2nd Quarter 2014 Commentary - ASTON/River Road Long-Short 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.
Highlighting the strength in financial assets, and the influence of current monetary policy, was investors’ reaction to the massive negative revision to first quarter Gross Domestic Product (GDP) released on June 25. Initially reported at 0.1%, and later revised to -1.0%, the final revision was a stunning -2.9%, representing the worst quarterly GDP growth on record for any non-recessionary period. Dismissing the report as irrelevant to current and future conditions, stocks closed higher on the day.
The Fund posted modest gains, roughly in line with its long-short mutual fund peers, though well behind the 4.9% returns of its unhedged Russell 3000 Index benchmark. With 46% average net long equity exposure, the portfolio captured 45% of the index’s performance. The long portion of the portfolio performed well while the individual short portfolio struggled
Shorting remains a challenge in this ultra-low interest rate environment. Historically, according to Empirical Research, companies that have actively paid down debt have enjoyed positive relative equity market performance. This has not been true the past five years (including this quarter) as some of the best performers have been less-profitable and more-cyclical companies that are adding more leverage to their capital structures. Not since the late-1950s through the mid-1960s, when interest rates were also low, has the market held such a high regard for these lower-quality stocks. Unfortunately, these are exactly the types of companies we like to short. The net debt/capital ratio of companies in the short portfolio is nearly twice the level of that of the long portfolio. We think adding any leverage to barely profitable and/or highly cyclical businesses adds significant risk that can potentially destroy value, and suspect will at some point lead to poor performance.
The biggest individual detractors from relative performance during the quarter were long positions in eBay and Coach, and a short stake in Conn’s. eBay suffered through a quarter of bad news which had no effect on our long-term thesis. Activist Carl Icahn withdrew his breakup proposal for a PayPal spin-off early during the period. This was followed by a data breach in May that forced eBay users to change their passwords, changes to Google’s Panda 4.0 search algorithm that had a negative impact on the search ranking of many of eBay’s webpages, and the June announcement that PayPal president David Marcus was stepping down to lead Facebook’s messaging products. We considered the share price weakness an opportunity to build the position closer to its target weight given an attractive valuation, growing business segments, an over-capitalized balance sheet, and talented management team.
Handbag and accessories retailer Coach faced intensifying North American handbag competition from Michael Kors, Kate Spade, and Tory Burch along with management uncertainty (i.e. a new CEO and Creative Director within the last year) that resulted in deteriorating operating results. This provided the opportunity to purchase the stock at a reasonable valuation, though given the heightened risk we established a tighter stop-loss. The company then reported a poor fiscal third quarter with same-store-sales down more than 20%, triggering our stop-loss and leading us to sell the position from the portfolio. The company’s Analyst Day several weeks later confirmed the business trajectory with a significant reduction to longer-term guidance and a dramatic makeover of its North American store base.
Conn’s is a subprime specialty retailer of furniture, appliances, and electronics in five states. Before the 2008 financial crisis, the company financed less than 50% of its overall sales (at a roughly 18% interest rate) and same-store-sales grew in the low single-digits. Now, it finances almost 80% with an average FICO score of 599. We are doubtful that its lending practices are sustainable given the working capital requirements. Unlike most brick-and-mortar retailers that are struggling to grow at all, Conn’s is now posting same-store-sales growth in the mid-teens with margins greater than the very best retailers in the U.S., as it sells products at inflated prices to customers that would not otherwise be able to afford those products. We suspect its aggressive lending practices will catch up with the firm the next time the economy meaningfully slows. Unfortunately, insider buying and a purchase from a high-profile hedge fund manager pushed the short holding to our stop-loss risk control limit and we exited the position. The stock will spend the next three months on our “cooling off” list before we will gladly consider the idea again.
Long positions in Molson Coors Brewing, International Game Technology (IGT), and Time Warner were the top contributors during the quarter. We think each have benefited from shrewd capital allocation decisions amid the low interest rate environment. After we purchased Molson Coors nearly two and a half years ago, the company promptly issued $2.5 billion worth of debt at just 3% to finance its purchase of Eastern European brewer Starbev. Investors ignored Starbev’s growth potential and impatiently sold the stock as the acquisition conflicted with the firm’s near-term capital return “story.” The company then relied on its significant free cash flow to bring leverage back down, raise its dividend earlier than planned, and put itself in a position to consider the transformational purchase of SABMiller’s 58% economic stake in MillerCoors JV.
IGT is a leading supplier of the gaming equipment market (slot and video poker machines). It benefits from high barriers to entry, as start-ups must meet regulatory requirements in thousands of jurisdictions, and the ownership of some of the most recognizable titles in the industry. Although the domestic gaming industry has slowed, it is not going away. The firm’s timely purchase of online gaming company DoubleDown in 2012 (customers buy chips that have no monetary value) represents a potential hidden asset as gross profits have more than doubled in the meantime.
Time Warner’s collection of top cable networks (e.g. TNT, TBS, and CNN) benefit from rising affiliate fees, increased distribution options, and international pay TV growth, with HBO the crown jewel in its media portfolio. HBO has nearly three times the number of subscribers as Netflix, is vastly more profitable, and has a superior library of original content. If the market placed as much value on an HBO subscriber as a Netflix subscriber, investors in Time Warner would pay almost nothing for the rest of the business. Chairman and CEO Jeff Bewkes has continuously chiseled away at the firm’s conglomerate structure and created massive shareholder value since taking charge in 2008. After spinning off magazine affiliate Time in June, it raised its target leverage ratio to match the firm’s improved cash flow resiliency and boosted its share repurchase authorization to capitalize on historically low interest rates and an inexpensive stock price.
