2nd Quarter 2013
The Federal Reserve began to rein in the party during the second quarter and alternative strategies underperformed. The market continued its steady ascent from the first quarter until late May. Just hours after the broad market S&P 500 Index set a new all-time high on May 22, a combination of comments from Fed Chairman Ben Bernanke, taken in the context of just released Fed meeting minutes, spooked investors. Interest rates spiked sharply over the days that followed, with the 10-year Treasury bond peaking on June 25 at 2.59%—nearly a percentage point above its quarterly low of 1.63%. Stocks that were popular bond substitutes, REITs and Utilities in particular, came under pressure during the second half of the quarter. The decline accelerated on June 19 when the Fed’s policy statement clearly indicated that the central bank could begin to slow down its current bond-buying program (QE3) later this year and possibly end it entirely by mid-2014.
The Fund posted marginally positive returns during the quarter, but trailed its long-only Russell 3000 Index benchmark. The long portion of the portfolio performed well while the short portfolio struggled. We were disappointed with the individual short portfolio performance as it underperformed the benchmark by more than seven percentage points. We build a concentrated short portfolio of challenged business models, and both these factors were big contributors to the short portfolio’s poor quarterly performance, while crowded short positions also detracted from performance. We think a quick review of each may be helpful.
We believe a concentrated short portfolio provides the best opportunity to outperform over time. That said, concentrated investing requires larger position sizes, which can result in volatile quarterly performance. Although 42% of the Fund’s individual short positions contributed positively to return during the quarter, two of the its larger positions performed poorly as a result of merger and acquisition (M&A) activity. A large conglomerate paid an above-average multiple for one of our short positions to bolster its position in a particular industry and another short position rallied after announcing “strategic alternatives.” These two shorts accounted for 25% of the individual short portfolio losses.
We think shorting a portfolio of challenged business models should lead to long-term outperformance. Over long periods, investors should earn close to what a business earns. Like “melting ice cubes,” we think stock prices should follow floundering businesses down over time. Over short periods, like this quarter, the market may choose to focus on something other than the quality of the underlying businesses.
Crowded shorts (when a sizeable portion of public shares are sold short) have historically outperformed the market as short sellers faced little competition. With the massive growth of the hedge fund industry now looking at the same short opportunities, we wonder if this historical relationship will weaken. The portfolio’s crowded short positions did not work this quarter, and we speculate that it was a large negative contributor for the broader long-short equity universe. The average return of the underlying stock of the portfolio’s crowded individual shorts was 20% versus just 7% for average non-crowded individual shorts. Company takeovers (both actual and rumored) plus crowded shorts accounted for almost 50% of the individual short portfolio’s losses.
Commodity stocks weighed on the long portfolio’s performance during the quarter. Four of the top-five negative contributors for the long portfolio were smaller commodity positions. These stocks were down nearly 13% on average, and we trimmed them by more than a quarter, with commodity hedges in the short portfolio offsetting some of the damage.
Mining equipment manufacturer Joy Global and silver miner Pan American were among the commodity-related laggards. Joy Global drifted lower along with coal (-5%), natural gas (-11%), and copper (-11%) prices, as well as a lower earnings outlook. We trimmed the position as it represented the portfolio’s largest unrealized loser, but did not eliminate it as we prefer to look past the current uncertainty and focus on the longer-term fundamentals. As long as coal remains a critical part of the world’s electricity demand, we think the company will prosper and remain an attractive takeout target for strategic buyers. Given that coal (not oil or natural gas) was the fastest growing fossil fuel in 2012, we have chosen to give the position more time to work out. Investors abandoned precious metal mining stocks like Pan American as underlying commodity prices declined (the price of silver dropped -31% during the quarter). We avoided a deeper decline by selling the position as one of the portfolio’s largest unrealized losers.
The largest individual detractor to returns during the quarter, however, was a short position in luxury retailer Saks. The firm generates more than 20% of its sales from its New York City flagship store and the brand has historically not resonated nationally, limiting both growth prospects and operational leverage opportunities. The stock rallied and hit our stop-loss after hiring Goldman Sachs to explore “strategic alternatives,” including a potential sale of the company. Fortunately, we had limited the position because it was a crowded short (more than 20% of its float sold short) and knew that it had takeover risk. We understand that a well-known brand with interesting real-estate assets could appeal to the right buyer, but we do not think there is enough value to offset a poor record of sluggish growth and low profitability.
Fine Young Cannibals
Since the financial crisis, investors have rewarded companies that return cash to shareholders. Investors have bid up high dividend-yielding stocks to the highest valuations in almost a century, while “cannibals” (noted investor Charlie Munger’s term for a company that buys back significant stock) also outperformed. The Fund’s cannibals were big contributors to the long portfolio’s outperformance during the quarter. The top-five long contributors repurchased almost 7% of their outstanding shares during the past year. Most importantly, these companies reduced their share counts at what we consider attractive prices.
The holdings with the highest contribution to returns during the quarter were long positions in General Motors, DirecTV Group, and ScanSource. The “old” (pre-bankruptcy) GM broke even at trend automobile demand, earned a profit at the peak, and burned through massive sums of cash at the trough. Having dramatically reduced debt and labor costs through bankruptcy, the “new” GM emerged as a more efficient global competitor that should be profitable at the bottom of the demand cycle in its core North American market. GM benefited during the quarter from a steady stream of positive news, including it rejoining the S&P 500 Index after a four-year absence and that its transition to core platforms, which helps reduce fixed costs, is progressing faster than expected. Finally, J.D. Power & Associates ranked GM as the #1 global auto maker for quality for the first time since the survey began nearly three decades ago.
