3rd Quarter 2011 Commentary - ASTON/River Road Long-Short Fund
3rd Quarter 2011
Stocks Plunge as Macro Risks Intensify
Equity markets plunged during the third quarter as investors reacted to a string of negative macroeconomic events, beginning with the debt ceiling fiasco in Washington and the subsequent U.S. debt downgrade by Standard & Poor’s, followed by the deepening financial crisis in Europe and a general slowing of economic growth around the globe.
The broad market S&P 500 Index declined nearly 14% during the quarter, its biggest drop since the fourth quarter of 2008 and the second worst calendar third quarter since 1928. The market’s macroeconomic focus also led to a dramatic increase in volatility. The Russell 3000 Total Return Index moved more than 2% on 19 of the 64 trading days during the quarter. By comparison, the index had just 22 such trading days during all of 2010.
Across all market capitalizations, stocks with the lowest beta (volatility) dramatically outperformed high-beta stocks. Within the S&P 500, the difference in returns between the lowest and highest quintiles was more than 23 percentage points! Higher quality stocks, as measured by higher return-on-equity (ROE), marginally outperformed lower quality stocks during the quarter as well. In addition, correlations among stocks increased significantly, again as a result of the market’s macroeconomic focus, with correlation within the S&P 500 are at a 25-year high according to BofA/Merrill Lynch research.
As would be expected in such a market correction, the Fund declined less than its long-only Russell 3000 Index benchmark during the quarter. The magnitude of the outperformance was substantial, however. Since the portfolio typically is long low-beta stocks and short high-beta stocks in accordance with our Absolute Value approach, a market that favors low-beta stocks was ideal. Fundamental long-short strategies, such as the one we employ in running the Fund, seek to be long the best performing stocks and short the worst. Although high correlations tend to minimize outperformance opportunities, the Fund managed to outperform in both the long and short sleeves of the portfolio.
Average net long equity exposure during the period was 31% as our Drawdown Plan went into effect in early August. The Drawdown Plan is a critical risk management tool we designed to help minimize portfolio losses in a declining market environment. If the portfolio falls 4% from its high-water mark (the highest peak in the Fund’s value), the Drawdown Plan calls for a reduction in net long equity exposure to no more than 50%, 30% (second level) if it falls 6%, and 10% (third level) if it falls more than 8%. The Drawdown Plan went into effect on August 3 and quickly progressed through its second and third thresholds on August 5 and August 9, respectively.
By quickly reducing the net market exposure in early August, the Drawdown Plan helped the portfolio limit the damage of the declining market. In addition to limiting losses, the Drawdown Plan significantly lowered volatility during the period. Compared to the 19 days of more than 2% moves for the Russell 3000 Total Return, the Fund experienced just one during the quarter.
The long portfolio dropped more than 13% during the quarter with an average exposure of 79%. Although the Drawdown Plan dramatically reduced net long equity exposure, it did not prevent us from increasing our long exposure when stocks began trading at compelling values. Long exposure stood at 71% when the portfolio reached the third threshold of the Drawdown Plan on August 9, but increased to 85% by quarter-end. We maintained the portfolio’s net equity exposure by offsetting increases in the long positions with equal increases in short positions.
The three largest individual contributors to performance on the long side were Rent-A-Center, Big Lots, and Medtronic. Rent-A-Center is the largest rent-to-own company in the U.S. In 2010, it began locating kiosks within furniture and electronics retailers to offer rent-to-own contracts to customers who could not qualify for in-store credit. These RAC Acceptance kiosks fill a need for consumers and retailers making them an exciting growth opportunity for the firm. Investors bid up the stock after it was reported that Best Buy began testing the kiosks in Chicago-area stores.
New store growth led to increased revenue at Big Lots during the second quarter despite a decline in same store sales. The management team also reacted quickly and decisively when speculation ended that Big Lots was an acquisition target of private equity. After its shares fell sharply, the company used its strong balance sheet to aggressively repurchase its own shares at a significant discount to our assessed Absolute Value. Medtronic is an example of a high-quality company that hit our discount target. It was added opportunistically after the portfolio reached the third stage of the Drawdown Plan. With high correlations among stocks, both high-quality and low-quality companies saw stock prices decline sharply in early August. Medtronic received a boost when the firm’s new CEO affirmed earnings guidance in his first quarterly conference call.
WMS Industries, Brink’s, and ManTech International were the biggest detractors from the long portfolio. Gaming equipment manufacturer WMS traded down sharply after management lowered the top end of its 2012 revenue growth range and withdrew its margin guidance, though overall quarterly results and guidance were in-line with our estimates. Security company Brink’s reported mixed second quarter results as its North American segment continues to suffer from pricing and volume pressures driven by aggressive competition. Weak organic growth and sovereign debt fears in Europe also pressured the stock. Industry consolidation fortunately eliminated a low-price competitor in North America in March and the Emerging Markets of Latin America and Asia-Pacific continue to be a bright spot for the company.
ManTech, a provider of information technology services to the Department of Defense and federal government agencies, was in part a victim of the U.S. debt ceiling debate. We believed when we established the position that defense contractors specializing in technology would be spared from the deepest cuts. When Congress and the White House agreed to raise the debt ceiling and continue debating the budget, they established defense cuts as the default if the budget Super Committee could not reach their target. Our conviction in the position weakened as the outlook for defense spending grew increasingly pessimistic. ManTech had also developed into one of the Fund’s largest losing positions so we eliminated the stake.
