3rd Quarter 2012 Commentary - ASTON/River Road Independent Value Fund
3rd Quarter 2012
Stocks Surge on Pledge from ECB
After drifting sideways in July, stocks surged during August following comments from Mario Draghi, head of the European Central Bank (ECB), that the bank would use the full force of its balance sheet to support the euro and suppress the high borrowing costs of struggling nations such as Spain and Italy. Although the action did not address the debt and deficits at the root of the crisis in Europe, it reduced concerns about the ongoing support from central banks in the region.
The rally lasted through mid-September when the US Federal Reserve formally announced another round of quantitative easing (QE3)—a program targeting $40 billion a month in bond purchases—and its intent to keep interest rates “exceptionally low” through at least mid-2015. To the surprise of many, the S&P 500 Index peaked just one day after the Fed’s announcement, drifting steadily lower thereafter. Even a subsequent announcement by the Bank of Japan that it would expand its asset purchase program by 10 trillion yen failed to reverse the market decline.
It is unclear whether the reaction to the Fed announcement was a classic case of “buy the rumor, sell the news” or whether investors believed that additional quantitative easing was unlikely to have a meaningful impact. Mounting research demonstrating that each successive round of easing has had a diminishing impact on markets, interest rates, and the economy supports the latter theory. Even the deputy governor of the Bank of England (BoE), Paul Tucker, recently made the statement that while BoE’s QE program still worked, it lacked the “bite” it once had.
Although economic growth during the third quarter likely topped the 1.3% rate experienced during the second quarter, it will be far from robust. Durable goods orders declined, company surveys remained gloomy, job growth was anemic, and the Conference Board’s Leading Economic Index (which small- cap stocks closely track) turned negative during the period. The housing sector provided a rare bright spot, with the S&P Case-Shiller Index rising 11% (on an annualized basis) during the prior three months. Data also showed notable improvements in home construction, sales of existing and new homes, pricing, and the inventory of distressed properties.
The Fund underperformed its Russell 2000 Value Index benchmark during the quarter and year-to-date through the end of September. The trailing relative performance was a direct result of high cash levels, which averaged 51% of assets for the quarter and year-to-date periods. The equity holdings in the portfolio have performed well, gaining nearly 8% for the quarter and 17.5% for the year-to-date.
Among the individual holdings in the portfolio, three notable detractors were Big Lots, Sykes Enterprises, and Contango Oil & Gas. Weak sales trends that began late in the first quarter continued at closeout retailer Big Lots. The company reported negative same-store sales comparisons and management noted that overall demand patterns weakened throughout the period and into the third quarter as well, causing it to lower full year earnings guidance. Although we lowered our normalized margin assumption, which decreased our calculated valuation, we think the stock continues to trade at a discount and it remains a holding in the Fund.
Outsourced call center operator Sykes has struggled over the last year due to declining demand and vendor consolidation. These top-line pressures have been compounded by the firm’s need to adjust capacity, a process that has depressed margins due to initial ramp down expenses and duplicated costs. Although many investors expected an improvement in the firm’s second quarter results and outlook, management lowered expectations due to economic concerns among its customer base that are causing additional program delays and cancellations. We expect that once demand for the company’s services stabilizes, the eventual benefits from the firm’s capacity reductions will allow margins to return to more normalized levels. Therefore, we remain patient with the investment and the Fund continues to hold the stock.
Contango, an independent natural gas and oil company with a focus in the Gulf of Mexico, also performed poorly during the quarter. Contango has a strong balance sheet, sizeable proven reserves, no debt, and is one of the lowest cost producers in the industry. Although earnings declined slightly in 2012 due to lower realized natural gas prices and slightly lower production, we believe the stock dropped as a result of CEO Kenneth Peak taking a medical leave of absence during the quarter. Mr. Peak will be replaced by Brad Juneau, the sole manager and general partner of JEX, a privately-held oil and gas exploration company. Contango and JEX have a long-standing relationship, with JEX providing exploration services and receiving a working interest in successful prospects in return. Due to this relationship, we believe the CEO transition will go smoothly and have not altered our valuation or the Fund’s position size.
