By Eric Cinnamond, Portfolio Manager, River Road Asset Management
The prices of small cap stocks approached or exceeded record levels during the first quarter of quarter 2012. Small-cap valuations appear elevated within the Russell 2000 and S&P 600 Indices based on aggregate price/earnings ratios. Unlike 2011, when periods of volatility in the small-cap market created opportunity, volatility was practically nonexistent during the first quarter, with the CBOE Market Volatility Index (VIX) reaching a five-year low in March. Periods of low volatility and near-record prices often cause investors to become complacent with regards to risk. We take the opposite view and believe risk levels increase when volatility is low and prices are high. In running an opportunistic strategy, we welcome volatility as it often coincides with risk becoming attractively priced. As the high cash level at the ASTON/River Road Independent Value Fund (ARIVX) would suggest, we do not believe, on average, that investors in our small-cap universe are being adequately compensated for the risk being assumed.
We believe managing risk is one of the most important factors in determining long-term investment results. Establishing when to assume risk, what kind of risk to take, and what required rate of return to demand for accepting risk are the cornerstones of our investment process. The ability to assume risk and refrain from accepting risk requires flexibility and patience. In the current environment, with small-cap prices rising consistently and trading near record highs, it is increasingly difficult to remain patient and disciplined. Lagging peers and benchmarks can result in career risk and performance anxiety for any portfolio manager willing to go against the herd. These professional and relative risks can cause conformity and, in our opinion, are counterproductive in managing the risk that matters most—the risk of permanent capital loss.
We believe an accurate valuation is essential in reducing the risk of permanent capital loss. Most of our valuations are calculated by discounting the future free cash flows of a business to present value. Although discounting future free cash flows is a common form of equity valuation, our process differs from most in that we use normalized assumptions. We normalize future free cash flows in an attempt to smooth the booms and busts associated with an economic or industry cycle. The cash-flow cycles of most businesses are nonlinear and have differing degrees of cyclicality. Therefore, to reduce valuation error, we believe it is important to avoid forecasting peak or trough cash flows far into the future. Instead of extrapolating recent results, we attempt to determine the amount of free cash flow a business will generate annually, on average, over an economic cycle. With corporate profits at record levels, we believe that extrapolating current operating margins and cash flows may provide overly optimistic and inaccurate valuations.
In addition to normalizing free cash flow, we use a required rate of return, or discount rate, in our valuation model that we believe properly reflects the operating risks of each business under review. We demand a higher rate of return for a business with more volatile and less certain future free cash flows. Conversely, we require a lower rate of return for a more stable business with more certain future free cash flows. Our required rate of return is typically calculated by combining the rate of return required as a debt holder, plus an equity risk premium. Interestingly, the required rates of return we demand are often similar to the internal investment hurdle rates used by many of the businesses we follow and value. Historically, that rate has been between 10% and 15%. In essence, the required rate of return assumption we use in our valuation model is our absolute return objective for our equity investments.
In an environment with rising small-cap prices, record corporate profits, and low interest-rates, it is tempting to adjust our cash flow and required rate of return assumptions in order to increase our business valuations. Higher valuations would allow us to justify purchasing more of the holdings on our Focus List and reduce the portfolio’s high cash position. Before adjusting our cash flow and required rate of return assumptions, however, we would need to be convinced that the cash flow cycle and the risks to cash flows have been permanently altered. We believe there is insufficient evidence to support the assumption that the current cash flow cycle and the risks to these cash flows are materially different than past cycles. Instead of manufacturing opportunities by altering our valuation methodology, we believe patience is the preferable course of action.
The Fund’s current high cash levels (53% as of March 31, 2012) illustrate our patient stance. This is in stark contrast to the average equity mutual fund’s cash level, which is near a record low of 3.6% according to the Investment Company Institute. Holding a large cash position is not an attempt to time the market’s direction, but is a direct result of the lack of opportunity we believe is in our small-cap universe. As a strategy that focuses on absolute returns, it is essential that we limit mistakes caused by overpaying for small-cap equities. In addition to protecting capital when prices are high, cash allows the Fund to act decisively, without the need to liquidate existing holdings, when opportunities arise. In other words, in addition to reducing risk, we believe the ability to hold cash aids our effort to maximize future returns.
Although small-cap stock prices have increased and profits remain elevated, our perception of risk has not changed. Instead of altering our valuation methodology to fit the short-term fluctuations in small-cap prices and corporate profits, we will remain patient and allocate portfolio cash only when we feel appropriately compensated. We believe patience is one of the most difficult investment disciplines to practice, but one of the most important. Until volatility returns and prices improve, it is likely that the portfolio will remain defensively positioned. In the meantime, we will continue to refine our list of high-quality, small-cap businesses that we look forward to owning in the portfolio in the future.
The information contained in this article first appeared as part of the First Quarter 2012 Commentary for the ASTON/River Road Independent Value Fund and is provided by River Road Asset Management (“River Road”), a subadviser utilized by Aston Asset Management, LP (“Aston”). River Road is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and River Road’s views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends, and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results.
Note: Small- and mid-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, carefully consider the Fund’s investment objectives, risks, charges and expenses. Contact (800) 992-8151 for a prospectus or a summary prospectus containing this and other information. Read it carefully.
Aston Funds are distributed by Foreside Funds Distributors LLC.