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.
The Fund was up slightly for the quarter but trailed its Russell 2000 Value Index benchmark. Above-average cash levels continued to weigh on overall returns, as the portfolio’s equity holdings mostly kept pace with the index. The three most significant individual detractors from performance were WPX Energy, Sykes Enterprises, and FTI Consulting.
WPX is an exploration and production company with more than 75% of reserves consisting of dry natural gas. It has focused on increasing its mix of oil reserves and production the last two years at the expense of its natural gas production. Furthermore, the firm’s plan to increase oil production is causing capital expenditures and debt to increase. Although the stock traded at a discount to the replacement cost of its high-quality reserve base, we reduced the position during the quarter in response to the increase in debt and higher degree of financial risk.
Call center operator Sykes’s revenues and margins have rebounded from last year’s depressed levels as client demand improved and the firm progressed on its long-term seat capacity initiatives. However, during the quarter the company announced that its final planned capacity rationalizations in 2014 would cause near-term profitability to remain below normalized levels. The portfolio continued to hold the stock as it remained at a discount to our assessed valuation, and we remain patient in anticipation of the completion of the firm’s capacity initiatives.
Despite better-than-expected fourth quarter results, new holding FTI announced weak guidance for the first quarter of 2014. The lower-than-expected outlook was primarily a result of an increase in compensation expense for a subset of its consultants as well as continued weakness in its core restructuring practice. Although we reduced our normalized cash flow assumption to address these issues, we believe its normalized free cash flows are above the current run-rate. Specifically, we think the restructuring business will improve as the depressed level of bankruptcies and restructurings eventually rebound. The stock traded at a discount to our valuation, but we did not increase the position size during the quarter as our risk management discipline prohibits us from adding to a holding whose valuation is in decline.
Mining Stock Rebound
The three largest contributors to performance were precious metals mining stocks AuRico Gold, Silver Standard Resources, and Pan American Silver. We believe strength in the precious metal sector (the Market Vectors Gold Miners ETF gained 12% during the first quarter) contributed to positive performance for AuRico. Commercial production at the company’s largest mine (Young Davidson) began in October, contributing to its sixth consecutive quarter of production growth. As the Young Davidson mine reaches full production, we expect free cash flow to increase, cash costs to decline, and production growth to remain elevated. We are encouraged by the firm’s strong balance sheet, limited capital needs, and emphasis on free cash flow generation. We reduced the portfolio’s position slightly as its shares appreciated, though it remains at a discount to our valuation and we continue to hold the stock.
A combination of announcements drove Silver Standard’s strong performance. First, guidance for 2014 indicated that the firm has been successful with its cost and capital reduction initiatives. Second, it announced the purchase of a producing gold mine in Nevada, which was well received by the market. Despite the favorable operating results, we reduced the position considerably as the stock approached our assessed valuation. Pan American’s operating results improved during the quarter with increased production and decreased cash costs. The company continues to possess one of the strongest balance sheets in the mining industry and its long-lived assets remain at an attractive discount to replacement value.
Cash levels increased from 67% at the beginning of the quarter to 71% at the end. Cash hit record levels again this quarter as we think most high-quality small-cap stocks continue to be expensive. Holding cash is not an attempt to time the market on our part, but is a direct reflection of the value, or lack thereof, we are finding in small-caps and within our 300-name potential buy list. Average valuation metrics of our potential buy list increased again this quarter and remained elevated on a price/earnings and price/sales basis.
The only new position added during the quarter was global business advisory firm FTI Consulting, noted as a detractor from performance above. We previously purchased FTI in the third quarter of 2013 and sold it after it exceeded our valuation later in the year. We repurchased the stock in early January as it fell back below our appraised value.
FTI has struggled the last three years due to a varying mix of headwinds to its revenues and margins, thus we had assumed that FTI’s current results represented approximate trough margin levels and established our normalized cash flow and valuation estimates based on this assumption. The initial guidance for 2014 indicated that these headwinds will cause further deterioration in the company’s results, however. We believe that recent weak results are due to either general economic or industry cyclicality, but recognize that it may take longer than initially expected to return to a more favorable operating environment. We adjusted our weaker trough scenario accordingly. We remain patient in anticipation of improved operating results at FTI due to the firm’s solid balance sheet.
Booms and Busts
The operating environment for the majority of small cap businesses we follow remained mixed during the quarter. Many consumer businesses reported sluggish operating results, with weak traffic trends and increased promotional activity. Although auto and housing operating results remained positive, year-over-year growth rates began to moderate. Businesses reporting weaker-than-expected results often blamed severe winter weather. Organic growth overall remained slow, even as companies continued to generate healthy profits and margins. On average, near-term outlooks remained mostly unchanged.