Top contributors to returns during the quarter were Pan American Silver, CSG Systems International, and Bill Barrett. The biggest detractor for the Fund last quarter, Pan American rebounded strongly as silver prices spiked amid a global precious metal rally in response to monetary action and policy statements by central banks. Billing software company CSG continued to perform well thanks to its ability to generate attractive operating margins and strong free cash flow. Management increased revenue and earnings guidance during the quarter, helping to boost the stock.
Energy exploration and production company Bill Barrett was another stock that saw a strong rebound from a poor second quarter as natural gas and oil prices increased during the period. In addition, the company reported increased oil production growth and forecasted strong oil production gains for 2013. Although Bill Barrett’s balance sheet has taken on debt during the past two years, we gained comfort knowing the company’s preliminary 2013 capital expenditure budget is in-line with expected discretionary cash flow. We continue to hold the stock, but at a reduced level given its appreciation as well as the addition of other energy names with less financial risk to the portfolio.
Cash levels in the portfolio increased from 49% at the beginning of the quarter to 51% by the end of September. The increase in volatility witnessed during the second quarter disappeared during the third quarter as the small-cap market drifted higher. Portfolio turnover remained elevated as we rotated out of stocks reaching valuation targets and into businesses we believe are selling at discounts. Cash levels remain high as we continue to have difficulty finding attractively priced small-cap stocks.
The largest new position added during the quarter was Tidewater, the leading supplier of marine support services to the offshore energy exploration and production industry. Tidewater operates in a cyclical industry and typically generates volatile earnings—and its last earnings cycle from 2009 to 2012 proved no exception. As with all cyclical businesses that we consider for purchase, Tidewater generates positive cash flow in the trough of its operating cycle and possesses a strong balance sheet. An important part of Tidewater’s capital allocation strategy is to keep its balance sheet strong so it can act decisively when volatility within its industry creates opportunity. Interestingly, we believe Tidewater’s capital allocation strategy is similar to our opportunistic investment approach. When the industry is booming and vessel prices are high, Tidewater refrains from aggressively adding to its fleet in order to maintain a strong balance sheet. When the industry is distressed and vessel prices are low, Tidewater uses its strong balance sheet to add new vessels.
Since January 2000, Tidewater has not only been able to renew its fleet but also to distribute significant dividends and repurchase shares of its stock. By the end of 2014, Tidewater expects its average vessel to be six-years old, down from 20-years old at the end of fiscal 2006. With the majority of expansionary capital expenditures now completed, we expect the firm to grow free cash flow and further strengthen its balance sheet. Although risks remain as the energy industry’s end demand is volatile and fluctuates with ever changing energy prices, we believe Tidewater is an established market leader that has generated strong cash flow and maintained a strong balance sheet throughout its fleet upgrade cycle. We also think that at current prices the stock is appropriately compensating investors for the risk assumed.
The operating environment for the majority of the small-cap businesses we follow slowed slightly from the previous quarter. Demand for a wide variety of products and services remains inconsistent and difficult to predict. Although profits and margins remain elevated, sales growth appears to be slowing making year-over-year earnings comparisons difficult. Companies that are seeing a slowdown in end demand are cutting costs promptly in an attempt to maintain margins. Common causes of concern include the European debt crisis, a slowdown in China, the upcoming U.S. presidential election, the government “fiscal cliff”, and volatile raw material and currency movements. Signs of growth, albeit from a depressed base, are occurring in the housing, auto, and aerospace industries. Overall, planning remains difficult and most companies are not predicting a meaningful change in operating results.
Despite the sputtering operating environment, small-cap stocks have rallied, reaching near record prices in September. Early in the quarter, as earnings announcements were being reported, the small-cap market showed some signs of stress. Central bank statements suggesting further monetary accommodation, however, quickly extinguished this brief period of volatility. Subsequently, investor focus appeared to shift from discounting company future cash flows to discounting future actions from central bankers.
