4th Quarter 2012 Commentary - ASTON/River Road Select Value Fund
4th Quarter 2012
Mixed Fourth Quarter Amid Strong 2012
The fourth quarter provided a fitting end to what was a volatile, yet successful year for equity investors. Stocks traded modestly higher in October before experiencing a sharp, post-election decline. Surprisingly positive employment data later led to a reverse of the slump with stocks propelled by rising optimism for a resolution of the fiscal cliff. The final surge arrived on December 31, as news emerged that lawmakers had finally cobbled together the framework for a deal.
Small-cap stocks led for the quarter, as the Russell 2000 Index gained 1.85%, nearly two percentage points more than the large-cap oriented Russell 1000 and S&P 500 Indices. For 2012, large and small-cap stocks delivered equally robust returns, with all three indices returning roughly 16%. Small- to mid-cap stocks were the best performing segment, with the Fund’s Russell 2500 Index benchmark gaining nearly 18%.
With Financials posting stellar returns and Technology stocks lagging, value stocks handily outperformed growth across the market-capitalization spectrum (as represented by the Russell indices) for both the quarter and 2012. Indeed, among small- to mid-caps, the Russell 2500 Value outpaced its small/mid-cap growth index rival for the first time in three years.
High-beta (volatility) stocks fueled the fourth quarter rally as risk aversion fell. The highest beta stocks (fifth quintile) in the benchmark outgained the lowest beta (first quintile) by more than six percentage points. High-beta stocks in the benchmark also led for all of 2012. Extended high-beta leadership this late in an economic recovery is unusual and, in our opinion, is a direct consequence of the Federal Reserve’s aggressive monetary policies. Fortunately, high-beta leadership has not coincided with low-quality outperformance, as higher-quality stocks led the benchmark during the first three quarters of the year before falling off during the fourth quarter rally. This is likely due to slowing profit growth, which encourages investors to bid up stocks with strong earnings metrics.
Active Managers Disappoint in 2012
Active small-value managers performed well during the fourth quarter in general, with 66% outperforming the benchmark, but they struggled in 2012 as just 35% outperformed. Since early 2011, we have commented on the unusually large percentage of small-value managers that have outperformed during recent periods of high-beta leadership—a trend that is counter to our long-term observations. Small-cap managers lagged in 2012, however, despite high-beta leadership. We believe the reason was the significant underperformance managers experienced during the second quarter, when low-beta stocks significantly outperformed and just 12% of small-value managers beat the benchmark. (Note: The second quarter was a particularly strong quarter for our low-volatility, high-quality style of investing.)
Active managers across the size and style spectrum have struggled against their benchmarks the past few years. Large-caps have been a particularly challenging segment, though small-caps have not performed well either. Small-cap managers posted their worst relative performance since 2008, and fewer than half of all active small-value managers have now outperformed since 2000.
As active managers have struggled, fund flows have shifted dramatically toward index funds and exchange-traded funds (ETFs) dedicated to U.S. stocks. Unfortunately, large flows into index funds and ETFs typically leads to higher equity correlations and a more challenging performance hurdle for active fundamental managers. Long-term, however, these flows result in crowded trades that can create inefficiencies for active managers to exploit.
It is difficult to say exactly why managers have struggled against the benchmark recently. Certainly, high equity correlations related to global macroeconomic events and strong ETF flows have been contributors. Within the small-cap space, value managers have suffered from outperformance in the Financials sector, particularly in real estate investment trusts (REITs)—where managers have generally been underweight.
The Fund underperformed its benchmark during the quarter, and substantially underperformed for the year. As noted in previous commentaries, the most challenging phase of the market cycle for our style is the early, high-beta/low-quality stage, which we believe ended in February 2011. Since that time, the portfolio has performed reasonably well in outperforming the benchmark. During this period, stock selection has been strong and volatility and turnover have remained consistently low.
The sectors with the lowest contribution to relative return during the fourth quarter and 2012, respectively, were Healthcare and Consumer Discretionary. Healthcare underperformed due to both an overweight allocation and poor stock selection, including one of the quarter’s largest negative contributors—skilled nursing and rehab services provider Ensign Group. Consumer Discretionary performance in 2012 was adversely affected by stock selection, most notably that of closeout retailer Big Lots.
Among the biggest individual detractors during the quarter were Ascena Retail Group, Endeavor International, and Energen. Specialty apparel store operator Ascena (dressbarn, maurices, Lane Bryant, Catherines, and Justice) sold off when the company reported results that were above expectations, but management failed to raise full-year guidance. They were also conservative in their estimates for synergies from the Charming Shoppes acquisition completed in June. The company expects to reduce overhead during the next three years to improve profitability and solid sales and earnings growth. We took no action on the position.
Independent oil and gas exploration and production firm Endeavor fell after the company failed to close two previously announced acquisitions of attractive North Sea assets. Although the company announced the acquisitions in December 2011, management did not disclose until December 2012 that there were insurmountable complications in negotiating the abandonment liabilities. These operational setbacks combined with increased balance sheet leverage significantly reduced our margin for error and impaired our investment thesis. We sold most of the Fund’s position just prior to year-end as the situation deteriorated.