Despite mixed operating results, the small-cap market continued its march higher. Investors appear unconcerned about the risk associated with paying record prices for small-cap stocks. Our concern and appreciation for risk is growing. In our opinion, small-caps are more expensive now than at any other time during our 15-year history investing in the space. A recent Bloomberg article noted, “Small-cap shares tracked by the Russell 2000 Index have rallied for seven straight quarters, the longest stretch ever, sending valuations 26 percent above levels at the height of the 1990s rally.” Investors who believed record prices in the late 1990s were sustainable eventually witnessed the Russell 2000 decline 43% between March 2000 and October 2002. After this boom and bust, small-caps reached another peak in 2007, before ultimately declining 60% by March 2009. At quarter end, the Russell 2000 was 244% above its 2009 trough and 38% above its 2007 peak. With many small-cap prices again well above what we consider fair value, we believe the risk of meaningful losses is significantly elevated.
The portfolio’s defensive position reflects this belief surrounding prices, risk, and an unattractive opportunity set. Through our bottom-up valuation work on hundreds of small-sized businesses, we believe most high-quality small-cap stocks are not adequately compensating investors for risk assumed. Instead of knowingly overpaying for stocks for the sake of being invested, we continue to remain patient and resist the temptations of inflating prices. As a result, the portfolio’s cash position reached 71% during the quarter—a record high for our strategy. While this cash level may be considered extreme, given current prices we believe a meaningful level of cash—or patience—is essential to meeting the Fund’s long-term absolute return goals. In our opinion, investing the cash in the current environment would ultimately lead to inexcusable investment mistakes and possible permanent loss of capital.
Our positioning differs significantly from most managed equity portfolios. The majority of mutual funds are considered fully invested with cash positions averaging 3.5%. With mutual fund cash levels near record lows, small-cap prices at record highs, and the Russell 2000 trading at 49 times earnings, we ask, “Where are the small-cap vigilantes?” During periods of sharply rising prices, the voices of investors willing to protest the madness of crowds are often drowned out by enthusiastic stock promotions and ever-increasing market forecasts. Headlines such as, “Investors Rush to Small Caps in Hunt for Risk” illustrate an environment of investor euphoria and risk dismissal, instead of careful risk consideration. Unfortunately, investment risk often becomes a hot topic only after asset prices take a plunge.
With small-cap prices at record levels and valuations stretched by any measure, we believe now is the time to carefully consider risk, think independently, and avoid investment conformity. We consider investment conformity—the reluctance or inability to look different from benchmarks—to be highly prevalent throughout the investment industry. In fact, recent academic studies indicate one third of all actively managed funds are “closet indexers.” Based on this conclusion, when combined with passively managed funds, approximately 60% of all assets under management are effectively indexed.
The allure of investment conformity is enhanced by human nature. Investing alongside one’s peers and respective benchmarks can provide a sense of security and reassurance. As Alan Greenspan implied in October 1999 while the tech bubble raged, how can millions of knowledgeable investors get it wrong? We now know that millions of knowledgeable investors can get it wrong and they often get it wrong when practicing groupthink. Merriam-Webster defines groupthink as, “a pattern of thought characterized by self-deception, forced manufacture of consent, and conformity to group values and ethics.” In investing, groupthink can cause participants to crowd into specific stocks, sectors, and asset classes, driving prices well above levels that future free cash flows and net asset values can support. While conformity may provide investors with a sense of security, in practice it can cause significant levels of asset mispricing and above average risk to capital.
In addition to human nature, we believe the tendency to conform within the investment industry is magnified by the obsession many investors have with short-term relative performance. Poor short-term performance can cause assets to leave a portfolio or firm. As such, instead of focusing on the risk to shareholder capital, asset management firms may consider looking different from a benchmark as an unacceptable risk to their business. Furthermore, many portfolio managers have compensation plans weighted toward short-term performance. During periods of inflated stock prices, as we think is the case currently, there is often an incentive for portfolio managers to increase risk in order to keep up with rising stock prices, instead of reducing risks in order to avoid overpaying.
Constraints placed on portfolio managers also increase investment conformity. Investment constraints may reduce a manager’s flexibility and ability to avoid overpaying. Many managers have cash constraints that force them to remain fully invested regardless of asset valuations. Portfolio managers may be required to own certain percentages of certain industries relative to a benchmark. Industry constraints can cause managers to own larger weights of sectors that are outperforming but may be significantly overvalued. For example, the largest weights in the S&P 500 Index in 1999 and 2006 were Technology and Finance, respectively. In hindsight, managers should have been discouraged from investing in these sectors, not encouraged to own meaningful positions. We believe many of the constraints placed on portfolio managers reduce the risk of a portfolio looking different from a benchmark or peers, not against the risk of losing shareholder capital.