Our focus remains unchanged—we are committed to our investment process and valuation methodology. An important component of our valuation methodology is the use of a normalized free cash flow assumption. By normalizing a business’s cash flow over a full market cycle, we attempt to avoid using peak or trough data in our valuation model. For example, in 2007 as corporate profits were near peak levels many small-cap stocks looked reasonably priced when they were in fact expensive based on normalized cash flows. Conversely, many small-caps in 2009 looked expensive based on the trough cash flows occurring at the time but were attractively priced based on normalized cash flows. We believe normalizing cash flows provides us with a more accurate valuation versus merely extrapolating current trends.
While we normalize the results of businesses we follow in an individual, bottom-up basis, we believe it is also important to understand the current level of overall corporate profits and the drivers of the current profit cycle. Our opinion on the corporate profit cycle comes from closely monitoring the operating results of the 300 small-cap companies on our possible buy list. We also keep track of corporate profits in aggregate and corporate profit margins. Furthermore, we believe monitoring speculative-grade bond yields is useful as low yields often coincide with peak profits. Currently, our profit cycle indicators suggest that we may be approaching peak corporate profits for this cycle. Corporate profits are currently at record levels and have surpassed the last cycle’s peak in 2006-2007. Corporate margins, or profits as a percentage of GDP, are also at record historical levels. Also, the yield on speculative-grade bonds reached a record low in September, suggesting interest coverage levels are also high. Although these are cautionary signs, the ultimate level of profits and the exact timing of when profits peak remains uncertain.
Every corporate profit cycle is unique with different drivers of its rise and fall. The previous corporate profit cycle (2002-2008) received a boost from strong private credit growth (particularly mortgage debt) that eventually proved unsustainable. As private credit growth slowed and eventually contracted, corporate profit growth turned negative. Corporate profits bottomed late in 2008 and a new profit cycle began in 2009. Similar to the 2002-2008 profit cycle, the current profit cycle is supported by credit growth. However, instead of mortgage debt, this cycle is driven by growth in U.S. government debt. Similar to the mortgage debt growth in the previous cycle, we believe the current growth rate of U.S. government debt is unsustainable and will eventually slow.
Once the growth in U.S. government debt abates, we believe the ability of the U.S. to fund record budget deficits will become increasingly difficult. Large U.S. fiscal deficits have stimulated the economy over the past several years and continue to play an important role in sustaining the current corporate profit cycle. We believe most companies during this period have benefited directly or indirectly from the high levels of government spending. Consequently, we believe the inability of the U.S. government to continue to fund its fiscal deficit is a threat to corporate operating results and profits. Although recent actions by the Federal Reserve may allow the U.S. government to continue to fund large fiscal deficits in the near-term, as in previous cycles we do not believe central bank intervention can sustain the peak of the current profit cycle indefinitely.
In conclusion, when normalizing free cash flows for valuation purposes we need to form an opinion of where we are in the profit cycle. While timing the inflection point of a corporate profit cycle is extremely difficult, we believe it is important for us to note current high profit levels and the drivers of the current cycle. We know from previous cycles that the extrapolation of corporate profits and rising asset prices is one of the most dangerous, yet too often unrecognized, risks in investing. It is during periods of high asset prices and high profits that appreciating assets become most seductive and risks appear low. Ironically, it is during periods of high prices and profits that the risk of permanent capital loss is most elevated. Whether the tech boom of 1999, home prices in 2005-2006, or prices of fixed-income securities in the current cycle, it is often during the peak of cycles that it becomes most difficult to maintain investment discipline.
When prices are high relative to normalized free cash flow, we treasure our ability to hold cash, remain patient, and wait for a more advantageous opportunity set. Unfortunately, we do not know when volatility will return or when the investment environment will become more favorable for the purchaser of risk. Assuming the price of risk does not improve, we expect the Fund to remain defensively positioned as we believe the majority of stocks on our possible buy list are expensive based per our normalized cash flow estimates. In the meantime, we will attempt to continue to participate in the rising small cap stock market with a strong emphasis on equity selection and risk control.
River Road Asset Management
16 October 2012
As of September 30, 2012, Big Lots comprised 1.22% of the portfolio's assets, Sykes Enterprises – 2.47%, Contango Oil & Gas – 1.27%, Pan American Silver – 3.48%, CSG Systems International – 2.30%, Bill Barrett – 1.32%, and Tidewater – 1.77%.
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.