By Eric Cinnamond, Portfolio Manager for the ASTON/River Road Independent Value Fund
In our view, extrapolation risk is one of the most important forms of risk to consider when investing. However, it is an issue seldom discussed by the investment community and academia. In fact, it is difficult to even 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. 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 method of analysis employed 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 recent 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 first quarter of 2013 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 in the ASTON/River Road Independent Value Fund (ARIVX), 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 aim to 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 purchases during the first quarter were in industries where we believe investors are extrapolating near-term trends too far into the future. For example, the portfolio’s largest holding at the end of the quarter was a leading U.S. natural gas producer. We believed it was a high-quality exploration and production business selling at an attractive price relative to the replacement value of its natural gas assets. The stock significantly underperformed the broad market for the year prior to our purchase, declining 11%. Investors 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. Higher demand and slowing production growth significantly reduced the inventory surplus during the past year, improving the fundamentals of the natural gas industry considerably.
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 our goal of minimizing downside portfolio risk during periods of excessive valuation and remain flexible in order to act decisively once volatility and opportunity returns.
Most of the information contained in this article first appeared as part of the First Quarter 2013 Commentary for the ASTON/River Road Independent Value Fund and is provided by River Road Asset Management (“River Road”), a subadviser utilized by Aston Asset Management, LP (“Aston”). River Road is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and River Road’s views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends, and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results.
Note: The Fund invests in small- and mid-cap stocks which 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. There are no guarantees that a strategy will be profitable or produce the desired results.
Before investing, carefully consider the Fund’s investment objectives, risks, charges and expenses. Contact (800) 992-8151 for a prospectus or a summary prospectus containing this and other information. Read it carefully.
Aston Funds are distributed by Foreside Funds Distributors LLC.