Our primary driver to minimize volatility is net long equity exposure. Our discount-to-Absolute Value indicator of the top-20 holdings in the portfolio averaged 80% during the quarter, which we consider extremely overvalued. At 46%, the portfolio’s net long equity was below the low end of our normal 50% to 70% range. With less than half of the exposure to the market, portfolio volatility was contained and the Fund’s beta (a measure of volatility) was less than 0.50. We are comfortable increasing the portfolio’s net long exposure (and the possibility for increased volatility) if we believe that it is being compensated for the increased risk assumed—which hasn’t been the case lately.
The portfolio’s gross market exposure (long plus short positions) increased during the quarter. The increase was nearly entirely attributable to a larger short portfolio. As low quality stocks continue to outperform, we have found plenty of opportunities to add to a short portfolio of businesses with strained balance sheets led by management teams with poor records of capital allocation. The short portfolio includes what we consider a diverse mix of challenged businesses, including over-valued commodity stocks with poor supply/demand characteristics (Teck Resources, ArcelorMittal), broken bubble stocks (3D printer Stratasys and discount teen retailer Five Below) as well as positions in a couple of utility and telecommunication stocks trading like bond proxies.
We still have been able to find enough new long ideas to grow the long portfolio slightly as well. The market rally has left behind a number of businesses we find attractive, such as the largest new position added during the quarter, PetSmart. Pet retailing is an attractive industry that has grown at a 6% rate the past two decades, and even grew during the 2008-2009 financial crisis. The humanization of pets illustrates the resiliency of the business and the opportunity for long-term growth. Nearly 70% of American households own a pet and the same percentage admits it would spend more money to ensure the wellness of a pet. We think the company’s broad suite of premium products and services (e.g. PETM is one of the few places that allows customers to bring in their pets) help differentiate the consumer’s shopping experience, drive overall traffic, and attract a relatively affluent customer base.
The company reported a weak first quarter and investors seemed to fear the cause was structural and attributable to general market competition and the growing e-commerce threat to pet food sales. We believe this risk is overblown. General merchants struggle to compete with PetSmart’s scale and premium food brands, which are only offered in specialty pet retailers Although e-commerce is a risk, it only represents around 4% of total industry sales. It is difficult to profitably sell and distribute 20 to 50 pound bags of pet food door-to-door given their low value-to-weight ratios. Firm management has a strong record as operators and is extremely shareholder focused, having opportunistically repurchased shares and maintained a conservative balance sheet while consistently growing the store base, and initiated a dividend in 2009 that has grown at a significant annual rate.
The market (as represented by the S&P 500 Index) has continued to defy gravity. The quarter marked the 1,000-day milestone without a correction (a -10% drop) in the market. According to Bespoke Investment Group, this is the fifth-longest stretch without a correction for the S&P 500 since 1928.
As central banks around the world have kept interest rates low, nearly every asset class has appreciated. For the first time in more than 20 years, stocks, bonds, and commodity indices all rose in unison during the first half of 2014. We designed the Portfolio with a relatively high “normal” net market exposure range of 50% to 70% in order to participate in bull markets. There comes a point, however, at which we simply can no longer justify ever-higher prices for stocks.
We think this period of ultra-low interest rates has resulted in a speculative fever among many financial/strategic investors and corporate management teams. Following their historical pattern, corporate management teams have increased buyback activity along with rising share prices. Corporate buybacks reached their highest level since 2005 during the first quarter of 2014, up 59% year-over-year. Rather than letting cash build on the balance sheet to earn next-to-nothing, management teams continue to chase their own stock prices higher and higher.
Many short-sellers have capitulated, as the percentage of shares borrowed by short sellers has dropped to the lowest level since before the Lehman Brothers collapse in 2008. We think this is the same mistake that the original class of hedge fund managers committed when they allowed their market exposures to rise along with the “go-go” markets of the 1960s only to crash and burn (and not hedge!) in the early 1970s. Between the close of 1968 and September 30, 1970, the 28 largest hedge funds lost two-thirds of their capital and most of the remaining hedge funds were wiped out in the 1973-1974 bear market. We remain committed to shorting.
We think the market is due for a pullback. Whether it is the plummeting volatility or skyrocketing margin debt, investors seem complacent. The S&P 500 ended the quarter having spent the last 404 trading days above its 200-day moving average, which represents the longest stretch since 1957. Our Drawdown Plan for seeking to protect capital should a correction take place remains in place for when fear returns to the stock market.
River Road Asset Management
As of June 30, 2014, eBay comprised 3.88% of the portfolio's assets, Coach – 0.00%, Conn’s – (0.00%), Molson Coors Brewing – 1.53%, International Gaming Technology – 1.92%, Time Warner – 4.05%, Time – 0.00%, Teck Resources – (0.94%), ArcelorMittal – (0.50%), Stratasys – (0.73%), Five Below – (0.75%), and PetSmart – 2.95%.
Note: Short sales may involve the risk that the Fund will incur a loss by subsequently buying a security at a higher price than it was previously sold short. A loss incurred on a short sale results from increases in the value of the security, thus losses on a short sale are theoretically unlimited. Value investing often involves buying the stocks of companies that are currently out-of-favor that may decline further. Investing in exchange traded and closed end funds are subject to additional risk that shares of the underlying fund may trade at a premium or discount to their net asset value.
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.