1st Quarter 2012 Commentary - ASTON/River Road Small Cap Value 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, its best first quarter since 2006 and ninth best on record. The small-cap index has rallied more than 37% from its October 2011 low and closed the quarter within 4% of its all-time high. 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.
Within the Fund’s Russell 2000 Value Index benchmark, for example, the highest-beta stocks (fifth quintile) returned 17% during the first quarter versus nearly 5% for the lowest-beta stocks (first quintile)—a remarkable gap. From a quality perspective, the lowest return-on-equity (ROE) stocks outgained the highest 18% to 11%. Non-dividend paying stocks also outperformed stocks that pay a dividend by nearly five percentage points. Investors should note, however, that high-beta leadership faded in March, which may be a sign that the current quantitative easing (QE) fueled risk trade has run its course.
Active managers delivered impressive performance during the period despite a dismal March. According to BofA/Merrill Lynch and Lipper Analytical Services, 65% of active small-value managers outperformed the Russell 2000 Value, but only 21% outperformed in March. The significant underperformance by active managers in March appears to have coincided with the higher-beta leadership beginning to fade in the small-cap universe. We first commented in early 2011 that, based on similar performance statistics, small-value managers appear to have adopted a higher risk profile than has historically been witnessed. We concluded this trend would likely result in managers underperforming as the QE-driven risk trade diminished. Our conclusion was evident during the corrections that occurred in the second and third quarters of 2011, and again as the high-beta leadership faded in March.
2011 Part Deux?
The Fund noticeably lagged its Russell 2000 Value Index benchmark during the quarter. The relative underperformance is disappointing, but understandable given the leadership of extremely high-beta stocks in the market. As expected, relative performance began to improve as high-beta leadership began to fade toward the end of the period. The Fund experienced a similar trend during 2011. The Fund lagged the benchmark appreciably during the first quarter of that year as well, as high-beta stocks led the market sharply higher. Once the QE2-fueled rally began to fade midyear, however, the portfolio outperformed. Although we believe the final 2012 market and portfolio returns will be significantly better than 2011, we expect a similar pattern of improved relative performance to emerge as the risk trade fades.
The sectors with the lowest contribution to relative returns during the quarter were Financials and Consumer Staples. Both sectors suffered from poor stock selection. Financial services firm SWS Group saw its brokerage business continue to suffer from lower interest-rates and declining trading volumes. Its bank segment, however, continues to improve the credit quality of its loan portfolio, leading us to stick with the stock in the portfolio as it still trades at an attractive discount.
In absolute terms, some of the biggest individual detractors from performance were Brink’s, Ruddick, and two Energy-related stocks, all of which posted losses amid the strong rally. Global security provider Brink’s continued to suffer from pricing and volume pressures in its North American segment, driven by aggressive competition. As a result, the company announced a significant cost savings plan to revive the segment’s margins. In addition, the firm plans to meet the obligation to its underfunded company pension plan primarily with equity. Although the cost of equity issuance at these levels is expensive and dilutive, debt issuance is not an option given the company’s desire to maintain its investment grade balance sheet, the inability to tax-efficiently repatriate its foreign earnings, and the poor cash flows of its North American business. We trimmed the portfolio’s position due to lower conviction in the company’s capital allocation strategy.
Ruddick, which officially changed its name to Harris Teeter Supermarkets on April 2, reported strong first quarter results, but its share price momentum slowed in 2012 after being one of the portfolio’s top performing holdings in 2011. We think it remains a well-run company with strong fundamentals and a solid balance sheet. It remains a high-conviction holding in the portfolio.
Cloud Peak Energy and Rex Energy both declined double-digits within the lagging Energy space. 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, a sustained period of low natural gas prices could permanently affect demand for coal. Small, independent natural gas company Rex Energy unexpectedly announced a poorly executed secondary equity offering to pay down debt. We trimmed both positions in the portfolio as a result of their respective issues.
