2nd Quarter 2014 Commentary - ASTON/River Road Independent Value Fund
2nd Quarter 2014
The Fund outperformed its Russell 2000 Value Index benchmark during the second quarter, with the equity holdings in the portfolio delivering double-digit gains. Investments in precious metal miners and energy-related companies were the primary driver of equity returns.
Pan American Silver, WPX Energy, and New Gold were the top performers. Pan American Silver has seven mines in production and operating results improved again during the second quarter with an increase in production and lower cash costs. The firm possesses one of the strongest balance sheets in the mining industry with significant cash and working capital available. We believe the company’s long-lived assets remain at an attractive discount to replacement value and continue to hold the stock in the portfolio.
WPX is an exploration and production company with approximately two-thirds of its reserves consisting of dry natural gas. During the quarter, WPX announced the sale of a portion of its Piceance property, with the proceeds going towards funding its 2014 capital expenditure program. It also reported improved quarterly results, highlighted by sharply higher natural gas prices and strong oil production. While the stock continues to trade at a discount to the replacement cost of its high-quality reserves, we reduced the position during the quarter in response to the reduced discount-to-value.
New Gold is another mining company with four producing mines and three major development properties. We were pleased with the company’s operating results, highlighted by lower-than-expected cash costs. We are optimistic cash costs will continue to remain favorable along with improving production levels throughout the year. The firm also reported that its expansion projects continued to be on time and within initial cost expectations.
Mining and Energy stocks were also at the forefront of the Fund’s underperforming holdings during the quarter. Precious metals mines Silver Standard Resources was the worst performer, as the firm disappointed investors with its higher-than-expected initial cost guidance for the recently purchased Marigold mine in Nevada. Management also postponed mine planning for its large undeveloped silver property in Mexico. We believe management’s actions will help maintain its strong balance sheet, allowing for the value of the company’s properties to be realized for patient investors. We increased the portfolio’s position as the stock price declined and the discount to our assessed valuation increased.
Although production results for Contango Oil & Gas were in line with management’s expectations, expenses were elevated due to an unsuccessful exploration attempt in the Gulf of Mexico. The dry hole in the Gulf of Mexico was disappointing, but we were pleased with the company’s onshore operating results. Contango’s strong balance sheet should allow it to continue to fund onshore production growth and reserves. We added to the position during the quarter as the discount-to-value increased.
Another bottom contributor was Convergys, a leading outsourced call center operator. Despite reporting strong call volumes and margins for the first quarter, the company noted that margins for the second quarter will decline due to lower growth rates and increased program investment. Management also noted that the integration of its recent acquisition was going as planned. We believe this is an important milestone given the large size of the deal and its importance to Convergys’ customer and geographic diversification efforts. We continued to hold the stock in the portfolio.
Cash levels ended the quarter unchanged at 71% of assets. Cash remains near record levels as most high-quality small-cap stocks continued to be expensive, in our opinion. As a reminder, holding cash is not an attempt to time the market but is a direct reflection of the value, or lack thereof, we are finding in the small-cap market and within our 300-name potential buy list. Average valuation metrics of our potential buy list remained elevated on a price/earnings and price/sales basis.
The only new position added during the quarter was American Vanguard, a specialty chemical manufacturer of agriculture-related products, such as insecticides, herbicides, and fumigants. The company sells its products to distributors that market to retailers, who then sell to farmers. While the company’s sales of corn-related products were very strong in early 2013, subsequent wet weather during the planting season caused actual application and sales volumes of insecticides to be much lower than anticipated. This left high inventories going into the 2014 selling season causing downstream customers to destock excess inventory rather than order additional products from the company. In addition, lower corn prices compared to a year ago reduced the total acreage dedicated to corn planting in 2014, reducing overall demand. The company has responded to these factors by reducing manufacturing utilization to normalize inventory but with a trade-off of lower sales and profitability in 2014.
