4th Quarter 2013 Commentary - ASTON/River Road Long-Short Fund
4th Quarter 2013
The economy demonstrated some real strength during the fourth quarter as the tone of economic reports was generally upbeat and the U.S. consumer appeared to notice. Both consumer confidence and spending finally returned to pre-crisis levels, as employment reports showed steady, albeit slow, improvement. In perhaps the most important test of the strength of the recovery, the federal government shutdown proved largely a non-event outside of the Beltway. The market appeared to key off this strength and was largely positive throughout the last two months of the quarter. In the end, the 32.4% return for the broad market S&P 500 for 2013 was its best return since 1997.
In what could prove a watershed moment for the current monetary cycle, on December 18, the Federal Reserve finally initiated a “taper” of their quantitative easing (QE) program, announcing a $10 billion reduction in monthly bond purchases. Although consensus were for an initial cut coming in the first quarter of 2014, an unexpected breakthrough in Washington D.C. trumped the flurry of constructive economic news. For the first time in years, the U.S. Congress managed to pass a budget, halting the cycle of fiscal brinkmanship that led Senator Schumer to declare the Federal Reserve, “the only game in town”.
Although the Fund marginally bested its long-short peers during the quarter, it trailed its long-only Russell 3000 Index benchmark. The portfolio performed roughly in line with expectations given that it maintained an average net long equity exposure of 49% during the period. The long portion of the portfolio outperformed the benchmark, while the biggest detractors from performance were short positions tied to low-quality, high-cost commodity producers.
All five holdings with the lowest contribution to returns during the quarter were short positions, including United Continental Airlines, Alcoa, and Cliffs Natural Resources. The airline industry reported its most profitable year in history during 2013, with an industry trade group expecting profits to rise even more in 2014. We are skeptical of the bull case and current capacity discipline. Profitability has historically attracted competition in the airline industry as periods of profits have typically been followed by devastating losses. UAL in particular has struggled to raise pricing, while margins have lagged its peer group. The company is a high-cost competitor with 80% of its workforce unionized and an older, less fuel-efficient fleet of planes. Its credit is junk-rated with a significantly underfunded pension and less than a quarter of its 2014 fuel needs hedged. We trimmed the position due to unrealized losses, but maintained a smaller weight as our thesis remained intact.
Alcoa is a high-cost aluminum producer with half of its work force unionized and a sizeable debt load. The cyclical high in aluminum demand is masking what we think is a poor underlying business that consumes capital and generates low returns on invested capital (even at peak aluminum demand). The company hosted an optimistic Analyst Day during the quarter, which highlighted the firm’s more profitable downstream segments. We suspect the aluminum market will remain in oversupply and our thesis remained intact. We trimmed the position as it developed unrealized losses.
Cliffs is the largest producer of iron ore in North America, a high-cost commodity producer that is exclusively dependent on the health of the global steel industry. The expansion of global steel consumption (mainly China) combined with the inability of suppliers to meet that demand in a cost-effective fashion have pushed iron ore prices to nearly nine times higher than where they traded a decade ago. We are skeptical of current iron prices as Chinese growth slows and major supply additions from the industry’s largest players start to come on-line. Cliffs is the most heavily shorted stock in its sector. It is a popular stock for global investors who wish to express a view on iron ore price/China/macro, etc. and short covering pushed the stock higher, one reason that we purposely limit the number of “crowded” shorts in the portfolio. We trimmed the position as it developed significant unrealized losses, but remained comfortable with the fundamental thesis.
The holdings with the highest contribution to returns during the quarter were all long positions, notably in FedEx, Comcast, and Tribune. Fedex reported a solid fiscal second quarter. The Street remains focused on the express segment, which had a good quarter as cost-cutting measures took hold and margins improved from a year ago. We think the ground segment’s exceptional operating performance makes it increasingly deserving of a UPS-like multiple. We were also pleased that the company announced a major share repurchase authorization and quickly repurchased a significant amount of its own stock (approximately 2% of the shares outstanding).
Cable company Comcast continued its operational momentum. It added video customers for the first time in six years and has consistently added more broadband subscribers than AT&T and Verizon combined in each of the last four years. It owns the best cable system in the country, maintains the most conservative balance sheet, and is led by a talented owner/operator. Critics fear that the roll out of fiber-to-the-home by telecommunication providers will threaten Comcast’s video and internet dominance. We think the company’s network can reach “fiber-like” speeds with much lower incremental investment than its competitors.
Tribune represents an “off the beaten path” idea as it trades on the “pink sheets.” The company emerged from bankruptcy protection in 2013 with a much improved balance sheet, an attractive portfolio of media assets, and a new CEO with a track record of creating value in the cable television industry. Tribune’s eight major daily newspapers, including The Chicago Tribune and The Los Angeles Times, receive most of the attention, but represent a small piece of the firm’s asset puzzle. It also owns the largest broadcast TV portfolio in the country, large stakes in the Food Network, CareerBuilder and Classified Ventures, and a sizeable real estate portfolio. The Federal Communications Commission’s (FCC) approval of Tribune’s acquisition of Local TV, owner of 19 television stations in 16 key markets, boosted the stock during the quarter.
Our calculated discount-to-Absolute Value indicator for the portfolio averaged 80% during the quarter. We view the market as “extremely overvalued” when this indicator rises above 80%, and begin to lower the Fund’s net long equity exposure. Net long equity exposure averaged just 49% during the quarter, which is slightly below the low end of the 50% to 70% range that we consider normal. With just half the exposure of the market, portfolio volatility was contained with a beta (a statistical measure of volatility relative to an index) was less than half the benchmark.
