1st Quarter 2013
The Fund significantly underperformed its Russell 2000 Value Index during the first quarter of 2013. High cash levels, which averaged 56% during the period, contributed to the poor relative performance. The equity holdings within the portfolio also lagged the benchmark.
Pan American Silver, AuRico Gold, and Contango Oil & Gas were among the biggest detractors to performance, each posting negative returns for the quarter. Mining companies Pan American and AuRico both declined meaningfully as the broader mining industry remained under pressure. Pan American announced production and cash cost results that were in-line with expectations but a 7% decline in silver prices during the period weighed on the company’s shares. AuRico announced growth in reserves, a much improved balance sheet, and an unchanged production forecast, but suffered along with other gold mining shares. The company’s strong balance sheet has more cash than debt, and its stock trades at a discount to tangible book value. Although we expect volatility to continue in the mining sector, the portfolio continued to hold Pan American and added to the position in AuRico throughout the quarter.
Independent natural gas and oil company Contango performed poorly, announcing disappointing operating results mainly due to lower natural gas prices and expenses associated with two dry wells. We expect results to improve this quarter due to higher natural gas prices and lower exploration expenses. Contango continued to trade at a discount to our valuation, and we maintained the position in the portfolio.
FLIR Systems Boost
The largest positive contributor to performance during the quarter was FLIR Systems. The company is the leading provider of infrared technology, servicing both commercial and government markets. The company’s products detect infrared radiation and convert it into a video signal. Despite announcing a decline in 2012 revenue and earnings, the company forecasted higher revenues and earnings per share in 2013. As business trends improved, the stock responded favorably and approached our calculated valuation. We reduced the position due to the smaller discount-to-value.
Other notable contributors included Owens & Minor and Harris Teeter Supermarkets. Owen and Minor is the leading distributor of consumable medical and surgical supplies to acute-care facilities. While the firm is experiencing margin headwinds from hospital consolidation and group purchasing organization contract renewals, management successfully offset gross margin pressure by reducing overhead and rationalizing suppliers. We believe the firm’s consistent operating results and dividend yield add to its attractiveness, but reduced the Fund’s position after the stock reached our estimated fair value.
An increasingly promotional environment pressured gross margins during grocery chain Harris Teeter’s most recent quarter. Management, however, was successful in maintaining positive same-store sales through its pricing strategies. In February, the stock responded favorably to the firm’s announcement that two private equity companies had approached it expressing interest in purchasing the chain. There has since been speculation that several large national grocers have potentially entered the negotiations. We trimmed the position in the stock as its price reached our calculated valuation.
Cash levels increased from 51% at the beginning of the quarter to 57% by the end of March. Cash levels remain high as we continued to have difficulty finding a sufficient number of attractively priced small-cap stocks. The average valuation metrics of our potential buy list remained expensive as of quarter-end.
The largest new position added during the quarter was previously mentioned AuRico Gold.
The firm has two mines in production in the favorable mining jurisdictions of Canada and Mexico. It has also shifted from a frequent acquisitions and divestitures strategy toward optimizing the production and value of its current mining assets. Management views opportunities at its existing mines as more attractive than external opportunities.
Recent divestitures and an improving free cash flow profile enabled AuRico to strengthen its balance sheet, which ended the quarter with $150 million in net cash. With its new focus on increasing production at developed mines, the company is not expected to make acquisitions or need additional capital. Thus, we anticipate the company will continue to focus on free cash flow generation and the return of capital to shareholders. It announced its first quarterly dividend during the period.
Although mining is inherently a volatile business with clear operating risks, we believe we have taken these risks into consideration by using an above average discount rate in our free cash flow valuation calculation. Furthermore, we are comforted by AuRico’s strong balance sheet, return on internal capital focus, and determination to enhance shareholder returns with its growth in production and free cash flow.
Including the Fund’s position in Pan American Silver, the portfolio had a 6.4% weight in precious metal mining companies at quarter-end. With the mining sector down 20% year-to-date and 30% during the past year, we believe there is value in this out of favor industry. When analyzing mining companies, we focus on those that possess both strong balance sheets and developed mines that generate free cash flow. Because of these traits, we believe we can be patient with both positions and wait for the value of their underlying assets to be realized.