The corn insecticide issue had an outsized effect on the firm’s results the last three quarters, but we view these fluctuations as a natural characteristic inherent to the volatile agricultural end market. Thus, we view the reduction of production levels in an attempt to normalize inventory favorably and do not extrapolate the current trend of customer destocking indefinitely. Instead, we normalize the firm’s cash flows at a level that assumes a more typical corn-product demand environment, while continuing to account for general agricultural end market cyclicality. The firm’s manageable balance sheet provides us with the patience necessary to allow results to normalize.
The operating environment remains mixed for the majority of the small-cap businesses we follow. Many consumer businesses reported sluggish results again this quarter, though several industries, such as auto and housing, displayed an improvement in demand as the effects of an unusually cold winter subsided. Businesses focused on energy infrastructure and aerospace continue to perform well. Transportation companies reported satisfactory results along with favorable trends in pricing. While not broad based, pricing actions and rising costs were more noticeable this quarter—a trend we will monitor closely going forward. Overall, near-term outlooks remained little changed, with added uncertainty created by the weather-related swings in demand. After averaging operating results from the first two quarters of the year, we believe organic growth remains sluggish, or similar to what most small-cap companies experienced in 2013.
Investors appear unfazed by the increased volatility of the operating environment as they continue to pay record prices for small-cap stocks. Complacency is high as investors dismiss risk in the pursuit of seemingly endless returns. We take an opposing view, believing investment risks have increased considerably with price. In recent quarterly commentaries, we have addressed many of these risks along with other relevant investment topics. Specifically, we discussed the drivers of the current profit cycle, questioned its sustainability, and provided our opinion on its trajectory. We expressed our view that the current profit cycle is non-linear and detailed the importance of normalizing future free cash flows for valuation purposes. As the corporate credit environment loosened and credit spreads tightened, we discussed our growing reluctance to assume financial risk. We also touched on other forms of risk that are less obvious, but extremely relevant today, such as extrapolation risk and the risk of conformity and groupthink. We emphasized the challenges and importance of maintaining a strict investment discipline in an environment saturated with excessive asset inflation. Lastly, we communicated the necessity of practicing patience and reiterated our determination to avoid overpaying for small businesses. In essence, over the past several quarters we repeated a common theme—small-caps are expensive, risks are elevated, and we believe maintaining a strict investment discipline in such an environment is essential.
In an investment environment dominated by overenthusiasm, conformity, and expensive valuations, how should a disciplined value investor respond? We suggest investors think independently and avoid the temptations of investing with the consensus—in other words, consider a contrarian view. Contrarian investors invest in a way that challenges conventional thinking and positioning. We think the ability to practice contrarian investing is an essential element of successful value investing. By avoiding crowded and overvalued securities and gravitating towards neglected and undervalued assets, we believe contrarian investing can enhance long-term investment results.
While a contrarian investment approach has clear benefits, it is often difficult to apply and maintain. When investors take a contrarian position and it goes without immediate vindication, pressures mount to reverse course and move back into the comfort of the herd. Contrarian investing can be especially difficult for professional investors to practice due to the investment management industry’s obsession with short-term relative performance and client perception. Short-term underperformance caused by positioning that is different from benchmarks and peers could alarm clients and affect business retention and growth in assets under management. We believe these disincentives increase the reluctance of professionals to invest independently and contribute to the mispricing of assets that investors are chasing or avoiding. During periods of significant disconnect between price and value, we believe investors willing to set aside their concerns surrounding short-term relative results and the perception of others have a tremendous advantage over the crowded consensus.
