1st Quarter 2014 Commentary - ASTON/River Road Long-Short Fund
1st Quarter 2014
It was a benign quarter for stocks with most of the major U.S. averages posting modestly positive returns, including the broad market S&P 500 Index (1.81%) and tech-oriented Nasdaq (0.54%) exchange. The only exception was the Dow Jones Industrial Average, which had a slightly negative return. Fourth quarter company earnings were generally in line with (reduced) expectations and, while severe winter weather negatively affected first quarter growth, there were relatively few macroeconomic surprises during the period.
The modest returns masked an increase in volatility, however, as a number of interesting cross currents and potential trend shifts emerged. Although indicators like the Chicago Board Options Exchange (CBOE) Market Volatility Index (“the VIX”) ended the quarter well below their historical average, most volatility measures trended higher during the quarter. The increase was largely associated with a nearly 6% drop in stocks (as measured by the S&P 500) between mid-January and early February—the largest correction since April-June 2012. The correction was triggered by weak data out of China, coupled with growing political and fiscal concerns in a number of developing nations. While the retreat was not particularly large or unexpected, the higher trend in volatility suggests that investors may be more reactive to negative data going forward.
Style, Home Security, and Short Hedges
The Fund did not meet expectations during the first quarter in posting losses versus a nearly 2% gain for its long-only Russell 3000 Index benchmark. This despite an average net long equity exposure of 50%. The primary driver of underperformance was poor stock selection. The long portion of the portfolio, individual short holdings, and short hedges all underperformed.
We designed our strategy to emphasize stock selection. With less than 100% exposure to the market, strong stock selection is required to generate equity-like returns over the long-term. Unfortunately, stock selection was particularly poor during the quarter, resulting in the Fund’s second worst absolute performance since inception. The quarter’s underperformance can be summarized into three groups—stylistic headwinds, home security long positions, and short hedges.
Our style of investing was not in favor. Put simply, we like to purchase high-quality stocks at discounted prices and short low-quality stocks at inflated prices. Unfortunately, both high-quality and cheap stocks underperformed this quarter. Bank of America/Merrill Lynch data shows that stocks ranked B+ or higher (i.e. high quality) gained only half as much as stocks ranked B or lower (i.e. low quality).
The Portfolio was also positioned in the wrong sectors. Consumer Discretionary was the worst performing sector in the market and it represented more than 40% of the long portfolio (we actually increased the weighting during the period as stocks in the sector became more attractively priced). We view many of the Consumer Discretionary investments as providing services consumers consider necessities, but they still declined along with the rest of the sector. More than 26% of gross average equity exposure was allocated to the media and cable industry within the sector, and we think many consumers no longer view their cable bill as discretionary.
The top two individual losers during the quarter were ADT and Ascent Capital Group, both home security stocks that “gapped” down during the quarter. The toughest risk to guard against is a stock that “gaps”—makes a sharp move in one direction—the wrong way. From a risk management perspective, it is easier to contain gradual losers than those that move violently against us. We attempt to minimize this risk through solid fundamental analysis and sizing positions that are inherently more risky at smaller weights.
ADT is the most well known brand in the home security market and has achieved scale with a market share more than six times its nearest competitor. In late November 2013, activist investor Keith Meister of Corvex Capital promptly resigned from the company’s Board of Directors and sold his entire stake back to the company at $44 a share. We maintained our position given that the company had just reported a strong quarter and it appeared the reason for Mr. Meister’s departure was a disagreement about future capital allocation. We thought that Corvex was pushing for more aggressive buybacks, while the company desired a more balanced approach of buybacks, dividends, and tuck-in acquisitions. The stock “gapped” down more than 20% in January after reporting poor quarterly results. Specifically, it cost ADT more than expected to add fewer-than-expected new customers, intensifying concerns that new competition from cable and telecom rivals was pressuring ADT’s business.
Unfortunately, we sized ADT as one of the largest long positions in the portfolio given that it is a stable business with shareholder-focused management and clear, but manageable, risks stemming from growing cable and telecom competition. We are not yet convinced that the cable/telecom threat is a long-term negative; rather, we think their emergence could actually grow the home security market, which is in less than 20% of all homes. We maintained a smaller position in ADT, and were surprised that the stock ended the quarter trading for less than six times its cash flow.
