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 small-cap Russell 2000 and, on the final trading day of the quarter, the S&P 500. Investors shrugged off more turmoil in Southern Europe and remained focused on accommodative central banks and steady improvement in the U.S. economy. One gauge of how consistent the rise was during the first quarter was that the CBOE Market Volatility Index (the “VIX”), a measure of the volatility of S&P 500, dropped 30%.
Alternative strategies in general did not keep pace with the double-digit returns of the stock market during the quarter, and this was the case with the Fund relative to its long-only Russell 3000 Index benchmark. This is understandable given that most alternative portfolios are hedged. The Fund did outperform a majority of its long-short peers. We were pleased it captured 62% of the benchmark’s impressive gain with only an average of 50% net long equity exposure, aided by strong security selection in both the long and short portions of the portfolio.
Strong Long Performance
Holdings in the long portfolio outperformed the benchmark by a solid margin. The market rewarded defensive and predictable businesses during the quarter as the bulk of the long portfolio’s top contributors came from the Consumer Staples and Utilities sectors, as well as the media industry.
The top-three long positions featured a take-out, a spin-off, and a “cannibal” (i.e. Berkshire Hathaway Vice-Chairman Charlie Munger’s term for a company that buys back significant stock). Slot machine and video game terminal manufacturer and distributor WMS Industries suffered from a stagnant replacement cycle and regulatory product delays that punished the stock throughout 2012. It had the best balance sheet among its peers to withstand any future industry weakness, though, and we thought the company had a attractive pipeline for 2013. Scientific Games also thought the shares attractive and announced that it was purchasing WMS in January 2013 at a 59% premium to the previous day’s closing price.
The spin-off was Starz Liberty Capital, which split 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.
Cable network operator Viacom owns six of the top-25 cable networks based on subscribers, and its Nickelodeon channel has remained the dominant force in children’s programming for more than 30 years. Weak ratings for its primary channels had weighed on the stock price, but management is addressing the ratings rough patch with new talent and programming and the depressed stock price with massive share buybacks.
Holdings in the short portfolio underperformed the benchmark overall during the quarter, aiding performance. The most reliable method for generating profits on the short side was dividend cuts. Given artificially low interest rates, we believe investors are bidding up some dividend-paying stocks primarily for their yield. Three of the top-four positive short positions in the portfolio cut their dividends resulting in significantly declines in their stock prices.
The bulk of the individual holdings with the lowest contribution to returns during the quarter were short positions, while commodity-related stocks hurt on the long side. Although our fundamental thesis remained intact for each of the portfolio’s three biggest losers—Albany International, Best Buy, and R.R. Donnelley & Sons—all three short positions traded higher amid the general euphoria for equities during the quarter.
Paper industry supplier Albany International surprised us by trading significantly higher during the quarter in reaching close to an average market multiple (on earnings) for its stock. The market shrugged off its lackluster fourth quarter results in trading higher. The firm’s revenues have shrunk steadily along with the printing industry the past six years, and it suffers from an underfunded pension and other post-retirement benefits that total more than 14% of its market-cap. We trimmed the position five times throughout February and March, well below our stop-loss target price. This is an example of why we are comfortable with seemingly wide initial stop-loss prices, as our other risk controls typically kick in before severe losses can mount.
Electronics retailer Best Buy also bucked what we considered deteriorating fundamentals in trading higher. The firm’s stores have become showrooms for online competitors as same-store sales have fallen in four of the past five years. Mass merchants, warehouse clubs, and online retailers have consistently undercut Best Buy on pricing, capturing market share. We are skeptical that management’s efforts to return an increasing amount of capital to shareholders is sustainable. We thought founder Dick Schulze’s inability to secure financing for a leveraged buyout in early March was a positive for the Fund’s short position. We were wrong as the market chose instead to focus on new CEO Hubert Joly’s “Renew Blue” plan, which is an attempt to improve bottom-line results by matching online prices, shrinking the store size, and cutting costs.
We think Mr. Joly’s background is impressive, but we also think his $20 million compensation package is excessive. Similar to other struggling retailer turnaround stories (e.g. Sears, J.C. Penney), we think our long-term short thesis remains intact. As famed investor Warren Buffett instructed in his 1989 shareholder letter, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” The Fund “stopped” out (sold the position when it hit our stop-loss target) of its Best Buy short position during the quarter, but we will reassess the situation in three months when the stock returns from our cooling off list and re-joins our short watch list.
