2nd Quarter 2013 Commentary - ASTON/River Road Independent Value Fund
2nd Quarter 2013
It was a volatile and somewhat confusing quarter for investors, with stocks ending the period higher despite a surge in interest rates.Stocks rose early in the quarter as investors saw tepid earnings growth and weak economic data as support for continued stimulus from the Federal Reserve. The fireworks began on May 22 when a mix of cryptic (and seemingly conflicting) comments from Fed Chairman Ben Bernanke, taken in the context of just released Fed meeting minutes, spooked investors. Just hours after the broad market S&P 500 Index set a new all-time high, stocks dropped sharply and the interest rate on 10-year US Treasuries rose above 2.0%.
Markets drifted lower in the following weeks. The decline accelerated on June 19 when the Fed’s policy statement clearly indicated that the central bank might wind down its current bond-buying program (QE3) later this year and possibly end it by mid-2014. Interest rates spiked over the days that followed, with the 10-year rate peaking on June 25 at 2.59%—nearly a percentage point above its May 2 low of 1.63%. During the final days of the quarter, equities reversed yet again with the S&P 500 rising 2% and the small-cap oriented Russell 2000 Index nearly 3%, as various Fed officials made public statements aimed at calming the markets.
Rising volatility and widening credit spreads do not typically favor the relative performance of small-cap stocks. With both factors well below their long-term averages and small-cap earnings expected to grow faster than large-cap earnings, however, small-caps maintained their performance advantage. Small-caps outperformed large-cap stocks for the third consecutive quarter, with the Russell 2000 returning 3.08% versus 2.65% for the Russell 1000 and 2.91% for the S&P 500. Mid-cap stocks, persistent leaders despite what we see as relatively unattractive valuations, finally finished behind both large- and small-caps, with the Russell Midcap Index returning 2.21%. Interestingly, a large portion of the small-cap earnings advantage comes from the booming housing sector, which according to Bank of America/Merrill Lynch now represents more than 18% of small-cap earnings compared with just 5% for large-caps.
Precious Metal Miners Decline
The Fund lost ground during the quarter, underperforming its Russell 2000 Value Index benchmark. Equity performance continued to lag as we sell stocks with strong price momentum and rotate into out-of-favor areas of the small-cap market. Although our increasingly contrarian position has reduced our equity performance in the near-term, the average discount to value in the portfolio has increased.
Precious metals miners AuRico Gold and Pan American Silver were the two largest negative contributors during the quarter. Gold miners remained under pressure as gold prices declined 23% during the period. AuRico recently announced growth in reserves, an improved balance sheet, and an unchanged production forecast, but the stock declined meaningfully along with the gold mining sector. AuRico continued to trade at a discount to our valuation and we increased the Fund’s position as its price declined.
Pan American’s stock remained under pressure along with the rest of the mining industry even though the company announced production and cash cost results that were in-line with expectations. The 31% decline in silver prices during the second quarter weighed on its share price. We think that Pan American possesses one of the strongest balance sheets in the mining industry, and though we expect further industry volatility we maintained the portfolio’s position as it remained at a discount to our valuation.
Another poor performer was independent natural gas and oil company Contango Oil & Gas. Several items affected Contango shares during the quarter. First, its founder and former Chairman, Kenneth Peak, passed away in April. Second, Contango announced its intention to merge with Crimson Exploration, increasing the uncertainty surrounding the strategic direction of the company. Lastly, the company reported a decline in production and higher operating expenses because of a well shut-in. The affected well resumed production in June, and we expect production from this well to contribute positively to operating results in the second half of 2013.
Grocery Stores Outperform
Among the Fund’s top contributors for the quarter were two grocery store chains—Harris Teeter Supermarkets and Weis Markets. Harris Teeter announced strong second-quarter results with comparable sales and gross margins rebounding sequentially, and costs remaining flat as a percentage of sales. The firm continues to evaluate strategic alternatives in regards to a proposed sale of the company. In fact, reports late in the quarter suggest that a large private equity firm had submitted a bid. We reduced the position during the period as the stock price exceeded our valuation.
Weis Markets, a grocery store chain with 165 stores located primarily in Pennsylvania, generated record operating results in 2012 and continued this positive trend in its most recently reported quarter. Weis has a very strong balance sheet with a sizeable cash stake and no debt. Although we continue to like Weis Markets as a business, its stock price exceeded our valuation and we reduced the position.