The stocks shorted by the portfolio declined an average of more than 18% with an average exposure of -48%, resulting in a net gain for the Fund. The short portfolio changed dramatically from the second quarter 2011 as we covered 17 of the portfolio’s 28 positions held on June 30 at their Absolute Value. Even though the Drawdown Plan called for a sharp reduction in net long equity exposure, we were not forced to sell long positions when covering shorts. A significant short position in the SPDR S&P 500 ETF replaced the covered positions and helped maintain the net long equity exposure dictated by the Drawdown Plan.
The ETF short was selected solely as a market proxy to achieve the desired net equity exposure. We do not have an opinion on the valuation of the S&P 500 Index. The SPDR S&P 500 ETF was chosen for its superior liquidity and lower borrowing costs versus ETF options for the Russell 3000. The short ETF position will be replaced by individual short positions as they present themselves and can be quickly covered to increase net long equity exposure when the Drawdown Plan ends.
The short position with the greatest contribution to short portfolio return was the SPDR S&P 500 ETF. Among other individual short positions, AMR and Texas Industries were notable positive contributors. Unlike most other legacy carriers, AMR (parent company of American Airlines) avoided bankruptcy and consolidation during the Great Recession. Its reward for weathering the storm is that its competitors emerged with stronger balance sheets and reduced pension liabilities. Furthermore, American Airlines operates one of the oldest and least fuel efficient fleets among legacy airlines. AMR has lost money in 12 of the last 16 quarters and experienced unusually high pilot retirements during August and September, fueling speculation that the company was planning to seek bankruptcy protection. The stock fell sharply, allowing us to cover the short position at our assessed Absolute Value.
We have maintained a short position in cement supplier Texas Industries since the inception of the Fund. The slowdown in residential and commercial construction and infrastructure projects has left the highly leveraged company in a predicament. Operating earnings have not covered interest expense in any of the last eight quarters, and to sustain itself the company has issued debt, drawn down cash balances, and suspended its dividend. When pressed by analysts for details of their liquidity plan during the quarterly earnings conference call, management could only offer that they needed the business environment to improve. We maintained the short position through quarter-end.
The short positions with the lowest contribution to short portfolio return were Bebe Stores, Frontier Communications, and CONMED. Only Bebe had a negative contribution to return, and the short position in Frontier was only established on September 28. Bebe held up relatively well during the third quarter as the market declined precipitously. A solid balance sheet that has no debt and its first positive same-store sales comparable in 17 quarters prevented the stock from participating in the market meltdown. Given the firm’s Chief Merchandiser left in early January 2011 and the retailer benefited from very easy comparables, we remain confident that this is a turnaround story that does not ultimately turn and we maintained the portfolio’s position.
When we established the short position in CONMED, we believed that management had put the medical technology company’s business at risk due to an underinvestment in research and development. We also noted the appearance of nepotism, overly generous pay packages, and a poison pill provision as evidence of poor alignment between management and shareholder interests. The firm reported low single-digit sales growth and margin expansion for 2010 and the first quarter of 2011, prompting two increases in our assessed Absolute Value and decreasing conviction in the short position. We covered the position prior to the firm’s second quarter earnings announcement.
Outlook and Positioning
Global economies are faced with macroeconomic problems that defy easy solutions. Sovereign debt and government obligations are a growing burden in the U.S. and much of Europe at a time when many economies are stalling. With this backdrop, we expect very modest growth from the U.S. economy in 2012. Markets moved a long way during the third quarter toward pricing in this economic malaise, however, and it is possible the market could rally even if economic growth is stagnant. If current estimates for 2012 earnings hold, we believe stocks are priced attractively. Even at reduced estimates, equities seem to offer a reasonable return opportunity.
Still, with volatility high and a tepid outlook we are comfortable beginning the fourth quarter with a net long equity exposure of only 11% (85% long and -74% short) in the portfolio. Our Drawdown Plan ends when the market begins to exhibit a positive trend, which we define as a positive change in the 50-day moving average of the Russell 3000. Once that happens we will increase net long equity exposure to at least 30% and may choose to increase exposure further if long opportunities are sufficiently compelling. Per the Drawdown Plan, we must return to a normal net long equity range of 50% to 70% once the 50-day moving average of the Russell 3000 has increased for 10 consecutive days.
We believe the sell-off has allowed us to build a solid long portfolio of high-quality stocks that rarely meet our discount-to-value criteria. When we begin to cover the short position in the SPDR S&P 500 ETF, we think we will be able to build exposure to a long portfolio with an attractive return potential even in a low growth economic environment. In addition, our short portfolio watchlist will help us rebuild the short portfolio once the equity markets begin to trend positively.
River Road Asset Management
10 October 2011
As of September 30, 2011, Rent-A-Center comprised 2.40% of the portfolio's assets, Big Lots – 3.91%, Medtronic – 3.56%, WMS Industries – 2.43%, Brink’s Co. – 2.72%, ManTech International – 0.00%, SPDR S&P500 ETF – (70.54%), AMR – (0.16%), Texas Industries – (0.36%), Bebe Stores – (0.52%), Frontier Communication – (0.14%), and CONMED – (0.00%).
Note: Short sales may involve the risk that the Fund will incur a loss by subsequently buying a security at a higher price than which 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.
Parameters set by the Subadviser are not a fundamental policy of the Fund and are subject to change at any time.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.