Energen, another energy exploration and production company, reported disappointing fiscal third quarter results due to a variety of production issues, mostly infrastructure related, that will likely temporarily affect. Poor results at two new wells at some of the firm’s more promising projects also dampened investor enthusiasm. As a result, the company lowered its production guidance for 2012 and 2013. Our assessed Absolute Value did not materially change and we maintained the portfolio’s position during the quarter.
Laggards for the full year 2012 were a mixed bag. Closeout retailer Big Lots lowered earnings expectations and guided toward its first negative annual comparisons in more than 10 years. Discretionary sales have been weak and management is working on various initiatives to address its merchandising issues. We eliminated the position in The Dolan Company, a provider of mortgage default processing and litigation services. The “robo-signing” scandal prompted mortgage servicers to delay processing foreclosures, which we believed would be temporary. Non-foreclosure solutions like short sales appear to have successfully resolved many delinquent mortgages, however. Finally, IT distributor Ingram Micro suffered after its new CEO announced the acquisition of Brightpoint, a global distributor for the cell phone industry. We lowered our assessed Absolute Value due to increased balance sheet risk and the potential for dilution, and significantly trimmed the position at a small loss during the second half of the year.
The sector with the highest contribution to relative return for both the fourth quarter and all of 2012 was Industrials. Stock selection drove performance led by the Fund’s top-performing stock for both periods, Geo Group. In 2012, Utilities and Technology also provided strong relative performance, with Utilities benefitting from a significant underweight position and Technology driven primarily by stock selection.
Shares of private prison operator Geo Group rallied when its Board of Directors announced the company would be converting into a REIT on January 1, 2013. To conform to the REIT rules of the Internal Revenue Code, the company paid a special dividend during the fourth quarter. The REIT conversion will improve the company’s tax efficiency, lower its cost of capital, and provide additional flexibility for growth opportunities. It should also increase the price investors give the stock as REITs are trading at a significant premium in the current low interest-rate environment. Although we do not typically invest in REITs, we do not feel compelled to sell a portfolio holding that converts into a REIT as long as our calculated discount-to-Absolute Value is compelling. Thus, we maintained the position in Geo during the quarter.
Other top individual performers during the quarter were Insperity and Madison Square Garden. Insperity provides full-service human resources to small and medium-sized businesses, and reported strong results with higher gross profit due to lower benefit costs. In addition, the company announced a special dividend and a Dutch auction share repurchase plan that cost it little as its stock rallied past the high end of the tender offer. Media and sports conglomerate Madison Square Garden reported solid quarterly results driven by their content deal with Time Warner and increased sales associated with Phase I of the Garden renovation. It helped that the New York Knicks had a fantastic start to their 2012-2013 basketball season. The National Hockey League (NHL) also finally reached a tentative agreement with the players union to end its league-wide lockout, which should eliminate a short-term risk for the company. We trimmed the Fund’s position as the stock approached our assessed Absolute Value.
For the full year, the best contributors were generally the portfolio’s largest holdings, including fourth quarter standouts Geo Group and Madison Square Garden. Strong operating results and the announcement of two industry transactions at attractive price multiples boosted the shares of Equifax, the largest credit bureau in the United States. We aggressively trimmed this long-time holding as it hit our calculated Absolute Value.
Five new holdings were purchased and seven sold from the Fund during the quarter. Among the five new positions, two were in the Industrials sector (Layne Christensen and Kelly Services). The new positions also tended toward the smaller end of the market-cap spectrum, with three having market-caps less than $600 million. Among the companies sold, four achieved our Absolute Value price targets and three were sold due to either accumulated losses and/or a negative change in our fundamental outlook for the firm. Overall, turnover for the year was among the lowest in the Fund’s history.
We have been comfortable with the portfolio’s positions and sector weights (excluding Financials) during the past two years and looking ahead do not foresee any major shifts in allocation. Industry and sector allocations are driven almost exclusively by company-specific opportunities. Perhaps one key difference from 2012 is that multinationals look a bit more attractive as estimates have been slashed along with their stock prices. We are also increasingly concerned about consumer stocks given tax increases and other fiscal headwinds, and will continue to monitor closely.
The largest new position added during the quarter was WMS Industries, one of three major manufacturers and distributors of slot machines and video lottery terminals. WMS has the scale and financial strength necessary to license attractive brands and navigate the labyrinth of regulations across hundreds of jurisdictions. The company is viewed as an innovator within the industry, a position that has led to significant share gains but also increased product risk. WMS struggled in 2011 to commercialize several new products because the complex nature of their latest technologies caused operational and regulatory delays, resulting in competitors regaining market share lost to the company in prior years. After gaining regulatory approvals and rationalizing its pipeline, the firm appears to be back on track.
We previously purchased WMS for the Fund in July 2011 and eliminated the position as a loser in July 2012. The stock subsequently dropped even lower. When we first purchased the stock, the leveraged balance sheets of casino operators were causing a delay in the replacement cycle. We believed that the company’s strong balance sheet would help them weather that type of operating environment. We did not expect the regulatory delays that caused the market share losses. We are now repurchasing WMS at an attractive discount to our previous sale with the belief that the company’s operating momentum is now on an upswing.