An underweight allocation and positive stock selection in Utilities and an overweight allocation to the surging Consumer Discretionary sector were the primary positive contributors to relative performance. Four of the Fund’s five top individual contributors—Ascena Retail Group, Big Lots, Pep Boys, and Madison Square Garden—came from the Consumer Discretionary sector.
Ascena which operates the dressbarn, maurices, and Justice specialty apparel chains reported strong holiday results, while favorable spring sales trends led the company to raise its earnings guidance for fiscal year 2012. The company has repurchased 2% of its outstanding shares year-to-date, and management is seeking accretive acquisitions. Closeout retailer Big Lots reported strong domestic same-store sales growth that exceeded management’s previous guidance. The outperformance was driven by improving trends in most major merchandise categories with seasonal and furniture posting the largest gains. The firm also reported lower than expected losses in its newly acquired Canadian stores. We trimmed both of these high conviction holdings as each approached our respective calculated Absolute Value.
Pep Boys, a national retail chain of automotive service centers, announced an agreement to be acquired by a private equity firm on January 30 at a 24% premium over the previous day’s closing price. The deal valued the company at a discount to our assessed multiple and $18 Absolute Value. Still, we were able to exit the position at a significant gain prior to quarter-end.
Madison Square Garden Company (MSG) owns the New York Knicks, the New York Rangers, the “World’s Most Famous Arena,” and affiliated regional sports networks. MSG shares moved higher from increased fan interest in the New York Knicks, largely due to the play of new point guard Jeremy Lin. This helped resolve a heated renegotiation with Time Warner Cable, resulting in new contract terms favorable to MSG.
Six new holdings were added to the portfolio during the quarter. These positions were widely diversified across industry groups with all but one, funeral services provider Service Corp. International (SCI), having a market-cap of less than $1 billion. We also strategically increased 11 existing positions, with the largest increases being made in True Religion Apparel, Dreamworks Animation SKG, and DST Systems.
Six positions were sold. Three had achieved their Absolute Value price targets, one received a buyout offer and was subsequently sold, and two were sold due to either accumulated losses and/or a negative change in our fundamental outlook for the firm. One of the investments sold in February, medical equipment manufacturer Integra LifeSciences Holding, was purchased in January. The stock surged higher following our initial analysis allowing us to acquire only a small position. Unable to justify buying more at the much higher price, we sold the small position near the stock’s assessed Absolute Value.
The only material change in sector positioning was a decrease in the Fund’s Consumer Staples stake, which reflected both underperformance in the group, as well as the sale of private label beverage manufacturer Cott and canned fruit and vegetable processor Seneca Foods.
Factors Weighing on the Market
During the first week of March, the market experienced its first significant pullback of the year when the Russell 2000 Index closed down 2% on March 6—more than 5% below its February high. The chief culprit appeared to be investor concern about rising gasoline prices, but Congressional testimony by Federal Reserve Chairman Ben Bernanke didn’t help. Although the small-cap market recovered from the early March correction, and moved on to set a new 12-month high, the events surrounding the correction highlighted what we believe are the three most significant near-term threats to higher stock prices—high valuations, rising gasoline prices, and no additional quantitative easing.
The March correction was preceded by a warning from our discount-to-Absolute Value indicator. Historically, and particularly over the past five years, the portfolio’s discount-to-AV has been a highly prescient indicator of impending market corrections and exceptional buying opportunities. By early February, the small-cap market had gained more than 12% on the year and the portfolio’s discount-to-value indicator moved above 80%—historically a point at which valuations are unattractive and rallies begin to buckle. From February 3 through March 6, the Russell 2000 declined more than 5% and the indicator moved below 80%. By quarter end, however, the index had rebounded and the indicator was near its historical high of 82%.
