3rd Quarter 2013
Where are the Three Bears?
Last quarter we wrote about the Goldilocks factor, meaning market forces that seemed just right. After a fantastic third quarter and year-to-date thus far U.S. equities, should we worry about the three bears coming home to discover Goldilocks sleeping in their beds and eating their porridge? We think no, since we see a continued attractive environment for stocks. We do not believe the conditions exist to usher in a bear market for either U.S. equities or the U.S. economy. It appears that there is a balance of opposing forces—monetary policy and fiscal policy—that should keep prospects in the U.S. on an even keel. The major factors keeping that balance are:
1. An accommodative Federal Reserve policy—the most liquid on record. Interest rates are likely to remain low, with only brief periods of volatility.
2. Low to no inflation. Looking at the Commodity Research Bureau Index, it has risen less than 2% the past 5 years since hitting a recession trough.
3. Slow to moderate growth in the U.S. economy. It has been one of the slowest recoveries in a generation, averaging 2% to 2.5% annual growth since the recession bottomed in the spring of 2009.
4. Onerous fiscal policy. Higher taxes, more regulations, and now the implementation of the Affordable Care Act should act as a damper on growth.
In the near term, we do not see any signs of these trends changing. Although the government shutdown and debt limit discussions could cause a rise in volatility, we would view that as an opportunity to add to existing positions or initiate new investments.
While the Fund’s third quarter and year-to-date performance looks terrific on an absolute basis, it trails its Russell 2000 Index benchmark by a notable margin. Amid such a great environment for stocks, why is the Fund underperforming?
Stocks performed well through September across the board, on average, but if you look at the big winners, a different picture begins to emerge. The extreme ends of both the growth and value spectrum is what has been driving the market. For example, there were 20 companies in the index with year-to-date returns in excess of 200%. Of these companies, 70% had no earnings in 2012. On the aggressive growth side, there were eight biotech companies, three online service companies, and a solar power company. In the deep value camp were two retailers that have seen little to no growth in sales the last five years. TAMRO’s core strategy tends to live in between these extremes, where we seek to find companies with a sustainable competitive advantage (unique product or service offering, experienced management, and financial flexibility in allocating capital) and where the valuation is attractive. We typically do not invest in speculative companies with no earnings or terribly depressed companies that are not well-positioned fundamentally.
The cause of this trend in market extremes seems to be attributable to points one and three above. The intent of flooding the system with liquidity is to encourage money to move into riskier assets, like stocks. This money has to find a home. In addition, the slow pace of economic growth makes it more difficult for companies to execute—to experience strong growth. So the companies that are growing rapidly continue to be bid up by investors with little concern for valuation.
This environment reminds us of conditions in late 1999 and early 2000, when the Federal Reserve flooded the system with liquidity on worries about the Y2K scare before reducing it after concerns dissipated. Back then, the liquidity pumped up mega-cap growth and technology stocks. When they eventually corrected, the rest of the market rose. Today, the liquidity is finding its way into speculative value and aggressive growth companies. Once the Federal Reserve stops pumping liquidity into the system and the pace of economic growth improves, we see a rebalancing of opportunities. We think that high-quality stocks that have been ignored would go up, while overvalued aggressive growth stocks will likely falter.
Although unhappy to be trailing the benchmark at this point, we have been in this position before. As Mark Twain is believed to have said, “History doesn’t repeat itself, but it does rhyme.” We are confident that our disciplined and strong process will help investors to achieve their goals over time.
During the quarter, stocks that missed quarterly earnings estimates or reduced guidance were taken to the proverbial woodshed by investors, driving the Fund’s underperformance relative to the benchmark. Stock selection in the Consumer Discretionary, Technology, and Industrials sectors was the biggest detractor, while stock selection in Financials aided the portfolio.
We remain positive towards equities. This has not been an average economic recovery, where a rising tide lifts all boats. A keener focus on competitive forces is imperative, as those companies that have attained a strong lead over their peers should continue to receive the market’s favor. Conversely, deep-value companies that have not executed up to their potential could attract activist investors to unlock value. Although we normally would expect to see rising consolidation in various industries, it seems the sluggishness of the economy has kept the growth of mergers and acquisitions subdued.
In this environment, valuations for companies that are executing may go higher than in recent years. We understand the need to differentiate between speculative stocks and those that are truly executing better, for which valuations can go higher.
From a sector perspective, changes in the portfolio were on the margin, as sector weightings are the result of our stock selection process. The largest three sectors remained the same from the last quarter, namely Financials, Consumer Discretionary and Industrials. On a percentage basis, Consumer Staples is a significant overweight, while Technology and Materials are underweight relative to the benchmark.
Six stocks reached full-position status during the quarter through either purchase, appreciation, or a combination of the two, including Carrizo Oil & Gas, Pool, and Bruker. Carrizo has largely completed its transition to an oil-focused exploration and production (E&P) company, with 76% of revenue now coming from oil. Less than 25% of Carrizo’s liquids-rich acreage has yet to be drilled, however, indicating a long production growth runway. A $200 million gap between cash flow generated by operations and its drilling capital expenditure program has weighed on the company’s share price, but management has several options to close the gap. We anticipate that Carrizo will be at cash flow/capital expenditure parity by the first half of 2014, after which we think it can generate higher levels of profitable growth.
Pool is the world’s largest wholesale distributor of swimming pool supplies, equipment and related leisure products. After successfully navigating the housing downturn, the company continues to take market share through “tuck-in” acquisitions or organic growth. We think shareholders can benefit from improved levels of profitability as well as growth in new pool construction (which contracted 80% from 2005 to 2009) and pool maintenance. Scientific instrument maker Bruker has a diversified product portfolio with strong market positions in nuclear magnetic resonance spectroscopy and mass spectrometry. A newly appointed Chief Financial Officer with significant industry experience is currently directing an operational restructuring where we see room for meaningful operating margin expansion over the next few years. Management’s recent progress is encouraging, and we believe the stock’s valuation is attractive relative to the company’s potential.
Eight full positions were sold from the portfolio during the third quarter. We typically sells stock when the valuation becomes stretched, when we think company-specific issues limit near-term potential, or when we identify a better relative opportunity. Valuation was the primary reason for the sale of E.W. Scripps, Health Management Associates, and Waddell & Reed, while long-term holding Colfax outgrew the portfolio as its market capitalization eclipsed $5 billion.
Cloud Peak Energy and MDC Holdings are examples of holdings sold at depressed levels (the valuation was toward the low end of its historical range) and replaced by other depressed stocks in which we had higher conviction. Both companies were experiencing external headwinds. For Cloud Peak it was lower-than-expected demand for coal and for MDC it was the higher interest rate environment.
Aruba Networks and Teleflex were sold because of the identification of better relative opportunities, not company-specific issues.
TAMRO Capital Partners
As of September 30, 2013, Carrizo Oil & Gas comprised 2.23% of the portfolio's assets, Pool– 1.98%, and Bruker – 1.75%.
Note: Small-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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.