Ascent is the second-largest home security monitoring company and operates Monitronics, an asset-light model that outsources the sales, installation, and field service functions to dealers. Monitoring contracts are 3 to 5 years with automatic renewals. ADT’s quarter weakened our conviction in the industry but did not invalidate our home security thesis. We eliminated the Ascent position, as we maintained the position in ADT, to reduce exposure to the industry. We favored ADT over Ascent for several reasons. First, we think the ADT brand is valuable and enduring. Second, Ascent is significantly more levered then ADT. Finally, ADT was much cheaper than Ascent. Ascent subsequently reported a strong quarter with no noticeable negative impact from the cable/telecom threat, which strengthened our long-term positive view of the industry.
Short hedged positions in exchange-traded funds (ETFs) United States Natural Gas (UNG) and the SPDR S&P 500 (SPY) also hurt performance. Slowing domestic gas production combined with a very cold winter boosted gas demand and the price of natural gas. We maintained the short position in UNG as its structural flaws remain intact. The entry and quick exit from our Drawdown Plan early in the quarter briefly required a short position in SPY.
Bright spots during the quarter included long positions in Microsoft, Berkshire Hathaway, and Quest Diagnostics. Although headlines routinely suggest that Microsoft is entirely dependent on the PC, the majority of the firm’s profits are tied to Microsoft Office (e.g. Excel, Word, and Power Point) and enterprise servers (more than half of revenues). We agree that the Windows business faces a challenging future, but assuming reasonable multiples for the rest of the firm’s businesses, we believe we paid nothing for this segment. The company generates roughly $25 billion a year in free cash to add to its $75 billion treasure chest. The market has been unwilling to place much value on this cash given the company’s previous decade of missed opportunities and poor acquisitions. We believe the market is beginning to appreciate the power of new leadership, however. Successful activist investor ValueAct Capital initiated a position early in 2013, and has reportedly been influential. We suspect capital allocation will greatly improve in the future and are encouraged the board chose Satya Nadella as the firm’s new CEO.
Warren Buffet-led holding company Berkshire Hathaway’s collection of businesses are executing well. The firm’s book value per share rose 18.2% in 2013. CEO Buffett placed a floor on the stock in December 2012 by stating the company would buy back stock at 120% of book value. The “Buffett put” rose along with book value per share this year. He seemed ready to buy back a material amount of stock in his recent annual shareholder letter, “We did not purchase shares during 2013; however, because the stock did not descend to the 120% level…if it does, we will be aggressive.”
Quest is the largest independent clinical laboratory company in the U.S. Wall Street is bearish on the stock due to obvious short-term challenges, including weak hospital utilization and reimbursement pressures. We are more optimistic regarding the long-term opportunities, including hospital utilization that should improve with the economy, the growing number of insured under the Affordable Care Act, and an increasing number of baby boomers hitting age 65 every year through 2030 that should need more lab tests. Investors had worried of an implied lower pricing from Medicare for Quest testing. This overhang was removed as Congress approved a “doc fix” bill at the end of the quarter, however, which delayed and eased upcoming reimbursement pressure. Although Medicare revenues only represent approximately 12% of Quest’s revenues, it is important as managed care pricing tends to follow Medicare pricing trends.
The portfolio’s maximum drawdown for the quarter was -5.01%, capturing 87% of the market’s drawdown. Given our normal net long equity exposure range of 50% to 70%, we expect to capture a sizeable percentage of an initial market descent. The extent of our drawdown capture during early market declines depends critically on stock selection. In this instance, we participated more in the market’s descent than we anticipated. The simultaneous combination of market weakness and poor long stock selection pushed us into the first level (down 4% from the Fund’s “high water mark”) of our Drawdown Plan. The importance of stock selection is critical in determining the portfolio’s capture during the first stages of the market’s decline, but fades quickly as the market moves lower and the significance of market exposure gains importance.
The first level of our Drawdown Plan does not require a significant reduction in net market exposure; it simply caps the maximum exposure at 50%, the low level of our normal exposure range. The market continued to decline over the next several trading days and we found attractive opportunities to increase exposure in the long portfolio. We paired these long purchases with the previously mentioned short position in the SPDR S&P 500 ETF to cap net long equity exposure below 50%. The market quickly bounced back and we were out of the Drawdown Plan, and the hedge, by the end of the quarter.
The disappointing drawdown performance during the quarter is unfortunate, but within the realm of possibilities. Our Drawdown Plan does not protect the Portfolio against small drawdowns, as some portfolio volatility is required to participate in up markets. It is designed to limit the portfolio’s maximum drawdown to -10% to -15% during severe market declines. We did not know the market’s descent would end at just -5.74% this quarter—timing the market is not a core competency for us—so we gladly paid the premium involved with the SPDR hedge to ensure the portfolio was prepared in the event of a larger market decline. It is worth pointing out that a 5.01% decline requires just a 5.3% gain to get back to breakeven.
