1st Quarter 2013
Stocks soared during the first quarter of 2013 as investors cheered the resolution of the fiscal cliff, positive momentum in the housing sector, and the enormous liquidity that continued to flow from the U.S. Federal Reserve and other global central banks. The rally elevated most of the major U.S. equity indices to new, all-time highs, including the Dow Jones Industrial Average, the Russell 2000 and, on the final trading day of the quarter, the S&P 500. All this despite seemingly stretched valuations, higher taxes, the government sequester, weak European economic data, and (most surprisingly) the banking crisis emanating from Cyprus—an event that almost certainly would have rattled markets just 12 months ago. The only laggard was the NASDAQ composite, which remained about 35% below its 2000 tech bubble peak.
Small-cap stocks led large-caps for the second consecutive quarter, with the small-cap Russell 2000 returning 12.4% versus 10.6% for the large-cap oriented S&P 500. The best performing size segment, however, was once again mid-caps, with the Russell Midcap index gaining 13.0%. Style performance across market-caps was mixed, as value outperformed among large- and mid-cap stocks but lagged among small-caps. The Fund’ s Russell 2000 Value Index benchmark returned 11.6% versus 13.2% for the Russell 2000 Growth Index.
Given the strong rally, it was surprising that low-beta (volatility) stocks outperformed high-beta among the small-cap stocks within the benchmark. This might imply that while investors still have an appetite for risk assets, they are trying to dial down the relative level of risk they are taking. If this is the case, it might further imply that equity markets are due for a pause, if not a more significant correction.
Supporting this position, high-quality stocks also continued their multi-quarter outperformance streak. Stocks in the first quintile for highest return-on-equity (ROE) in the Russell 2000 Value bested the stocks with the lowest ROE by a healthy margin. As discussed in detail last quarter (and in prior commentaries over the years), low-beta and high-quality leadership factors typically benefit the portfolio’s low volatility style of investing.
Mid-Stage of the Market Cycle
The Fund kept pace amid the quarter’s strong rally in modestly outperforming its benchmark. As we have noted in the past, the most challenging phase of the market cycle for our style is the early stage when investors are aggressively accumulating risk. This is the stage when high-beta/low-quality stocks tend to lead. Two years ago, we wrote that the early stage of this cycle had finally ended in February 2011 and the mid-stage had begun, which should have a positive impact on the portfolio’s relative returns.
Since that time, the Fund has performed well, despite a headwind created by strong real estate investment trust (REIT) performance. The largest underperforming sector in the portfolio during that period was Financials, more specifically REITs. Our strategy does not invest in REITs, as we take an institutional approach that treats real estate as a separate asset class. Historically, this has not had a material impact on intermediate to longer-term returns. During the past two years, however, investors have bid up income generating investments such as REITs. Thus, the impact of not investing in REITs has been material.
REITs may not reverse their upward trend in the near-term with interest rates expected to remain low. Still, we think REITs are trading at historically high valuations. When the Fed does begin to signal a change in policy, REITs could dramatically reverse, counteracting the headwind faced the last couple of years.
(Note: River Road excluded GEO Group from this analysis of REIT performance, as GEO only converted to a REIT effective January 1, 2013. Occasionally, a holding will convert to REIT status after we have initiated a position. This is typically positive, as REITs receive a relatively high multiple on their earnings. Such was the case with GEO, the Fund’s top performing holding the past two quarters. While we do not buy REITs, we do not feel compelled to sell immediately if a stock converts to REIT status, preferring instead to sell after the stock’s price has closed the valuation gap. This is what has occurred with GEO.)
Tech and Consumer Discretionary Boost
Technology and Consumer Discretionary were the two sectors with the highest contribution to relative performance during the first quarter. Tech holdings benefited from strong stock selection, while both an overweight allocation and stock selection helped within Consumer Discretionary.
As noted above, the top individual performer was Geo Group. The second largest provider of outsourced prison services in the United States, Geo converted into a REIT and management announced that it would refinance the company’s credit facility during the first half of 2013, allowing the company to increase its current dividend. The stock attracted increased investor attention, gaining inclusion into more REIT indices. As the portfolio’s largest holding at the beginning of the quarter, we cut the position in half as it approached our calculated Absolute Value.
Madison Square Garden and Big Lots were the standouts within Consumer Discretionary. MSG is the owner of the eponymous sports facility and of the New York Knicks, hockey’s New York Rangers, and an affiliated regional sports network. The year started on a positive note when the National Hockey League (NHL) reached an agreement with the players’ union ending a four-month lockout. Later, MSG surprised investors with better-than-expected quarterly results, as higher affiliate and advertising revenue drove strong cash flow growth. We significantly trimmed the portfolio’s position as shares traded near our Absolute Value. Closeout retailer Big Lots rallied in January on a strong earnings report and rumors that private equity may be looking again at potentially acquiring the firm. The balance sheet also improved as the company used free cash flow to pay down debt.
Although the Fund does not typically invest in “high tech” companies, we commonly invest in “lower tech” companies. DST Systems, a top-five contributor during the quarter, is a good example of the type of tech companies in which we like to invest. It is the largest third-party provider of mutual fund shareholder accounting services. These outsourced back office services offer strong margins, long-term contracts, and high switching costs. The company reported robust organic revenue growth with meaningful margin expansion during the period. While still a high-conviction holding, we trimmed the position as the risk/reward profile became less favorable given the stock’s recent appreciation.
