3rd Quarter 2012
After drifting sideways in July, stocks surged in August following comments from Mario Draghi, head of the European Central Bank (ECB), that the bank would use the full force of its balance sheet to support the euro. Although the action did not address the debt and deficits at the root of the crisis in Europe, it reduced concerns about the ongoing support from central banks in the region.
The rally lasted through mid-September when the US Federal Reserve formally announced another round of quantitative easing (QE3)—a program targeting $40 billion a month in bond purchases—and its intent to keep interest rates “exceptionally low” through at least mid-2015. To the surprise of many, the S&P 500 Index peaked just one day after the Fed’s announcement, drifting steadily lower thereafter.
The Fund captured 58% of its Russell 3000 Index benchmark gain during the quarter despite maintaining only 50% average net long equity exposure. We maintained the 50% average net long equity exposure (and 102% gross exposure) as we trimmed long positions that approached our calculated Absolute Values and it became increasingly difficult to identify attractively priced, high-conviction long opportunities. We kept the portfolio’s individual short exposure (excluding hedges) in a tight range, spending much of the quarter between -22% and -25%, as we balanced an improving short opportunity set with a risk control discipline that required a reduction in losing short positions.
Both the long and short portions of the portfolio beat the benchmark during the quarter. Unfortunately, the strong stock selection could not overcome the performance drag of just 50% net long equity exposure. The long portfolio gained more than 7% with an average exposure of 76%. Half of the Fund’s top-10 long contributors were retail and energy positions, investments with considerable operating risk. Although we are willing to take operational risk when we think we are being compensated for it, these riskier stocks are typically smaller positions within the portfolio. Consequently, many of the riskier winners were positioned conservatively at about half of our target long position size. The short portfolio increased slightly more than 6% with, an average exposure of -26%. Secular decliners such as airline, solar, and consumer electronic retailing companies drove the short outperformance.
The top contributors to performance were all long positions, notably Molson Coors Brewing, Kohl’s, and National Fuel Gas. Molson has built a powerful North American presence since 1786 in Canada and 1873 in the United States. The company enjoys a duopoly position in each of the light beer markets in which it competes, which leads to pricing power and predictable cash flows. We think investors under-appreciate both Coors Light as a top (and growing) global beer brand and Molson’s ownership of Tenth and Blake, the #1 craft beer company in the U.S. We also like the recent acquisition of Central and Eastern European brewer StarBev, despite skepticism from Wall Street, as it was financed with inexpensive debt and is benefitting from an expanding middle class in that part of the world. The stock rallied during the third quarter as European worries eased.
We admire Kohl’s retail and capital allocation strategy. The firm maintains industry-leading margins through its off-mall strategy and increased focus on exclusive and private label brands. The company has directed its free cash flow to shareholders in the form of share buybacks and rising dividends. The stock rallied on same-store sales gains in July and August after three months of negative numbers. Integrated natural gas utility National Fuel Gas surged as natural gas glut concerns subsided and prices increased. The firm’s ownership of large tracts of land in the low-cost Marcellus Shale provides long-term growth potential. Unlike most E&P companies that lease acreage and are required to drill regardless of price, ownership has allowed the company to reduce capital spending while natural gas prices remain low.
Long positions purchased during the quarter were concentrated in sectors with more economic sensitivity and operational risk, namely in the Industrials and Consumer Discretionary sectors. As a result, new additions were smaller position sizes, contributing to the lower net long equity exposure. We were comfortable investing in potentially more volatile positions given the financial strength we saw in the underlying companies.
In an environment of global central bank easing, we have kept the short portfolio defensively positioned with an emphasis on diversification. The individual short portfolio ended the quarter near our limit for the number of short positions we prefer to hold, with an average position size of just 62 basis points (0.62%). Relative to the long portfolio, the short portfolio is positioned in lower-quality and slower-growing stocks with higher earnings expectations.