Reflecting on the past decade, it is typical for us to underestimate market returns in the early stages of the profit cycle, be on target in the middle, and then hit or miss in the late stages depending on how overextended valuations become. That has been the case with this current cycle as we underestimated the market recovery during the first two years and were largely in-sync the past two years. As mentioned in our last outlook, the recent slowdown in profit growth may indicate markets are entering the late stage of the cycle. Thus, you may rightfully sense that our conviction in our outlook for this year is a bit more tempered than that of the last two years.
Although our outlook is not a forecast, our perspective of the economic and market environment can affect our stock valuations and portfolio positioning. Valuations are the primary driver of our outlook. When stocks are cheap we get excited, when they are expensive we become more cautious. We would categorize current valuations as approaching full value. In other words, we are more cautious than excited, but not yet sounding the alarm. Employing our proprietary discount-to-Absolute Value measure, valuations were slightly below their historical peak at year-end, but with the market appreciating about 4% since year-end the indicator is now at 81%—uncomfortable territory for us. External measures show small-cap stocks being fairly valued, not grossly overvalued. That said, our proprietary measure has proven to be far more useful in predicting near- to intermediate-term corrections than any external measure we monitor.
In addition, we believe consensus small-cap profit expectations are too high and likely to fall in the upcoming quarter, just as large-cap expectations have declined in recent months. The current expectation for Russell 2000 median profit growth is in excess of 17%. From our perspective, growth in the range of 8% to 12% for 2013 is more realistic. These factors imply some level of near-term weakness for small-caps as profit expectations decline, but perhaps solid single-digit stock returns over the course of the coming year, though given that we are in the late stages of the economic recovery cycle our conviction is low.
Despite modest economic growth and firmer employment data, US Federal Reserve monetary policy remains hyper-aggressive. Chairman Bernanke has explicitly expressed his strong preference for higher asset values during periods of deflationary pressure and deleveraging. He also recently declared the Fed would continue to provide extraordinary stimulus until unemployment reached 6.5%. While it is unlikely we will see a 6.5% headline unemployment figure in 2013, 7% is a possibility if growth accelerates. Furthermore, Fed officials Bullard and Plosser have stated that quantitative easing (QE) measures could end at 7%. Either way, we think the Fed continues to stimulate equity prices, but if unemployment drops more quickly than expected, the Fed is likely to begin to withdraw its more extraordinary stimulus measures sooner than the market currently anticipates.
Fiscal policy is poised to be the major headwind as we look ahead, however. Higher taxes, lower federal spending, fewer economic incentives for business, and the upcoming debt ceiling debate collectively represent the greatest risk to our outlook. As recently reported by the New York Times, upper income earners now face the heaviest tax burden in more than 30 years. The debt ceiling debate promises to be highly contentious and, according to ISI Research, spending cuts are highly unlikely to produce the longer-term savings necessary to keep credit rating agencies from further downgrading U.S. debt. If there is one concern that should keep investors up at night, it is the chaos and policies currently emanating from our capitol.
There is a profound and lingering nervousness among businesses, consumers, and investors hanging over this recovery. That is not uncommon following a major financial crisis, especially one resulting in massive credit deleveraging. Fortunately, stocks have thus far successfully climbed the wall of worry. With China averting a hard landing and European tail risks diminishing, we see investors facing fewer global macro concerns in 2013 than in 2012. This should be positive for fundamental stock pickers, as investor focus shifts away from the macro and toward the micro.
A significant improvement in CEO confidence would have an especially positive impact on equity markets and the economy. One possible outcome would be improved merger and acquisition (M&A) activity. M&A activity was reasonably healthy in 2012 (best since 2007), but remains constrained by a lack of CEO confidence to invest in future growth. From our perspective, with record levels of corporate cash on balance sheets and depressed secular growth, even a modest improvement in confidence could result in a surge in M&A activity.
Continued improvement in housing and unemployment are wildcards that have received a lot of attention and could provide upside support in 2013. We believe the biggest potential catalyst for stocks in 2013, however, is a true wildcard—a rout of the government bond market. The bubble in government bonds is so massive that a significant rise in rates has the potential to spark a massive outflow of liquidity into stocks, blowing away any otherwise rational equity valuation or forecast model. We are not predicting this to happen, but the potential is very real.
River Road Asset Management
16 January 2013
As of December 31, 2012, Ensign Group comprised 1.51% of the portfolio’s assets, Big Lots – 3.15%, Ascena Retail Group – 2.22%, Endeavor International – 0.18%, Energen – 1.11%, The Dolan Company – 0.00%, Ingram Micro – 0.59%, Geo Group – 3.96%, Insperity – 1.86%, Madison Square Garden – 2.97%, Equifax – 0.55%, Layne Christianson – 0.71%, Kelly Services – 0.50%, and WMS Industries – 0.85%.
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.