1st Quarter 2012 Commentary - ASTON/River Road Long-Short Fund
1st Quarter 2012
Stocks Extend Rally
Stocks delivered one of the best first quarter performances on record in 2012, extending the rally that began in October 2011 and lifting most major indexes to new 12-month highs. The Nasdaq exchange led with an astonishing 18% return, its best first quarter performance since 1991, while the S&P 500 Index gained more than 12%—its best first quarter since 1998. The Russell 2000 Index kept pace with the S&P 500, in delivering its best first quarter since 2006 and ninth best on record. Surprisingly, the Russell 2000 lagged the large-cap oriented Russell 1000 Index during the quarter—a rare occurrence amid a period of such strong returns.
The key drivers of the equity rally have been widespread, including improved U.S. economic data, attractive corporate earnings growth, easing concerns over the Eurozone crises, and the extraordinary liquidity provided by major central banks across the globe. The “risk-on” nature of the recent rally is almost certainly the result of monetary stimulus and is evident in the continuing high-beta (volatility), low-quality leadership themes. For the most part, the laggards of 2011 surged during the first quarter of 2012.
Within the S&P 500, for example, the highest-beta (volatile) stocks as grouped by quintile gained nearly 20% during the first quarter versus 4% for the lowest-beta stocks—a remarkable gap. Low-quality and distressed stocks also rallied. According to BofA/Merrill Lynch, low-quality outperformed high-quality by more than 3 percentage points while Morningstar’s distressed stock universe rose nearly 30%.
As might be expected amid such a strong rally, long-short equity strategies underperformed long-only strategies. The HFRX Hedged Equity Index gained only 3.9% during the quarter versus nearly 13% for the Fund’s long-only Russell 3000 Index benchmark. The Fund bested the HFRX index by nearly two percentage points, but severely lagged the long-only benchmark during the brief period. Since its May 2011 inception, however, the Fund has outperformed both the benchmark and the HFRX Index, the latter by a significant margin.
Underperformance during the quarter was primarily driven by the portfolio’s net long equity exposure and, to a lesser extent, stock selection. With an average net long equity exposure of slightly more than 50% during the period we expected to generate greater than half of the market’s return. The portfolio captured only 46% of the market’s return due to the performance of the short portfolio. The short portfolio consisted of stocks with challenged business models that tended to be high-beta and low-quality, areas which rallied the most during the quarter.
The long-only portion of the portfolio increased nearly 13% during the period, with an average exposure of 75%. The stocks with the highest contribution to long portfolio performance were Microsoft, General Motors, and Liberty Interactive Corp. After several years of neglect investors finally embraced Microsoft’s consistent dividend increases, AAA-rated balance sheet, and PC dominance. Although tablets have commanded attention with eye-opening growth rates, tech research firm Gartner predicts healthy 2012 PC growth from which Microsoft stands to benefit. The Fund still holds the stock, but we trimmed the position given the strong rise in price.
General Motors made massive cuts to rationalize its cost structure during its bankruptcy in July 2009, allowing it to remain profitable through the demand cycle. The stock rallied during the quarter as the underfunded status of its pension was in much better shape than feared. In our analysis, the stock still traded only marginally above its net cash and investments during the first quarter. Liberty announced during the quarter that it would convert to two tracking stocks in order to highlight the value of its QVC home shopping network. Chairman John Malone will likely continue his proven track record of aggressively repurchasing shares in the tracking stock structure. We maintained the portfolio’s position.
The stocks with the lowest contribution to long portfolio return during the quarter were Newmont Mining, Cloud Peak Energy, and Patterson-UTI Energy. Leading gold producer Newmont declined after reporting a weak fourth quarter that missed expectations. Specifically, production remains stagnant, costs are rising, and 2012 guidance was uninspiring. We think that bebasement of fiat currency combined with stagnant gold supply growth supports a long-term tailwind for gold, and Newmont investors should benefit due to its gold-linked dividend policy. Coal producer Cloud Peak suffered from rapidly declining natural gas prices that have put pressure on coal as power generators increasingly switch to cheaper natural gas. Although Cloud Peak hedged more than 90% of its expected 2012 production and 60% of its expected 2013 production, longer-term coal prices continue to decline. As one of the biggest losers in the portfolio, we sold the stock.
We invested in Patterson-UTI near the end of the quarter after the stock materially underperformed the market. The company is a top-three onshore domestic driller for oil and natural gas, and a leading pressure pumping provider. The stock remained under pressure as investors continued to associate it with natural gas drilling and lower natural gas prices. The firm, however, has upgraded its rig fleet over the last four years and now 60% of its rigs drill for liquids, most under long-term contracts. We added to the stock during the quarter in building toward the portfolio’s target position size.
The short portion of the portfolio increased 15% during the quarter, negatively affecting performance, with an average exposure of -22%. Individual short positions (hedges excluded) gained nearly 19%, materially detracting from returns as high-beta and distressed stocks rallied. Pulte Group, AOL, and Western Refining were the three biggest negative contributors to the short portfolio.