Satellite television provider DirecTV highlighted both its capital allocation and operational skills during the quarter. After much speculation, the market was relieved that it showed capital discipline and walked away from overpaying for Brazilian telecom GVT. The company instead directed its free cash flow towards repurchasing 4.5% of its stock, which completed 40% of its recently authorized buyback plan in one quarter. Operationally, the company grew its subscriber base and margins in both its U.S. and Latin American segments.
ScanSource, distributor of point-of-sale, barcode, and communications equipment, represents an “off-the-beaten-path,” well-run distributor that rarely gains Wall Street’s attention or trades below its book value. Issues implementing a new company-wide software system and an uninterested market pushed the stock down to its book value for the first time since the 2008/2009 economic crisis and only the second time in the last decade. Fortunately, thanks to having an actionable watch list, we were ready to invest for the one week it traded at these levels during the quarter.
We did have some success on the short side during the quarter. The Fund’s short winners were concentrated in the Utilities and Financials sectors, specifically the real estate investment trusts (REITs) and housing industries within the latter. As 10-year Treasury yields increased, investors finally gave dividend-paying stocks a breather. According to Bank of America/ Merrill Lynch, dividend growers underperformed the overall market. We believe high dividend-yielding stocks remain overvalued.
One of the primary drivers we use to reduce portfolio volatility is net long equity exposure. Our discount-to-Absolute Value indicator spent part of the quarter above 80%, which represented “extreme overvaluation,” and triggered our proactive approach to net market exposure management. As a result, the Fund’s net long equity exposure averaged just 49% during the period, just below our 50% to 70% normal range. With less than half exposure to the market, we considered portfolio volatility contained.
One of the reasons we are comfortable running concentrated long and short portfolios is that we have established a robust set of risk controls. We understand that stock selection will at times be out of step with the market, as it was on the short side for the portfolio this quarter. Our risk controls aim to minimize these inevitable mistakes. To contain volatility and minimize losses, we rely on thorough fundamental research up-front, do not average down once we have established a target position, set stop-losses, and systematically reduce unrealized losses both at the portfolio level and in individual short positions that develop high momentum. We utilized each of these risk controls to help contain the negative impact of poor stock selection during the period.
The largest new position added during the quarter was a long position in FedEx. Known for its overnight delivery, the company’s Ground segment represents a hidden gem inside the $32 billion transportation company. Fedex has consistently taken share from United Parcel Service (UPS) and others to build the Ground segment into its most valuable business. It relies on an independent contractor model and a distinct network to beat UPS on delivery times in nearly 30% of all shipping lanes while matching them in most others. The results have been impressive. Doubling of its market share the last decade to nearly 30%.
The market obsesses over Fedex’s high-profile, cyclical, and currently low-margin Express segment. We think we paid little, if anything, for this business while its global network of planes, drop boxes, sorting sites, and rights to fly create an almost insurmountable barrier to entry. Management announced a restructuring plan for the segment that should result in significant cost savings by May 2016. Overall, we are pleased that the company has wisely directed its free cash flow to growing its Ground segment and raising the dividend.
Opportunity and Patience
On the last day of the quarter, Federal Reserve President Jeffrey M. Lacker explained, “As market participants gain additional insight from the words of Federal Reserve officials or by policy actions in coming quarters, further asset price volatility seems likely.” We hope that Mr. Lacker is correct. As value investors, we see volatility as an opportunity to buy attractive businesses at inexpensive prices and short challenged businesses at overvalued prices. We take comfort that we partner with management teams that are smart capital allocators on the long side. We think increased asset volatility in a low-return world represents excellent conditions for top capital allocators to operate. Conversely, we believe many of the short positions in the portfolio pursue capital allocation policies that will be detrimental for long-term shareholders. Some cannot afford their dividends, but refuse to cut them. Others employ leverage in cyclical or declining businesses. In each case, these companies seem focused on satisfying Wall Street or short-term “speculators” instead of long-term investors.
Similar to the top companies that we strive to own for the long portfolio, we seek to grow the Fund’s long-term value through skilled capital allocation (we outsource the operational expertise to the companies’ management teams). We think equity-like returns are best achieved with a framework built on patience, flexibility, and opportunism. If we cannot find attractive businesses to purchase at attractive prices, we are not compelled to buy for the sake of buying. We can let cash pile up. The Fund ended the quarter with 20% of the portfolio in cash. When we do find something interesting, however, we want the position to matter and that is why we run a concentrated portfolio.
We view investing as a scientific art. Strong stock selection is an art form. Passion, common sense, and “flare” (Gerald Loeb’s term for creativity from his 1937 book, Battle for Investment Survival) are needed to find undiscovered and off-the-beaten-path ideas that ultimately drive outperformance over the long-term. We think managing volatility and protecting capital is best achieved through a more scientific approach to contain the damage when the market is telling us our investment thesis is wrong or when the market is plummeting. The Fund ended the quarter with only 56% net long equity exposure, and we have been actively reducing losing positions the past three months to help contain volatility. We will utilize our Drawdown Plan to help protect capital if the portfolio starts to lose a material amount of money, as we understand the negative compounding consequences of deep drawdowns. As such, we feel the portfolio is well positioned to meet the goals of the Fund.
River Road Asset Management
As of June 30, 2013, Joy Global comprised 1.78% of the portfolio's assets, Pan American Silver – 0.00%, Saks – (0.00%), General Motors – 2.20%, DirecTV – 3.92%, ScanSource – 0.00%, and Fedex – 3.54%.
Note: Short sales may involve the risk that the Fund will incur a loss by subsequently buying a security at a higher price than 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.
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.