More than 60% of R.R. Donnelley’s revenue is attributable to end markets that are either not growing or steadily shrinking—magazines, catalogs, retail inserts, books, directories, forms, labels, etc. Donnelley also destroys capital, having recognized more than $4 billion of restructuring and impairment charges over the last five years. Its fourth quarter results beat expectations, however, sparking a sharp rise in the stock. We think that Donnelley is a crowded short, which makes it particularly volatile around earnings reports and other newsworthy events. We understand this dynamic and strive not to allow it to shake us out of solid short positions. Employing our unrealized loss sell discipline, we chose to make two small trims in the position during the latter part of the quarter.
In summary, glimmers of hope in each short position—an unprofitable segment is improving at Albany, a new CEO has big plans at Best Buy, and Donnelley reported less-bad-than-expected results—resulted in losses for the portfolio. Our risk controls required action for each loser, but we only eliminated one of the three positions and simply trimmed the other two positions. We designed these risk controls to reduce exposure to losing short positions, but not to eliminate indiscriminately carefully researched shorts where the fundamental thesis remains intact.
Our discount-to-Absolute Value indicator for the portfolio crossed into “extremely overvalued” territory during the first quarter. Not only does the indicator, which measures the weighted average discount-to-Absolute Value of our top-20 long holdings, aid us in positioning the total portfolio for a correction and/or bear market, it also helps us keep the long portfolio fresh. For example, as the indicator signaled “extremely overvalued”, we trimmed back more expensive long positions and cheaper long positions moved into the top-20 holdings. This process brought our indicator back down, ending the quarter at a greater discount to our aggregate Absolute Value.
The Fund ended the quarter with a net long equity exposure of 48%. With only half of the portfolio exposed to the market, we believe it is positioned for a move in either direction by the market. If the market declines, we will happily put some cash to work and accept more market risk in exchange for higher expected returns. Cash typically accumulates on the long side of the portfolio in rapidly rising markets, as we reduce winning positions and often struggle to find attractive new long holdings, while risk controls prevent the short portfolio from getting too large. The Fund ended the quarter with a sizeable cash position. The cash stake is not a top-down allocation but a residual of our process. If the market continues its ascent in the second quarter, the cash position will likely grow larger and the portfolio will become more prepared for a market correction.
If the market continues to rise, we think that the Fund’s long portfolio of superior companies with predictable and sustainable cash flows will continue to shine. We will invest in companies that do not produce predictable results, but we cannot develop the same fundamental conviction in them and tend to limit these two groups—commodities and retail stocks—to just 15% each of the total portfolio. Roughly 20% of the portfolio was invested in these types of stocks as of quarter end. Of the two groups, we have found the most value in various commodity companies, including coal, natural gas, oil, potash, and precious metals. Each position owns a unique asset and has a solid balance sheet.
Almost 40% of the short portfolio was concentrated in retailing and housing/real estate positions. We are not pairs-traders, but we do not mind that nearly 60% of the portfolio’s long retailing position is hedged with retailing short positions. We re-introduced several housing-related short positions during the quarter. Fortunately, our risk controls forced the elimination of several housing-related short positions early in 2012 that went on to advance much further. Housing companies have not earned their cost of capital over a full cycle. We think some investors are valuing housing-related companies as if another 2005 to 2007 housing boom is right around the corner. As several housing-related shorts lost their momentum, we added them to the short portfolio.
History suggests that a relentless rise in the stock market can induce complacency and make shorting seem pointless. The original class of hedge fund managers allowed their market exposures to rise (and not hedge!) along with the “go-go” markets of the 1960s, only to crash and burn during the early 1970s. Between the close of 1968 and September 30, 1970, the 28 largest hedge funds lost two-thirds of their capital and most of the remaining hedge funds were wiped out in the 1973-1974 bear market. We see signs that investors may again be becoming too cavalier in regards to risk. During the first quarter, margin debt expanded back to 2007 levels while short interest retreated to five-year lows.
We designed this long-short strategy to participate in rising markets, but not recklessly so. We have no interest in fighting the Fed or the tape. Our typical net market exposure range of 50% to 70% is higher than many traditional hedge funds. Once prices advance to a level that does not make sense to us (i.e. more than 80% on our discount-to-Absolute Value indicator), however, we transition our focus from participation to capital preservation. We see multiple red flags that confirm and support our anxiety over current market valuations, including aggressive consensus profit expectations and heavy insider selling. If the market continues its advance, we will not be lured into complacency and are prepared to live through a period of uncomfortable defensiveness. With nearly a quarter of the portfolio residing in cash, we will remain patient and wait for our favorite businesses to become more attractively priced.
River Road Asset Management
14 April 2013
As of March 31, 2013, WMS Industries comprised 0.00% of the portfolio's assets, Starz Liberty Capital – 0.00%, Viacom – 2.80%, Albany International – (1.16%), Best Buy – (0.00%), and R.R. Donnelley & Sons – (0.91%).
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.