The operating environment for the majority of the small-cap businesses we follow did not meaningfully change during the quarter. Profits continue to be healthy with moderating year-over-year growth rates. Housing and auto related businesses continued to improve, though operating results of consumer-related businesses remain inconsistent overall. Domestic risks linger, such as rising gas prices, U.S. budget uncertainty, and higher taxes. Growing concerns surrounding the government sequestration affected defense spending. Volumes were mixed across the Transportation industry, with most companies reporting low single-digit growth. Several businesses claimed, without clear or consistent reasoning, that they expect improved results in the second half of 2013. The majority of management commentary was little changed from the previous quarter, and most companies expect 2013 to be similar to 2012.
In our recent quarterly commentaries, we have discussed the corporate profit cycle, its sustainability, and the natural cyclicality of individual businesses we consider in our valuation calculations. Our belief remains that profit cycles of businesses are non-linear and this cycle will not proceed on its current trajectory indefinitely. With corporate profits at record levels and margins elevated, we are committed to normalizing free cash flow for valuation purposes. While this valuation technique may appear overly conservative during profit booms and overly aggressive near troughs, it has served our strategy well during past cycles. By smoothing the extremes of the profit cycle, we believe we can determine business valuations more accurately versus extrapolating recent operating results far into the future.
We believe extrapolation risk is one of the most important forms of risk to consider when investing, but it is an issue seldom discussed by the investment community and academia. In fact, it is difficult to find a standard definition. We define extrapolation risk as the tendency of investors to forecast recent operating conditions and trends too far into the future. Incurring excessive extrapolation risk can lead to inaccurate valuations, poorly timed investment decisions, and permanent loss of capital. Although few in the industry frequently discuss extrapolation, it is a common form of investment risk and is incurred by most market participants throughout each profit cycle.
Investment analysts often extrapolate near-term results when forecasting future earnings. In 2007, near the previous profit cycle’s peak, analysts were expecting earnings per share for the broad market S&P 500 Index to be $100 in 2008 and $106 in 2009. Actual results were approximately 12% and 35% lower, respectively, with S&P 500 earnings per share declining to $68 near the end of 2009. Stocks responded negatively to the disappointing results, with many investors incurring significant losses. Based on current earnings expectations and record high equity prices, we believe analysts and investors are again assuming meaningful extrapolation risk. Earnings estimates for 2013 and 2014 not only assume current record profits will be maintained but that profit growth will accelerate. Specifically, analysts are expecting earnings of companies in the S&P 500 to increase 15% in 2013 and another 12% in 2014. Based on our analysis of a broad range of businesses and industries, we believe estimates of double-digit earnings growth over the next two years are difficult to justify. Therefore, we are avoiding making similar assumptions in our valuation calculations.
Similar to the equity markets, we believe extrapolation risk is clearly on display in the bond markets. According to Dow Jones, the junk bond market broke another record during the quarter with yields declining to 5.56%. In our opinion, given historical default rates, junk bond yields are not providing investors with a sufficient margin of error. Bloomberg recently noted that the long-term average global junk bond default rate is 4.7%, while the 12-month trailing default rate is 2.7%. Given current yields on junk bonds, we believe investors are extrapolating near-term default rates instead of relying on long-term averages. Memories seem to be short as it was only a few years ago in 2009 that junk bond default rates reached 10.2%! Due to the current record low interest-rate environment, we believe investors desperate for yield are ignoring historical default rates and are assuming the Federal Reserve, through its use of quantitative easing, can suppress bond yields indefinitely. We do not believe government intervention in the bond market is sustainable and are avoiding extrapolating current interest rates for valuation purposes.
In addition to equity and bond market participants, we believe the Federal Reserve frequently falls victim to extrapolation risk by assuming near-term economic and profit trends will persist for an extended period. During the previous profit boom, the Federal Reserve pointed to elevated profits in its forecast for continued economic expansion. The Federal Reserve’s August 2007 minutes state, “Participants expected that business investment would be supported by solid fundamentals, including high profits, strong business balance sheets, and moderate growth in output.” A few months later, the National Bureau of Economic Research declared that a recession officially began. More recently, during the semiannual monetary policy report to Congress in February 2013, Chairman Bernanke downplayed concerns about a potential equity bubble fueled by ultra-loose monetary policy by referencing elevated corporate profits. In March 2013, Chairman Bernanke again pointed to high profits when asked about record high stock prices. Chairman Bernanke stated, “I don't think it's all that surprising that the stock market would rise given that there has been increased optimism about the economy and the share of income going to profits has been very high.” We believe Chairman Bernanke’s comments on asset prices and profits suggest the Federal Reserve is again extrapolating the current economic and profit environment too far into the future.