The Fund’s fourth quarter performance highlighted the importance of an all-cap strategy. As a rising market environment pushed the discount-to-Absolute Value indicator over 80% several times throughout 2013, we were able to keep it from levitating higher with the market by transitioning the portfolio to where we found value. The long portfolio’s large- and mid-cap exposure increased while small-cap exposure declined during the year. Four of the top-six long contributors during the fourth quarter were large-cap stocks.
Although the portfolio lost money shorting during the quarter, we were encouraged that underlying fundamentals seem to matter more to market participants. Intra-market correlations continued to decline to pre-crisis levels. In contrast to earlier periods this year, companies that reported poor fundamentals declined. All of the top-five short positive contributors either guided or reported lower profits and the stocks declined, while the top-five short negative contributors reported positive earnings reports or future restructurings to improve the business. Our process allows us to determine whether the positive quarterly data voids our theses or is simply a short-term blip and our theses remain intact. We eliminated several short positions this quarter after digesting the news and honestly admitting our mistakes. We trimmed several other short positions for risk control purposes, but maintained the positions since our fundamental theses remained intact. We remain committed to finding “off-the-beaten” path short ideas and the short portion of the portfolio grew larger during the quarter.
The largest new position added during the quarter Quest Diagnostics, the largest independent clinical laboratory company in the United States. The company offers routine diagnostic testing, anatomic pathology, esoteric testing, and substance abuse testing at the nation’s most extensive network of 2,100 patient service centers. The company is out of favor with Wall Street, and the near-term outlook is undeniably cloudy—hospital visits have been weak, private physician practices that use independent labs are selling out to hospitals, in addition to consistent pricing pressure. We think the well-documented risks are priced into the stock, while the longer-term view sees opportunities for the company to overcome these risks as growth emerges and the benefits of scale kick in. Quest has built a massive scale advantage that should help offset pricing pressures and the trend towards more testing being completed in hospitals as physician groups sell their practices. The company has eliminated three layers of management and is integrating its legacy IT systems, and we are pleased that it is taking advantage of the current price weakness with accelerated share repurchases while maintaining an investment-grade balance sheet. The company has repurchased a quarter of its shares since 2008 and tripled the dividend since 2010.
The economy remains stuck in slow-growth mode, having likely grown only 2% to 3% in 2013, in line with the historically low 2.3% average growth rate since the recovery began during the second quarter of 2009. Low economic growth has severely limited sales growth, while low interest rates and the lack of wage inflation have boosted profit margins to record levels. With profitability already at record levels (and little expansion for the past seven quarters) and multiples approaching all-time highs, investors must increasingly rely on top-line growth to fuel further gains in the stock market.
Our Absolute Value philosophy seeks to invest in excellent companies with predictable and sustainable cash flows at compelling prices. Unlike some value approaches, we appreciate the power of long-term growth. Small increases in long-term growth expectations result in large increases in value. In an economy that continues to grow at historically low rates, investors bid up those companies that are expected to grow.
Finding these sorts of investments at discounts to their Absolute Values has become more challenging with the market’s relentless advance. Companies with obvious growth potential are particularly cherished in this environment. Therefore, we have built a long portfolio with companies that we think have overlooked growth potential (holdings such as Molson Coors Brewing, DIRECTV, and News Corp.).
It is easy to lose perspective on shorting in a raging bull market. It is tempting to throw in the towel on shorting after years like 2013. It is easy to forget that most stocks underperform broad indices and many lose money over time. We designed our strategy to resist this temptation and remain committed to short-selling over the long term.
We strive to short challenged business models, or companies that do not earn their cost of capital, struggle to grow revenues, or rarely generate any free cash flow. Over the long haul, a stock cannot earn much more than the return that the underlying business earns. If a business earns 3% on capital over decades, the stock will return something close to 3% (regardless of the price paid). At year-end, the short portion of the portfolio had earned roughly 3% on its invested capital over the past several years. This same short portfolio, however, rose 40% in 2013. Either these businesses will radically improve in the future or the shorts in the portfolio should be well-positioned for the future. We will continue to follow our risk controls and eliminate those shorts that threaten serious damage to the overall portfolio, while attempting to keep the short portfolio full of challenged business models such as northeastern utility UIL Holdings, printing company Quad/Graphics, and video game maker Electronic Arts.
We were pleased to have participated in the market’s impressive advance in 2013, which did not favor our conservative style of investing. As the Fed unwinds its QE program, we expect individual stock correlations to continue to fall and more interesting opportunities to emerge. As of December 2013, correlations were finally back to pre-crisis levels and closer to long-term averages, which is a favorable environment for active stock selection. Rising interest rates and overly optimistic earnings expectations for 2014 may set the stage for increased volatility. Analysts still cavalierly expect 15% earnings growth in 2014 despite the worst negative-to-positive earnings guidance ratio on record. Entering 2014 with only 49% net long equity exposure and a sizeable cash seems appropriate.
Complacency is back. The Chicago Board Options Exchange Volatility Index (VIX), a measure of expected volatility, remains at very low levels. Margin debt as a percentage of market capitalizations is at an all-time high (and equal to 26% of all commercial/industrial loans in the U.S. banking system). Almost two-thirds of the initial public offerings (IPOs) completed this year are not profitable, which is the most since the 1999 - 2000 dot com bubble. Many hedge funds are launching long-only funds.
We think Warren Buffett’s message from Berkshire Hathaway’s 1989 shareholder letter is timely, “The less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
River Road Asset Management
As of December 31, 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.