The largest contributor to performance during the quarter, however, was natural gas producer WPX Energy. The stock benefited from the combination of appreciating natural gas prices and its attractively-valued, high-quality reserves. WPX also benefited from increased investor attention as it was recommended at an influential value investing conference in May. Lastly, the company revealed plans to increase its non-core asset sales, putting its holding in publicly traded Apco Oil and Gas International up for sale in addition to the previously announced Powder River Basin property.
Cash levels increased from 57% at the beginning of the quarter to 60% by the end. Cash levels remain high as most high-quality small cap stocks continue to be expensive, in our opinion. The average valuation metrics of our potential buy list remained elevated at quarter-end with a ratio of 23 times price to earnings and 1.8 times price to sales. We continue to focus on maintaining a portfolio of companies with strong balance sheets and limited financial risk. Throughout the quarter, we continued the rotation out of overvalued stocks and into stocks that we viewed as attractively priced, but out-of-favor. This shift in the portfolio has created a more contrarian posture.
The largest new position added during the quarter was Silver Standard Resources, the largest publicly traded miner in terms of in-ground silver resources. The firm’s sole operating mine is in Argentina, though most of the firm’s value exists in the reserves of its major undeveloped properties in Mexico, Peru, and its 19% ownership of the Brucejack gold deposit in British Columbia.
Another attractive feature is the company’s strong financial position, which will allow it to mostly self-finance projects at these undeveloped properties. Due to the firm’s favorable balance sheet and funding position, we view the opportunity to purchase its discounted reserve base with little to no future reliance on the capital markets as an attractive one. In addition, a strong liquidity position allows us to remain patient with this investment in the highly volatile and out-of-favor precious metal mining industry.
At quarter-end, the portfolio had a 7.5% weighting in precious metal mining companies. With the mining sector down 50% year-to-date through June and 60% the past year, we believe there is value in this extremely out-of-favor industry. We remain committed to only owning miners with very strong balance sheets. All three of our mining positions have meaningful assets relative to liabilities and possess more cash than debt. Given this balance sheet strength, we believe we can patiently wait for these companies to realize the value of their underlying assets. While the performance of the miners has hurt near-term performance, we continue to believe they sell at attractive discounts to net asset values and plan to continue to maintain the portfolio’s positions.
The operating environment for the majority of the small-cap businesses we follow did not change meaningfully during the quarter. While corporate profit growth is slowing, overall profits and margins remain healthy. Consumer businesses continue to report mixed results, with credit sensitive industries such as housing and autos showing noticeable growth. Meanwhile, retailers focusing on middle- to lower-income consumers are reporting a more challenging environment. Companies reporting weaker than expected results often mentioned cooler spring weather and delayed tax returns. Capital investment remains moderate, with most capital expenditures mirroring depreciation. The majority of management commentary and outlooks changed little from the previous quarter, with most companies expecting 2013 to be similar to 2012.
Since 1998, we have witnessed two and a half market cycles, including three bull markets and two bear markets. The terms bull and bear market are frequently used to indicate the predominant trends in stock prices within a market cycle. While many investors find the direction of prices useful, we prefer focusing on trends in corporate profits. Through our bottom-up analysis of hundreds of small-cap businesses, we believe we can measure the health and direction of the corporate profit cycle. Given that stock prices and profits are highly correlated, we find our observations on profits are often confirmed by trends in stock prices. However, this is not currently the case as we are witnessing a divergence between the stock prices and profit trends of the businesses we follow and analyze. The small-cap market, measured by the Russell 2000 Index, is up 18% over the last three quarters. Meanwhile, most of the businesses we follow are not reporting commensurate gains in profits. In fact, total seasonally-adjusted corporate profit growth was essentially flat from the fourth quarter of 2012 through the first quarter of 2013. Based on recent earnings reports and management commentary, we are expecting another quarter of anemic earnings growth. We believe sharply rising stock prices and slowing profit growth is noteworthy and could indicate that we may be approaching the later stages of this market and profit cycle.
Sharply rising asset prices are not unusual near the peak of profit cycles. During the technology bubble of the late-1990s, investors experienced a profit cycle that peaked with spectacular asset inflation. At that time, then-Federal Reserve Chairman Alan Greenspan spoke of the “productivity miracle” while the media and many others were expounding on the wonders of the “New Economy.” After the technology bubble ended and the economy fell into a recession, these terms were seldom heard again. The next profit cycle was aided by a private credit boom, which began in 2002 and ended in 2008. Near the later stages of this profit cycle, investors and policy makers attempted to justify the sustainability of excessive credit growth by finding comfort in its main source of collateral—residential housing. It was believed that the credit growth supporting the profit cycle could persist indefinitely based on the widely held assumption that home prices could never fall nationally. Indeed, Federal Reserve Chairman Ben Bernanke stated in 2005, “We’ve never had a decline in home prices on a nationwide basis.” National home prices eventually did decline, of course, and the economy fell into a deep recession in 2008.