Several positive comments from multiple homebuilders resulted in a rally for the industry, including Pulte. The company is one of the largest and most levered homebuilders in the industry and has a history of poor capital allocation. We believe that falling home prices and rising cancellation rates will continue to be problematic for homebuilders, but exited the position as the stock hit our stop-loss price in complying with our short portfolio risk controls.
AOL rallied after hiring Evercore Partners to find a buyer for its patent portfolio, despite widely varying estimates of the worth of those patents. The market was also excited about the firm’s double-digit advertising revenue growth during the fourth quarter of 2011, ignoring the easy prior year comparisons. Subscriber revenue, where the company generates virtually all of its cash flow, declined 18% and the company saw another executive departure. We maintained the portfolio’s short position.
Independent oil refiner Western Refining only owns “non-complex” refineries, which means it is unable to process a wide variety of crude oils. It is currently benefiting from its ability to buy crude at discounted West Texas Intermediate (WTI) prices and sell its oil based on Brent pricing. We do not think WTI prices will remain discounted forever and will revert to its historical mean as new infrastructure capacity comes online. We exited the position per our short-covering discipline after it hit our stop-loss price.
Positions with the highest contribution to return in the short portfolio were the United States Natural Gas ETF (UNG), Best Buy, and R.R. Donnelley & Sons. As happened last quarter, during periods of contango (a condition where the price of a forward or futures contract is greater than the expected spot price at contract maturity) the net asset value of UNG deteriorated as the ETF rolled its futures contracts. As a result, the ETF has historically captured more of the downside moves in natural gas prices and less of the upside movements in the commodity. Best Buy’s stock declined after reporting a dismal fiscal fourth quarter that missed expectations. The company surprised Wall Street with negative same-store sales and remains the poster-child for “showrooming”—customers visiting a store only to test out products that they then purchase cheaper from an online competitor. As the world’s largest printer, R.R. Donnelley continues to suffer as the decline in printing accelerated. We closed the position as it approached our Absolute Value, though it remains on our Watch List in the event that yield-hungry investors bid the stock up to a premium valuation.
Positioning and Outlook
Our discount-to-value indicator for the portfolio remained in a relatively tight range around 75% and the Fund did not experience a material drawdown during the quarter. As a result, the portfolio remained within its normal net long equity exposure range of 50% to 70%. As the market rose during the quarter, we naturally increased the short portfolio and were excited to add several ignored, high-quality large-cap stocks to the long portfolio. Although net long equity exposure only increased from 51% to 54% during the period, gross market exposure (overall long plus short positions) increased from 85% to 109%.
On the long side, out-of-favor or underfollowed stocks left behind during the market’s unwavering rise during the period primarily consisted of stocks that require sum-of-the-parts analysis (which does not easily lend itself to Wall Street sell-side coverage) and energy-related opportunities. Long exposure increased from 68% to 82% as the team discovered several new, compelling long ideas. Despite plummeting natural gas prices, we were thrilled to add to the Fund’s energy portfolio. We believe our ability to short structurally flawed ETFs, like UNG, hedges out commodity price risk. In addition, we believe we can capitalize on a market correction using a nearly 20% cash stake to build existing long positions and initiate positions in new long ideas without having to sell anything to raise funds.
We also took advantage of the market rally to increase the individual short portfolio from -15% to -25% as the market focused on those companies we consider to have the most “serious operating problems,” which represent our favorite short opportunities. Our unrealized loss discipline identified a risk exposure to cyclical stocks and we transitioned some of the short portfolio to a broader list of securities. With multiple consumer measures (average earnings, disposable income, savings rate, etc.) at 12-month lows we felt comfortable building a larger position in consumer-oriented short positions. With investors also starved for yield, the portfolio has a sizeable short position in select REITs, rural telecom providers, and other stocks that cannot support their dividend from cash flow. We believe junk rallies provide attractive opportunities to short fundamentally challenged businesses at attractive valuations.
Although global economic growth moderated during the quarter, the domestic economy continued its slow and steady expansion with an historically warm winter serving as a tailwind. Rising gasoline prices, insider selling, interest rates, and investor complacency, however, have been associated with meaningful stock market volatility and drawdowns in the past. We believe our robust risk management, stock selection, and nimble net market exposure are ideal for such an environment. Until the market refocuses on these risks, however, we expect to stay within our normal net long equity range of 50% to 70%.
River Road Asset Management
9 April 2012
As of March 31, 2012, Microsoft comprised 1.51% of the portfolio's assets, General Motors – 2.76%, Liberty Interactive – 3.14%, Newmont Mining – 2.50%, Cloud Peak Energy – 0.00%, Patterson-UTI Energy – 2.88%, Pulte Group – (0.00%), AOL – (1.68%), Western Refining – (0.00), The United States Natural Gas Fund ETF – (0.92%), Best Buy – (0.86%), and R.R. Donnelley & Sons – (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, 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.