The largest new position added during the quarter was ADT, a recent spin-off from Tyco that is the largest home security service provider in the U.S. We have invested in spin-offs in the past and think they represent an attractive source of new ideas. We think the firm is an attractive takeout target for private equity given its limited leverage, predictable cash flows, and recent valuation. Strategic acquirers (e.g. cable and telecom companies) may also be interested given that they target the same customer base and are searching for growth. Risks include new competition from telecom and cable companies and the threat of municipalities fining individuals or ADT for false alarms. We believe, however, that the current price more than compensates for these risks.
Our risk management process begins with fundamental analysis. We seek to avoid or minimize mistakes through bottom-up fundamental research. Despite our best efforts, however, we still make mistakes. We attempt to dampen the damage of these mistakes by not averaging down on target positions, setting stop-losses, systematically reducing the unrealized losses at the portfolio level, and by monitoring the momentum of individual short positions. Over long periods, we think such a robust risk management plan should prove valuable in generating more consistent and less volatile returns.
The holdings with the lowest contribution to return during the quarter included two long positions—Hill-Rom Holdings and Visteon—and a short position in Questcor Pharmaceuticals. All three positions were eliminated for risk control purposes. In hindsight, each losing position was eliminated within 10% of its 52-week low (for the long positions) or high (for the short position), and then promptly turned around and outperformed the benchmark for the remainder of the quarter. We do sometimes leave profits on the table due to our risk controls, but are comfortable occasionally missing out on profits to help protect against individual positions seriously damaging the portfolio.
Hill-Rom dominates the hospital bed market with a 75% market share. It reduced guidance as hospitals delayed orders in response to an uncertain operating environment. The company also announced the acquisition of Aspen Surgical Products, a private-equity roll-up with a suite of branded consumable surgical products. Given that the stock was trading at a significant discount, we would have preferred management had chosen to acquire its own shares instead. The combination of weakening fundamentals, questionable capital allocation, and an unrealized loss in the position made it a logical target for reduction to comply with our unrealized loss sell discipline.
Automotive supplier Visteon emerged from bankruptcy in October 2010 with a leaner operation, a much cleaner balance sheet, a 70% interest in publicly-traded Halla Climate Control, and a 50% interest in a Chinese joint venture called Yanfeng Visteon Automotive. The stock sank in late July after the company was unsuccessful in acquiring the 30% of Halla it did not own. At the time, the portfolio had crossed our unrealized loss threshold and the stock represented the largest unrealized loss in the Fund in addition to a great deal of uncertainty, so we eliminated it.
Questcor Pharmaceuticals’s only drug, Acthar, was approved by the FDA to treat infantile spasms in 1952, and was acquired by the firm in 2001. The company raised the price of the drug from $1,650 to approximately $23,000 in 2007 and targeted additional off label uses to drive the bottom-line and investor excitement. We covered the Fund’s short position in early September after the firm received positive Medicaid reimbursement news, which represented a fundamental improvement. Unfortunately, the stock then quickly turned down after Aetna announced it would not reimburse for Acthar beyond infantile spasms and the government initiated an investigation involving the company’s promotional practices. We were too quick to abandon an intact fundamental thesis and over-estimated the importance of the Medicaid news.
The Fund spent more than half of the quarter with one of our net market exposure management controls in place. The quarter began with the portfolio in our Drawdown Plan and ended with our discount-to-Absolute Value indicator for the portfolio’s top holdings flashing “extremely overvalued.” We reduced net long equity exposure from 51% at the beginning of the quarter to 43% by quarter-end, for an average of 50%.
The objective of the Drawdown Plan is to protect capital in declining markets, while allowing the portfolio to participate in rising markets. The Drawdown Plan officially ended on August 8 after the Russell 3000 Index’s 50-day moving average achieved 10 consecutive positive days, allowing us to return to a normal range of 50% to 70% net long equity exposure. This marked the completion of the third drawdown event since the Fund’s May 2011 inception, in-line with our historical analysis that concluded that we should expect roughly two (typically minor) drawdown events per year.