The only sector with a negative contribution to relative returns during the quarter was Industrials, which suffered from poor stock selection. The primary detractor within that sector, and the broader portfolio, was human resources firm Insperity. The company reported strong fourth quarter results, but the stock sold off on lowered earnings guidance for 2013. Management noted that new business additions will not offset the higher attrition of large accounts and less hiring within its customer base. Insperity had expanded its sales staff in anticipation of new business associated with increased regulations for small-medium business owners. With an overall gain in the portfolio’s position, we took advantage of the price weakness to add to the holding.
Another poor performing Industrials name was Layne Christensen, the world’s largest driller of water wells. The company preannounced losses in its Heavy Civil segment. This was not a surprise since the company has been working through unprofitable legacy contracts priced by the previous management team. The current management team noted that the backlog of Heavy Civil was improving for fiscal year 2014. We took advantage of the price weakness to increase the Fund’s position closer to our target weight.
Mining stock Pan American Silver reported fourth quarter results that were in-line with expectations, but from early February through the end of the quarter the price of silver declined substantially. Although we expect the company will remain sensitive to changes in silver prices, we think there is a significant discount between the value of the company’s proven reserves and the current spot prices for silver. We initiated a position in the portfolio in January in the belief this gap would close over time.
The Fund purchased 11 new holdings and sold 15 during the quarter. This high level of activity followed a year of unusually low turnover in the portfolio, owing primarily to the large number of companies that achieved their price target during the quarter. Thirteen holdings achieved our Absolute Value price targets, including two from strategic takeovers. We liquidated only two holdings due to declining fundamentals or accumulated losses.
A positive catalyst for the market (and the portfolio) has been acquisitions and share buybacks. The market experienced a material upswing in merger & acquisition (M&A) activity beginning towards the end of last year and extending into the first quarter. The portfolio experienced takeover bids at Alterra Capital Holdings and WMS Industries, as well as a major asset sale by Atlantic Tele-Network that was similar to an acquisition. Heightened M&A activity has historically been a positive catalyst for portfolio performance and the recent pick-up appears to be consistent with that trend.
New positions in the Fund were diversified across industry groups and continued to trend toward smaller market-caps, where we are finding valuations most attractive. The biggest challenge during the quarter was establishing a full position before the rising market lifted share prices beyond what we were willing to pay. An example of this was pay-TV network Starz Liberty Capital.
Starz spun-off from John Malone’s Liberty Media in January 2013 at a substantial discount relative to industry peers, especially given that the firm’s networks—Starz and Encore—are the second most-watched premium duo in the United States (behind HBO). Wall Street sell-side analysts initiated coverage of the stock with an almost unanimous negative opinion on concerns about Starz’s ability to renew licensing agreements and the firm’s lack of original content. That issue was addressed in February when the company successfully extended its contract with Sony Pictures for an additional five years (through 2021) at similar terms. Regarding content, CEO Chris Albrecht brings an impressive record of developing original content from his previous tenure as CEO at HBO. We think he will have time to expand the firm’s library of original content beyond its initial hit show Spartacus. By quarter end, the market awarded the stock a multiple closer to those of other premium networks and we trimmed the position as it approached our Absolute Value.
We strategically reduced 13 positions in all, most of which were related to price appreciation. We also strategically increased positions in 27 existing holdings, among these the largest increases were in Tower Group and Cloud Peak Energy. We stated last quarter that we have been comfortable with the Fund’s positions and sector weights (excluding Financials) over the past two years and, looking into 2013, did not foresee any major shifts in allocation. This remains the case.
The downside of the recent equity rally is that we think it has pushed valuations to an extreme level. At the end of 2012, we calculated the portfolio’s discount-to-Absolute Value as 79%, indicating room for modest upside. Not more than three months later it was trading at 85%—a new, all-time high and well above its historical peak of 83%! This is a cautionary signal to investors, though we continue to find new ideas trading at attractive prices (which is unusual in a period of extremely high valuations). Unfortunately, many of these opportunities have proven difficult to buy due to limited liquidity and/or stock prices that are rapidly moving higher. Portfolio growth and valuation metrics also continue to look attractive relative to respective benchmark metrics and the multiples we are using for the top 20 holdings are well below historical peak—both positive indicators for future relative performance.
The challenge with valuation is that while small-cap stocks are clearly priced at a premium, so is nearly every other asset class. Unlike 2006, which was a consumer-driven equity bubble, the current market appears to reflect an overall liquidity bubble. This presents a unique asset allocation challenge for investors.
From our perspective, the market is due for a correction. In the absence of a major negative catalyst, and as long as the Fed and European Central Bank (ECB) remain supportive, we think any correction should be reasonably modest in depth and duration. Although we expect small-cap earnings growth expectations to contract in the months ahead, we believe positive momentum in the housing, employment, and financial markets will help to maintain a reasonable level of growth—at least for the next few quarters. In additional, M&A activity is at a healthy level and there is ample investor cash waiting for a more attractive entry point into U.S. equities. That said, this rally and the overall profit cycle are beginning to look very mature. Thus, we are keeping expectations firmly in check.
River Road Asset Management
14 April 2013
As of March 31, 2013, Geo Group comprised 2.57% of the portfolio’s assets, Madison Square Garden – 1.73%, Big Lots – 3.25%, DST Systems – 3.18%, Insperity – 1.39%, Layne Christiansen – 0.53%, Pan American Silver – 1.08%, Alterra Capital – 0.00%, WMS Industries – 0.00%, Atlantic Tele-Network – 1.30%, Starz Liberty Capital – 0.76%, Tower Group – 1.46%, and Cloud Peak Energy – 1.13%.
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.