2nd Quarter 2014 Commentary - ASTON/River Road Small Cap Value Fund
2nd Quarter 2014
Stocks traded higher during the second quarter as investors became increasingly confident about a second half rebound in economic growth. Delivering a sixth consecutive quarterly gain (a feat only achieved seven times in history), the broad-market S&P 500 Index rose 5.2% for the period in closing at an all-time high. The index also exhibited its lowest volatility since 2007, helping to extend the time without at least a -10% correction to a staggering 683 trading days—more than twice the 331 day average for the typical secular bull market.
Small-cap stocks lagged large-caps for the third consecutive quarter, with the Russell 2000 Index returning a mere 2.0% versus 5.1% for the large-cap oriented Russell 1000 Index. Small-caps also displayed significantly greater volatility than the broader market, dropping -9.3% from March 4 to May 15 before bouncing back sharply. Still, it was the eighth consecutive quarterly gain for the Russell 2000, marking its longest winning streak since 1995-1996.
Low-beta (volatility) stocks continued to modestly outperform stocks with higher volatility within the small-cap universe. Quality also continued to outperform, with the stocks with the highest return-on-equity besting the lowest, on average. Notable, however, was that according to a study by Bank of America / Merrill Lynch, companies actively repurchasing shares were among the worst performing stocks within both the S&P 500 and Russell 2000 during the first half of 2014. Share repurchases have been enormously popular with both companies and investors over the past few years as a way for companies to boost earnings per share in a low growth environment. With valuations rising, investors seem increasingly concerned with the price companies are paying to buy back shares, and are more interested in firms that can actually grow their core business or return the cash to shareholders through dividends. Indeed, dividend yield was one of the best performing factors among small-caps.
Another interesting observation came via a recent study from Jim Furey Research, a specialist in smaller-cap stocks. The study showed that loss-making companies have outperformed profitable companies by more than six percentage points since 2009, after having lagged by a similar amount the previous four decades. Since the most recent rally began, profitable companies have outperformed loss makers in just one out of every three quarters, when historically that number has been closer to 60%. As the study indicated, this trend has been unfavorable to active small-cap managers, especially those focused on higher quality companies.
From a sector perspective, seven of the 10 economic sectors in the Fund’s Russell 2000 Value Index benchmark posted positive returns for the quarter. Sectors with the highest total return included Utilities and Energy, while Telecommunications and Materials were the worst performing areas, posting minor losses.
Weakness in Materials and Energy
The Fund posted a modest loss during the quarter in lagging its benchmark. Poor stock performance, primarily within the Energy and Materials sectors, was the primary driver of the underperformance. Although disappointed with this quarter’s results, we firmly believe the security-specific underperformance owed largely to temporary headwinds.
The biggest detractor to performance was American Vanguard, a Materials company that develops, manufactures, and sells branded crop protection chemicals (insecticides and pesticides). The company reported weak first quarter results due to higher than usual inventory levels from persistent wet weather at the end of the 2013 planting season and severe winter weather that delayed the start of the 2014 season. Although the entire agricultural chemical industry is facing these temporary headwinds, the impact felt at American Vanguard was more acute given its product portfolio’s higher concentration to corn (and lack of offsetting soybean exposure). We think 2014 will be a transition year for the company and that 2015 will likely produce more normal results.
Within Energy, independent oil and gas company Evolution Petroleum was a bottom-five performer. The firm’s primary assets are royalty and working interests in the Delhi field in Louisiana. Due to disputes with field operator Denbury Resources, conversion of its working interest has been delayed until later this year. Given Evolution’s strong balance sheet, with cash on hand and no debt, plus Denbury’s assertion the conversion will occur in October at the latest, we view this as a short-term issue that does not negatively affect our conviction or thesis.
Another poor performer was Outerwall, manufacturer and operator of automated retail kiosks for home video rental (Redbox) and coin-counting (Coinstar). In early June, management reiterated its 2014 guidance, but warned that the second quarter would be negatively affected by weak DVD product, with the number of titles down 40%. Redbox continued to gain market share, offsetting overall market contraction. Furthermore, Redbox and Coinstar are cash cows, and management has pledged to return 75% to 100% of free cash flow to shareholders. We also believe ecoATM (an automated kiosk that pays cash for used mobile devices) represents a compelling growth story that the market is ignoring. We maintained the position during the quarter.
The sectors with the highest contribution to relative return during the quarter were Financials and Consumer Staples. Both sectors benefited from strong stock selection, with two REIT (real estate investment trust) holdings—CareTrust REIT and Geo Group—among the top-five performers, a primary driver within Financials.
CareTrust spun off from portfolio holding Ensign Group during the period, and owns the real estate of 94 skilled nursing facilities and three independent living facilities operated by Ensign. We quickly eliminated the position post-spin at a premium to our assessed Absolute Value. We continue to hold Ensign. Private prison operator Geo Group delivered solid quarterly earnings driven by a smooth reactivation of previously idled facilities in California and a launch of new managed-only contracts in Florida. Management raised its earnings guidance for the year and maintained a bullish tone regarding future deployment of idle capacity. Management optimism was also evident in CEO and founder George Zoley aggressively buying shares in recent months.
The top performing individual holding in the portfolio was Murphy USA, one of the largest convenience store chains in the U.S. with more than 1,220 stations—nearly all of which are located next to Walmart stores in the South and Midwest. Despite posting lackluster quarterly earnings due to weak fuel margins, Murphy generated impressive free cash flow from ongoing operational and inventory efficiency improvements. Management subsequently authorized a new stock repurchase authorization. The company also benefited from a positive mention in the financial publication Barron’s and two recent merger transactions in the industry. We sold the position at a premium to our calculated Absolute Value.