We avoid allowing near-term performance and perception concerns to influence our investment decision-making process. In fact, our strategy often invests differently than its peers and popular small-cap benchmarks, especially near small-cap market peaks and troughs. Throughout each market cycle, the degree of contrarian positioning within the portfolio fluctuates depending on the opportunity set. When investors pour into the same stocks and sectors, the assets chased are typically expensive and we avoid them. Conversely, as investors neglect certain sectors or individual stocks, we find prices are often more attractive and become more interested. Over the past year, we have increased the number of contrarian holdings within the portfolio as we rotate out of high-quality small-cap stocks that have performed well and purchase out-of-favor equities that we consider undervalued. While such a contrarian positioning may cause performance to differ from its peers and benchmark, we believe it is essential in our attempt to avoid preventable investment losses and meet our long-term absolute return goals.
We think contrarian investing can also improve diversification and reduce correlations to other equities and asset classes. Rising correlations among asset classes are becoming a growing problem for investors seeking diversification. This issue was highlighted during the past market downturn in the Forbes article, “Understanding the Recent Rise in Correlations.” In the article, William Coaker notes, “Investors who increased allocations to international stocks, emerging markets, real estate, hedge funds, high-yield bonds, and natural resources during the previous decade did so at least partly because these investments’ correlations to U.S. stocks and to each other, had been low in the past. Unfortunately, the correlations increased significantly in recent years. As a result, an expected reduction in risk did not occur, and in the 2008 bear market investors suffered much larger losses than expected.”
High correlations between asset classes appear to be continuing in the current cycle. The Wall Street Journal reported on June 28, 2014, “Six closely tracked gauges of world stock, bond and commodity performance are headed for gains in the first six months of the year, the first time they have all risen since 1993.” Hedge funds also appear to be leaning in the same direction, with the Financial Times reporting on June 29, 2014, “Hedge funds’ correlation with the equity market has risen back to pre-financial crisis highs raising fears that the $2.7 trillion industry could again suffer sharp losses in the event of a market slide.” Although correlations going forward are uncertain, we think valuations appear expensive (risk elevated) in a variety of asset classes. Therefore, we would not be surprised if correlations are again elevated during the inevitable completion of the current market cycle. We would expect the portfolio’s contrarian positioning to reduce its correlation to the market.
Correlation statistics support our belief that our contrarian positioning will differentiate the portfolio considerably from the small-cap benchmarks. For example, year-to-date the portfolio’s beta is 0.17. Beta measures how volatile the portfolio’s performance is relative to an index (in this case, the Russell 2000). A portfolio with a beta greater than one should move more than the market, while a beta less than one should move less. The portfolio’s daily tracking error of 0.89% also indicates our contrarian positioning has reduced correlation to the markets. Tracking error describes how much the portfolio’s return deviates from the benchmark on a daily basis (one standard deviation). We consider a daily tracking error of 0.89% to be meaningful and reinforces what we frequently notice anecdotally—the portfolio often zigs when the market zags in the current environment. With a 0.17 beta and a 0.89% tracking error, we conclude the portfolio’s performance is not significantly dependent at present on the movement of the overall small-cap market. Given our opinion that small-caps are expensive and risks are elevated, possessing a low correlation with the small-cap market is comforting to us. Again, it is important to emphasize that during peaks, or periods of excessive valuation (risk), we want to avoid positioning the Fund like everyone else.
Cash and Precious Metals Miners
Currently, we believe cash and asset heavy companies (commodity-related) are the two largest contrarian positions in the portfolio. Given our strict buy and sell discipline (refusal to buy or hold overvalued stocks), the Fund’s cash position reached an all-time high this year. Within the equity holdings, we are finding value in out-of-favor asset-heavy businesses, such as precious metal miners and natural gas producers. Although such positioning conflicts with conventional wisdom, we believe our refusal to overpay for small-cap stocks and our opportunistic purchases of out-of-favor asset heavy businesses will ultimately benefit returns.