Consistent with the prior two drawdown events, the Fund performed well during this volatile period, outperforming the benchmark with a lower maximum drawdown. Historically, drawdown periods have led to strong stock selection results. The spread between our long and individual short performance has averaged 1,645 basis points over the three drawdown events. We are content to let gross exposure move lower during periods of market complacency like the present. We believe the eventual return of market volatility will present attractive stock picking opportunities.
With the portfolio’s discount-to-Absolute Value signaling an “extremely overvalued” environment as the market rallied through quarter end, our discipline required that we reduce the Fund’s net long equity exposure below 50%. The purpose of the discount-to-Absolute Value indicator is to proactively reduce exposure in preparation for a future market consolidation or correction. We trimmed the long portfolio from 87% at the beginning of the quarter to just 68% at the end, while maintaining mid-20% individual short exposure throughout.
We have a three-tiered objective with the Fund. We seek to generate equity-like returns with reduced volatility and an emphasis on capital protection. Generating equity-like returns requires that we find excellent companies to buy and challenged businesses to short. For the first time since inception, we have struggled to find many high-conviction long ideas (e.g. steady and predictable companies) to buy. We think the market is over-paying for stability. We have found pockets of opportunity in higher-risk stocks (e.g. transportation, energy, and precious metal companies), but we believe it is imprudent to build a concentrated portfolio of these stocks in the current environment. Generating equity-like returns over the long-term requires patience in the short-term, and we are fortunate to run a strategy that allows us to be patient. With nearly one-third of the portfolio in cash, we are ready to buy stocks from our watch list and add to existing positions when opportunities arise.
We are in a business in which mistakes are inevitable. We believe the primary difference between the winners and losers is that winners make small mistakes and losers make big mistakes. Given a rising market and a portfolio that continued to grind higher, our risk management dashboard did not require any major action. Momentum in the short portfolio is the one exception. We trimmed those stocks that reached "extremely high" momentum on a weekly basis. Monitoring short momentum prevented further losses on the short side as nearly two-thirds of the short watch list remained in the top half of our momentum rankings, prohibiting inclusion in the portfolio. Although we view shorting as a second source in which to add value, we are aware of the costs involved and the asymmetric risk/reward profile of selling stocks short. As a result, we rely on our momentum risk control to improve timing and avoid shorting those stocks that are on a roll in the market.
If the market continues its ascent during the fourth quarter, we expect both upside capture and volatility to ratchet lower. We keep net long equity exposure flexible to reduce volatility. As long as the market is providing enough opportunities (discount-to-Absolute Value indicator remains below 80%), we are content to keep net long equity exposure relatively high at 50% to 70%, participate in rising markets, and experience more portfolio-level volatility. We stop participating once opportunities run out, and shift our focus to protecting the gains we have achieved.
Many traditional long-short hedge funds have struggled in recent years as volatility and market drawdowns have come at unexpected times. We do not know when the market will consider risk again, but we think the portfolio is well-positioned for when it does. The rising market has led to a shrinking long portfolio and kept many of our short ideas on the watch list. Both of these actions led to declining gross market exposure. Thus, we are following the advice of one of our favorite investors (and the CEO of one of our largest holdings—Loews), Jim Tisch, who says about investing: “If there’s nothing to do, do nothing.”
River Road Asset Management
16 October 2012
As of September 30, 2012, Molson Coors Brewing comprised 2.91% of the portfolio's assets, Kohl’s – 1.64%, National Fuel Gas – 2.28%, ADT – 3.53%, Hill-Rom Holdings – 0.00%, Visteon – 0.00%, and Questcor Pharmaceuticals – (0.00%).
Note: Short sales may involve the risk that the Fund will incur a loss by subsequently buying a security at a higher price than which 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.
Parameters set by the Subadviser are not a fundamental policy of the Fund and are subject to change at any time.
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.