We have a differing view. All-time high stock prices, analyst profit expectations, junk bond yields, and statements from the Federal Reserve all suggest record corporate profits will increase from current levels. We believe the profit cycle has reached a plateau, with the future direction of profits remaining uncertain. In fact, profit margins of larger companies are already showing signs of stress, with margin contraction contributing to the 2% decline in S&P 500 earnings per share during the fourth quarter of 2012. Margin contraction at the later stage of a profit cycle is not unusual. As profit cycles mature, businesses generating above average operating margins typically attract natural threats to profitability. Elevated margins often lead to scrutiny from competition, labor, government, suppliers, and customers. As cycles mature, the assumption that a non-recessionary environment will continue indefinitely is eventually challenged as the drivers of the expansion fail to sustain perpetual growth. We believe the natural cyclicality of the business cycle will ultimately prevail. We believe extrapolating profits at this stage of the cycle carries meaningful risk and should be avoided.
The tendency of investors to extrapolate influences the price of the small-cap equities we analyze, which affects our investment decisions. When small-cap prices are expensive, we often take a more contrarian stance by not only holding a large cash position, but also avoiding sectors that display above average levels of extrapolation risk. For example, we currently have limited exposure to the improving housing market and consumer discretionary stocks. While we acknowledge housing is improving and unemployment has declined, at current prices we do not believe investors in these sectors will be adequately compensated for the risk assumed. For instance, homebuilder stocks have returned 69% the past year, with some even selling above enterprise values (market cap plus debt) seen during the recent housing bubble. Although operating results are improving, valuations of homebuilder stocks suggest investors are extrapolating unrealistic earnings growth far into the future. Avoiding certain sectors displaying excessive extrapolation risk has hurt the Portfolio’s performance year-to-date, similar to prior speculative periods, but we believe our positioning will help reduce the risk of permanent capital loss and adverse performance in future periods.
As we avoid sectors of the small-cap market that we believe are pricing in overly optimistic future results, we are attracted to areas where investors appear too pessimistic. Several of the Fund’s recent purchases have been in industries where we believe investors are extrapolating near-term trends too far into the future. For example, the portfolio’s largest holding is WPX Energy, a leading domestic natural gas producer in the United States with sizeable natural gas reserves. We believe WPX Energy is a high-quality exploration and production business selling at an attractive price relative to the replacement value of its natural gas assets. Despite our favorable view of the company’s assets, its stock has significantly underperformed the broad market over the past year, declining 11%. Investors have punished the natural gas sector due to concerns over abundant natural gas supplies and depressed natural gas prices. Instead of extrapolating the large natural gas supply surplus and low prices of the past year, we attempt to normalize the historically volatile natural gas cycle. We believe depressed natural gas prices are already leading to a more favorable supply and demand balance. For example, demand has increased over the past year as electric utilities increase use of natural gas in place of coal. Furthermore, a sharp drop in rigs searching for natural gas has affected supply. Many of the natural gas producers we analyze are expecting production to decline 5% to 15% in 2013, which should further reduce supply. During the past year, higher demand and slowing production growth significantly reduced the inventory surplus. Although the fundamentals of the natural gas industry have improved considerably over the past year, many of the natural gas stocks we follow remain depressed and, in our opinion, represent a compelling opportunity.
As an investment manager, we have experienced similar periods of elevated profits and expensive valuations. Based on our experience, as the profit cycle matures and extrapolation risk increases, it is beneficial to position the portfolio in a more contrarian manner. We are following the same contrarian path in the current cycle, with a large cash position and an increasing weight in businesses we believe are undervalued and very out of favor. We do not believe extrapolating the current environment to justify record small-cap prices is appropriate, nor do we believe it will help us achieve our long-term absolute return goal. While we understand the potential opportunity costs associated with our contrarian positioning, we remain steadfast in our valuation discipline of only assuming risk when being adequately compensated. Furthermore, we remain committed to the diligent management of risk during periods of excessive valuation and remain flexible in order to act decisively once volatility and opportunity returns.
River Road Asset Management
12 April 2013
As of March 31, 2013, Pan American Silver comprised 3.44% of the portfolio's assets, AuRico Gold – 2.91%, Contango Oil & Gas – 1.00%, FLIR Systems – 2.29%, Owens & Minor – 2.02%, Harris Teeter Supermarkets – 2.29%, and WPX Energy – 4.05%.
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.