Most conventional valuation metrics—including our discount-to-Absolute Value indicator—suggest the market is overvalued. As the market has soared over the last five years due to multiple expansion, it becomes more challenging to find compelling values and creates pressure on value investors to “keep up” with a rising market. It is tempting to stretch valuations, invest in areas outside our normal comfort zone, and hold on to winners too long to avoid becoming underinvested, which we believe results in inferior ideas in a portfolio. It is wise to remember the words that Ben Graham wrote over six decades ago in the Intelligent Investor, “The risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.”
The market remains infatuated with small-cap stocks and secular growth stories (e.g. biotechnology, internet, and 3D printing). Fast growers—firms growing revenues at more than 30%—are now trading at the high-end of their 60-year valuation range. The valuation disparity between large-caps and small-caps is reaching historical extremes. The long portfolio may appear a bit stodgy in comparison. Top long holdings include large-caps with steady, albeit slow growth, solid financial positions, and talented management teams. These include cable companies Comcast and Time Warner, as well as food and beverage conglomerate Nestle. It is during frothy environments that we transition our emphasis from valuations to the quality of businesses.
The largest new position added during the quarter was Time Warner. Almost three quarters of the firm’s cash flow comes from a collection of top cable networks—TNT, TBS, and CNN—and HBO, the dominant premium pay TV network. The rest comes from film producer Warner Brothers and Time, the largest domestic print magazine publisher. Chairman and CEO Jeff Bewkes has continuously chiseled away at the conglomerate structure and created massive shareholder value since taking over in 2008. With the spin-off of Time expected in the second quarter of 2014, what remains will be a pure-play content company able to benefit from rising affiliate fees, increased distribution options, and international pay-TV growth. As Americans consume an increasing amount of content each year, we think the company is well positioned to benefit.
The largest risk Time Warner faces is continued cord-cutting. The number of Americans that pay for TV fell for the first time in 2013. We continue to monitor this trend, but ultimately think quality content will be rewarded. We suspect any decline in domestic cable subscribers will be more than offset through rising rates for quality content and international subscriber growth.
We believe the Portfolio well positioned for an aging bull market. We were disappointed with the Fund’s performance during the first quarter, but think the long portfolio suitably exposed to higher-quality long positions and a diverse short portfolio of melting ice cubes and overvalued, mediocre businesses.
Rising geopolitical tensions and optimistic earnings estimates may lead to increased market volatility, however. With only 50% exposure to the market and a sizeable cash position, we believe the portfolio is also well positioned to dampen volatility. We suspect a larger market decline may be on the horizon. As Fed Governor (and FOMC voting member) Richard Fisher recently noted, “I fear that we are feeding imbalances to those that played a role in the run-up to the financial crisis. With its massive asset purchases, the Fed is distorting financial markets and creating incentives for managers and market players to take increasing risk, some of which may result in tears.” We developed the Drawdown Plan—our method to attempt to preserve capital—to try to avoid those tears.
We think the best way to beat an index over time is to not be the index, and that investing in a concentrated portfolio of “best ideas” represents the best way to outperform an index over time. Relying on fewer names to meet our objectives also increases the odds for periods of significant underperformance, like this quarter. We believe a robust set of risk controls gives us the confidence to invest in a concentrated portfolio. These risk controls include conducting thorough fundamental research up-front, not averaging down once we have established a target position, setting stop-losses on short positions, and systematically reducing unrealized losses both at the portfolio level and in individual short positions that develop high momentum. We continue to follow the same time-tested Absolute Value stock-picking process that we have since inception. This Absolute Value philosophy embraces the foundations of “common-sense” value investing. We seek to pay attractive prices for excellent businesses that avoid excessive leverage and are run by shareholder-oriented management teams.
River Road Asset Management
As of March 31, 2014, ADT comprised 2.73% of the portfolio's assets, Ascent Capital Group – 0.00%, United States Natural Gas Fund – (0.85%), SPDR S&P 500 – (0.00%), Microsoft – 2.46%, Berkshire Hathaway – 3.70%, Quest Diagnostics – 1.91%, Comcast – 4.41%, Time Warner – 4.05%, and Nestle – 3.46%.
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.