According to Laffer Associates, the current level at which household budgets will get “slammed” by rising gasoline prices, significantly increasing the likelihood of a recession, is $3.22 (wholesale, series—Conventional Gasoline, NY Harbor, Regular). In February, the price was $3.04; in March, it was $3.17. Economic growth has averaged between -2.8% and -0.5% during the six quarters following a spike in gasoline prices above this household budget-busting level. Thus far in 2012, offsetting warm weather and lower heating costs have eased the consumer pain of higher gasoline prices. A sustained spike in gasoline prices from those experienced in March, however, would present a significant threat to a continued economic recovery, especially if the unseasonably warm weather continues through the summer months.
The withdrawal of monetary stimulus also poses a threat to the recovery and may be linked to rising oil prices. When the Federal Reserve first hinted at QE2 in August 2010, markets rallied sharply. Leading that initial rally were cyclical industries, small-cap stocks, and high-beta stocks. After approximately five months, the market experienced a modest correction, rebounded briefly, and then fell sharply. When the initial high-beta rally ended it was marked by a sharp rise in commodity prices, most notably oil.
Essentially, the initial impact of QE2 was to inflate financial assets (boosting consumer net worth, confidence, and spending). The rally in financial assets was relatively brief, however, and gave way to a sharp rise in oil and other commodity prices. The end of the rally also coincided with our discount-to-value reading of 82%.
The recent rally was sparked by the announcement of a massive long-term refinancing operation (LTRO) from the European Central Bank and the effect on equity markets has been the same as QE2. The current rally is approximately six months old and has been led by the same high-beta, highly-cyclical stocks. Similarly, the rally is beginning to buckle following a sharp rise in oil prices.
In summary, we continue to believe the market is in the middle stage of a low growth recovery. This means the pace of earnings growth will likely slow in the months ahead and the recent strong economic data we have experienced will moderate. It also means that equity market volatility will likely increase in the months ahead. Stocks, however, have come a long way from their recent lows and are likely due for a correction. Both our internal measures of value, as well as trusted external measures, show the market is overvalued. In the absence of a surge in oil prices or European crisis, the correction may not be especially deep or long, but at these levels is likely to occur.
Admittedly, we are frustrated by the resurgence in low-quality, high-beta leadership. This leadership theme is highly unusual for the current stage of the recovery and we believe directly attributable to the massive flood of liquidity by the major central banks. There is no way of knowing when the central banks will stop providing additional QE. In the absence of a recession, we believe the Fed is likely to continue reining in expectations for further QE, setting the stage for higher rates over the next 12 to 24 months. Any such signals from the Fed are likely to result in near-term volatility, as investors struggle to decide whether the current recovery can be self-sustaining.
The wild cards are oil and, as the year progresses, uncertainty around the federal budget cliff. Further increases in oil prices are likely to weigh heavily on the economy. If oil prices experience a sustained move higher, we may have seen the high in stocks for the year. If oil prices stabilize around current prices, however, there may be room for a bit more upside before year-end, especially if investors like the outcome of the elections in November.
With regard to the fiscal cliff, it is difficult to speculate whether Congress will be able to successfully pass an extension of current tax rates prior to higher rates going into effect. If no extension is passed, we believe stocks are likely to come under significant pressure.
From a portfolio perspective, we remain pleased with the quality and positioning of our holdings, which are focused on stable growth, attractive valuations, healthy balance sheets, and other characteristics we believe the market will reward in the months ahead.
River Road Asset Management
9 April 2012
As of March 31, 2012, SWS Group comprised 0.57% of the portfolio’s assets, Brink’s Co. – 1.94%, Ruddick Corp. – 4.00%, Cloud Peak Energy – 0.79%, Rex Energy – 0.31%, Ascena Retail Group – 2.25%, Big Lots – 3.86%, Pep Boys – 0.00%, Madison Square Garden Co. – 3.52%, Service Corp International – 0.40%, True Religion Apparel – 0.84%, Dreamworks Animation SKG – 1.32%, DST Systems – 3.06%, and Integra Lifesciences – 0.0%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity. Value investing often involves buying the stocks of companies that are currently out of favor that may decline further.
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.