The current profit cycle was born in early 2009. Major drivers of today’s cycle include historically low interest rates, government fiscal deficits, and unconventional monetary policy. Since 2008, the U.S. government has accumulated $5 trillion in fiscal deficits while the Federal Reserve’s balance sheet has expanded by $3 trillion! Given the level of fiscal and monetary stimulus, it is not surprising to see margins and corporate profits near record levels. Small-cap stocks have responded to higher profits, with the Russell 2000 Index up more than 200% from its March 2009 low. However, now in its fifth year (the average length of a profit cycle since 1970 is 5.8 years) the current profit cycle is showing signs of fatigue and its future is becoming increasingly uncertain. Nevertheless, equity investors remain committed to driving prices higher and are again taking comfort in popular phrases that convey today’s conventional wisdom.
With 0% interest rates on most risk-free short-term investments and yields on bonds insufficiently rewarding investors for risk, equities are often mentioned as “the only game in town.” During this quarter, the acronym TINA, which stands for There Is No Alternative (to U.S. stocks), became a popular expression among many market commentators. While we love owning high-quality equities, especially when being adequately compensated for the underlying risk, we disagree with “TINA” and believe equities are not the only viable alternative for investors. We suggest investors consider patience.
We believe patience is one of the most effective, yet most underutilized, options in investing. Patience allows investors to defer committing capital when investment options are unappealing and the chances of permanent loss of capital are elevated. Patience also provides investors with the necessary flexibility to act decisively once opportunity appears (often without notice). Despite its advantages, patience is not an option for every investor. Many professional investors have mandates that require them to be fully invested and are limited in the amount of cash they can hold. Furthermore, most managers are judged relative to a benchmark, which can increase the pressure to reduce tracking error and not veer too far from a particular benchmark. We believe the investment industry’s focus on relative performance directly and indirectly influences most managers’ investment decisions. In our opinion, the pressure of relative investing affects the ability of managers to practice patience, especially in sharply rising markets, as the fear of losing money is often replaced with the fear of underperforming a benchmark.
Although patience is not an option for every investor, we treasure our ability to practice patience and believe it is an invaluable component of our investment process. When we value a business via discounting future free cash flows, we use a specific required rate of return, or hurdle rate, that we demand for that particular business. The specific rate used depends on the risk of the business’ future free cash flows. A higher risk business will have a higher hurdle rate relative to a lower risk business. If appropriate returns relative to risk cannot be met, we do not invest and will hold cash as we search for better opportunities. Throughout the profit cycle there are often periods of significant undervaluation and overvaluation within the small-cap market. When opportunities are abundant, we tend to be positioned more aggressively, and when prices and valuations are extended, we typically appear more defensive. Currently, few small-cap investments are meeting our hurdle rate requirements, and as a result, the portfolio’s position in patience (cash) reached an all-time high during the quarter.
In conclusion, our views and positioning have changed little since last quarter. We remain disciplined and are willing to maintain current positioning until future opportunities justify change. We continue to adhere to a strict discipline of selling positions that exceed our valuations, and increasing positions in out-of-favor stocks that we believe are priced attractively. We remain reluctant to assume financial risk and believe the Fund’s holdings, on average, have exceptionally strong balance sheets. As a result, we feel the portfolio is well-positioned for rising interest rates or a tighter credit environment. Given the high cash level and contrarian positioning, we expect performance to continue to deviate from our peers and small-cap benchmarks. However, we feel this positioning is appropriate given the current investment environment and prices investors are demanding for most small-cap equities. As the current profit cycle matures and we near the completion of the third market cycle since 1998, we anticipate opportunities will resurface. We intend to remain committed to two of the most important principles of our value investing approach—patience and not overpaying.
River Road Asset Management
As of June 30, 2013, AuRico Gold comprised 3.10% of the portfolio's assets, Pan American Silver – 2.63%, Contango Oil & Gas – 0.89%, Harris Teeter Supermarkets – 1.41%, Weis Markets – 0.66%, WPX Energy – 4.36%, Silver Standard Resources – 1.83%.
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.