury General – (0.73%), AmTrust Financial Services – (0.45%), Tribune – 2.53%, News Corp – 2.46%, and Loews – 3.34%.
Note: Short sales may involve the risk that the Fund will incur a loss by subsequently buying a security at a higher price than 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.
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.