At 12% of assets, precious metal miners represent the largest contrarian position in the equity portfolio as of the end of the quarter. Precious metal stocks suffered through a devastating bear market in 2013, with the Market Vectors Gold Miners ETF (GDX) declining 54%. Although one should not invest based on declining prices alone, our extensive research, analysis, and valuation work led us to initiate several precious metal miner positions last year. We considered the position contrarian given the current consensus view that mining stocks are poor investments. The consensus often criticizes the mining industry, suggesting that they are unattractive businesses, poor cash flow generators, and highly correlated to the overall market. We disagree. Based on our research, we believe there are certain mining companies that possess many of the attributes investors seek in high-quality businesses. We also believe there are select miners that trade at meaningful discounts to the replacement value of their assets, have strong balance sheets, and are capable of generating strong cash flow over an industry cycle.
From a balance sheet perspective, the mining companies in the portfolio are financially strong with significantly more assets than liabilities. Many of the mines and reserves would be very costly and difficult to replicate, especially as industry-wide reserves become more expensive to find and extract. As new deposits and economically feasible reserves become increasingly rare, we believe established miners with proven reserves are becoming more attractive, not less (as the consensus believes). There are also large barriers to entry in replicating reserves and mines in production, including many years of exploration and development along with hundreds of millions of dollars of construction costs.
While we acknowledge cash flows in the mining industry can be volatile, over a full cycle, many developed mines are capable of generating abundant cash flow. In fact, the Fund’s largest position, Pan American Silver, generated $1 billion in cash from operations the past five years. A large portion of this cash flow remains on Pan American Silver’s balance sheet in the form of a large cash balance and net working capital. Management also used this positive cash flow to reinvest in the business, pay an above-average dividend, and buy back stock.
Regarding concerns surrounding how mining stocks will perform during the next market downturn, we believe sharp declines already experienced by many mining shares provide us with a sufficient margin of safety. We also note that correlations among the mining sector and the Russell 2000 have diminished meaningfully the last two years. While mining stocks are volatile, given the discounts to replacement value of the mining companies we own, we believe the risk/reward balance favors our contrarian positioning.
Several of the portfolio’s mining positions have increased in value this year and are responsible for the majority of year-to-date returns, yet we continue to believe the group remains attractively priced. In our opinion, the avoidance of mining companies by professional investors has been partially responsible for the current disconnect between their price and value. In a recent Grant’s Interest Rate Observer, Pierre Lassonde commented on professional investors’ reluctance to own mining shares, “If you look at the institutional holdings, whether it’s Canada, the U.S., etc., the most under-owned stocks in the world are the commodities. And gold is even more under-owned.” We believe negative investor sentiment surrounding the mining companies is reflected in their shares and has created an opportunity for those investors willing to be positioned differently. While our investment in the precious metal miners to date has had its ups and downs, given the Fund’s average cost on investment, we strongly believe that our positioning will ultimately lead to an attractive long-term return relative to risk assumed.
In summary, with expensive small-cap valuations, rising correlations, and mounting pressures to invest alongside the consensus, we believe now is an ideal time to consider contrarian investing. We believe contrarian investing has a vital role in asset diversification, risk reduction, and, ultimately, attractive long-term performance. Currently, our main forms of contrarian investing are holding above-average cash levels and avoiding expensive high-quality small-cap businesses. Furthermore, the portfolio remains overweight asset-heavy businesses that we believe are selling at meaningful discounts to the replacement value of their underlying net asset values. While contrarian investing may be uncomfortable in the near-term, as in past cycles, we believe investing independently will serve the Fund well, and allow us to achieve our long-term objective of generating attractive absolute returns relative to risk assumed.
River Road Asset Management
As of June 30, 2014, Pan American Silver comprised 4.30% of the portfolio's assets, WPX Energy – 1.96%, New Gold – 2.32%, Silver Standard Resources – 1.35%, Contango Oil & Gas – 0.55%, Convergys – 1.51%, and American Vanguard – 0.31%.
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. There is no guarantee that any particular strategy will achieve the desired outcome or result in favorable performance. Diversification does not guarantee a profit or protect against a loss.
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.