By the end of the second quarter, the Fund held 68 positions, down from 75 at the end of the previous quarter. Cash in the portfolio reached 8.3%, a slight increase from before. Only three new holdings were purchased and 11 sold, including the previously mentioned spinoff—CareTrust REIT and Murphy USA. Of the 11 stocks sold, nine had achieved our Absolute Value price targets. Just two holdings (Resolute Energy and AuRico Gold) were sold due to accumulated losses or a negative fundamental change in our outlook for the company.
We strategically increased the position size of 23 holdings during the quarter. The two largest increases were in security firm Brink’s and prepaid payment network Blackhawk Network Holdings, the latter a top performing holding during the quarter as Safeway completed the spinoff of its stake in the firm, making it more attractive to institutional buyers. We reduced the stakes in just six positions as we struggled to put the cash generated by position sales to work.
The annual rebalancing of the Russell indices occurred on June 30, and was relatively uneventful. The Fund’s benchmark experienced only minor changes, with Consumer Discretionary seeing the largest increase (1.0%) and Financials the largest decrease (-1.3%). The former was due mostly to an increase among specialty retailers and latter to the removal of Business Development Companies (BDCs) by Russell from its indices. The largest holding in the index declined from $11.6 billion in market-capitalization to $4.4 billion, which is still large by historical standards. Within the portfolio, noteworthy changes in sector positioning during the quarter included modest increases to Technology and Industrials, and decreases in Healthcare and Materials.
The largest new position added during the quarter was Francesca's Holdings, holding company for specialty women’s retailer Francesca's Collections. The company operates 513 boutiques in 46 states and has a “broad and shallow” merchandising strategy that keeps inventory fresh and low risk. Perceived item scarcity and new shipments arriving five days per week promote repeat visits and foster a “treasure hunt” shopping atmosphere. Short production times of four to 12 weeks from order to store allow for quick responses to changing fashion trends. Recent earnings disappointments in a difficult retail environment have sent the company’s shares down substantially from their late 2012 high.
We believe the company is trading at trough multiples on depressed earnings, offering an attractive risk/reward scenario. Positive same-store sales growth should leverage store-level operating costs, and management sees the opportunity to grow the store base to 900 in the next six to seven years. In addition, Francesca’s generates significant free cash flow, has a net cash position on its balance sheet despite its rapid store growth, and management initiated a share repurchase program 2013 that has reduced shares outstanding by five percent through the end of the first quarter 2014.
Market returns and reported earnings are in line with our initial expectations for 2014, leaving our outlook for the remainder of the year largely unchanged. As noted in January, while it is philosophically difficult for us to anticipate positive returns in light of unattractive valuations and weak growth, monetary policy combined with our recent experience supports a modest return expectation for the year.
Conviction in our outlook remains low, however, with risk weighted overwhelmingly to the downside. Pockets of inflation are beginning to emerge (Core CPI is up sharply over the past few months, wages are rising, capacity utilization is up) which if combined with even a modest increase in growth could accelerate expectations for the Federal Reserve to raise interest rates. We think this heightened inflation awareness is already beginning to weigh on small-cap returns. Housing trends have also weakened (which we did not anticipate) and, with nearly 20% of small-cap earnings tied to the housing sector, it will almost certainly weigh on returns if the trend persists.
Of course, as fundamental, value-oriented investors, our biggest concern remains valuations. Our proprietary portfolio valuation metric, the weighted discount-to-Absolute Value for the portfolio’s top-20 holdings, has actually improved in recent months, declining from 85% at the start of the year to 80% on June 30. Although we still consider this figure “expensive”, it has declined to the lower boundary of that designation. That decline, however, came at a cost as the weighted conviction in those top 20 positions also modestly declined. This balance of risk and reward, along with the portfolio’s current concentration level and elevated cash balance, reflects our highly disciplined response to the scarcity of traditional, high-quality value stocks in the current equity environment.
As discussed in the past, the challenge with valuation analysis in this environment is one of absolute versus relative. We think stocks are expensive on an absolute basis, but what is the appropriate discount on a stock when the risk-free rate is essentially zero? Perhaps an 85% discount is more comparable to 75% or 80% in a normal rate environment. We admittedly do not have all these answers, but our investment discipline and valuation models are firmly anchored to our Absolute Value approach that has stood the test of time over many market cycles. We further believe that those investors who choose to ignore market history are doomed to repeat it—and history through the lens of current small-cap valuations continues to say “look out below.”
The portfolio’s relative fundamental metrics continue to look attractive to us. From a growth perspective, the long-term earnings growth forecast for the portfolio’s holdings in aggregate is greater than the benchmark. The portfolio also continues to exhibit far less volatility than the market and many of its peers, which we think should benefit the Fund once monetary policy begins to normalize and stocks revert to more sustainable valuations.
River Road Asset Management
As of June 30, 2014, American Vanguard comprised 1.35% of the portfolio’s assets, Evolution Petroleum – 2.16%, Outerwall – 1.72%, CareTrust REIT – 0.00%, Ensign Group – 0.91%, Geo Group – 1.97%, Murphy USA – 0.00%, Brink’s – 2.21%, Blackhawk Network Holding – 2.29%, and Francesca’s Holdings – 0.83%.
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.