We believe the booms and busts of the profit cycle also increase investment conformity. Investors tend to be more comfortable in periods of high profits and often point to rising profits as a reason to buy stocks. When the operating environment is positive and profits are high, investors often extrapolate favorable trends far into the future. In essence, investors begin to persuade themselves that booming profits are no longer a cyclical phenomenon, but are permanent. According to a recent Wall Street Journal article, net profit margins are at record levels: “Companies’ net profit margin for the fourth quarter was 9.8% ... the highest it has been in records dating back to 1994 and probably ever.” According to the article, the average net margin over this time span was 7.5%. We acknowledge profits and margins are currently elevated, but avoid extrapolating these record levels of profitability for valuation purposes. We continue to believe the business cycle remains cyclical, not linear. In essence, we have not conformed to the belief that current profit margins are sustainable.
Investing differently can have its cost in the near term, but we believe following the herd can have greater longer-term consequences. If active managers do not take a stand when valuations are expensive, they increase the risk of overpaying and ultimately losing shareholder capital. For strategies that practice peer and benchmark conformity, shareholders may begin to question the effectiveness of active management. Ironically, investing similar to a benchmark due to the fear of underperforming and losing assets under management may actually increase capital flight. We believe conformity amongst many actively managed funds has sped up the movement from active management to passive strategies. In fact, since 2007, equity exchange-traded funds (ETFs) have almost doubled their market share of assets under management relative to mutual funds. According to a recent Bloomberg article, “ETFs are among the fastest-growing investment classes in the history of finance—with $2.4 trillion in assets under management as of the end of December, a number that has doubled in just the past four years.” We believe this trend will continue, assuming actively managed funds embrace conformity over flexibility and independent thinking.
The Fund’s current positioning differs significantly from its small-cap benchmark and peers. Investing differently goes beyond holding a large cash position when prices are expensive and being fully invested when prices are attractive. There are instances when we must avoid equities that are performing well, but are overvalued. Examples include Technology in 1999, Financials in 2006, and high-quality small-cap operating businesses currently. Conversely, there are instances when we gravitate towards stocks that are performing poorly, but we believe are undervalued, such as natural gas producers and precious metal miners in 2013. During each market cycle, the degree of contrarian positioning within the portfolio will fluctuate with the changing opportunity set. The number of contrarian holdings within the portfolio has increased in the past year as we rotate out of high-quality small-caps that have performed well and purchase out-of-favor equities that we consider undervalued. While such contrarian positioning may cause performance to differ from peers and the benchmark, we believe it is essential in our attempt to avoid investment losses and meet long-term absolute return goals.
Similar to our level of contrarian positioning, as the opportunity set shifts, the risk profile of the portfolio will also fluctuate. Cash levels shift depending on the value we find within our 300-name potential buy list. The amount of operating risk and financial risk we assume also changes along with the economic and credit cycles. We believe the risk profile of the portfolio is currently very defensive. Given current prices of high-quality small-cap businesses, we believe such a risk profile is required. However, it is important to note, we do not expect to remain defensively positioned indefinitely. As the small-cap market and profits complete their cycles, we expect the portfolio’s positioning and risk profile to adapt to the rapidly changing opportunity set.
In conclusion, we believe investment conformity is an investment risk that deserves considerable attention and consideration. We believe there are periods when it is necessary to look significantly different from one’s peers and benchmark. Although positioning the portfolio differently may cause relative underperformance in the near term, we believe it is essential to maintaining investment discipline and avoiding preventable losses to capital. We must avoid allowing the fear of underperforming and temptations of investment conformity to interfere with our investment process. While we cannot determine when the current period of inflated small-cap prices will abate, we remain steadfast in our refusal to overpay for businesses with shareholder capital. We will not conform to enhance near-term relative performance. We will not conform to maintain assets under management. And we will never use investment conformity as a replacement for the time-tested investment discipline of only taking risk when being appropriately compensated.
River Road Asset Management
As of March 31, 2014, WPX Energy comprised 2.87% of the portfolio's assets, Sykes Enterprises – 3.28%, FTI Consulting – 1.76%, AuRico Gold – 3.34%, Silver Standard Resources – 0.83%, and Pan American Silver – 3.73%.
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.