3rd Quarter 2013 Commentary - ASTON/River Road Independent Value Fund
3rd Quarter 2013
The Fund posted positive returns during the third quarter but lagged its Russell 2000 Value Index benchmark. Above-average cash levels along with below-average equity performance continued to weigh on results. Equity performance has lagged the small-cap market as we sell stocks with strong price momentum and rotate into out-of-favor areas that we believe are undervalued.
Precious Metals Decline
Precious metals mining stocks AuRico Gold and Pan American Silver were the two biggest detractors to performance. AuRico’s quarterly operating results were in line with expectations, with annual production and cash cost guidance remaining unchanged. The completion of its largest mine (Young Davidson) remains on schedule with commercial production expected to begin in October. As that mine reaches full production, we expect free cash flow to increase, cash costs to decline, and production growth to remain elevated for the next three years. We are encouraged by the company’s strong balance sheet, limited capital needs, and emphasis on free cash flow generation. Although the mining sector remains volatile in the near term, we remain focused on the value of AuRico’s long-lived assets, not the swings in its stock price. We added to the portfolio’s position during the quarter as its stock declined and its assets became more attractively priced.
Pan American reported mixed operating results during the period. Although production was lower than expected, cash costs at its higher-cost mines declined. Management stated production results improved in the current quarter and believed it will meet annual production and cash cost targets. We think the company possesses one of the strongest balance sheets in the mining industry with significant amounts of cash and net working capital. We maintained the Fund’s position as the stock continued to trade at a discount to our valuation.
Another poor performer was leading rent-to-own retailer Aaron’s. Although the company reported another quarter of positive same store sales comparisons, the increase was less than investors were expecting. Demand has been soft the past two quarters due to general economic stress among Aaron’s customer base. Lower-than-expected sales caused management to reduce its annual sales forecast as well as its earnings guidance. While we do not believe the company’s operating environment will improve in the near-term, we continue to hold the stock as it trades at a discount to our valuation.
The top performing stocks during the quarter included CSG Systems International, Sykes Enterprises, and FLIR Systems. Cable and satellite industry billing firm CSG recently renewed its contract with Comcast and does not have a another major contract renewal until 2017. With a large portion of revenue locked in by contracts, we think the company will be able to generate consistent operating results and abundant free cash flow. Management has reiterated its operating targets for the year and expects to return 25% to 50% of free cash flow to shareholders in the form of dividends and stock buybacks.
Outsourced call center operator Sykes has struggled the past two years due to weak demand and capacity issues. During the quarter, however, it reported a return to organic growth and indicated that its planned capacity initiatives were progressing on schedule. The company also noted an improving demand outlook from increased customer outsourcing and market share gains. FLIR reported its first quarter of positive organic revenue growth since 2011. The company continued to generate meaningful cash flow while backlog orders improved as quarterly bookings reached their highest level in nearly five years. Although encouraged by the operating results and financial metrics, we reduced the position as the stock exceeded our valuation.
Cash levels increased from 60% at the beginning of the quarter to 64% by the end. Cash hit record levels again this quarter as most high-quality small-cap stocks continued to be expensive in our opinion. The valuation metrics of the stocks on our potential buy list remained elevated, with prices trading at an average of 23 times earnings and two times sales. We continue to focus on maintaining a portfolio of companies with strong balance sheets and limited financial risk. At quarter-end, the portfolio’s debt-to-equity ratio was 34% versus 76% for the Russell 2000 Index. Throughout the quarter, we continued the rotation out of overvalued stocks and into small-caps that we believed were attractively priced, but considered out-of-favor. We expect to maintain the Fund’s contrarian positioning until small-cap prices accurately reflect the risks of their underlying companies.
The largest new position added during the quarter was global business advisory firm FTI Consulting. FTI’s results have deteriorated over the last two years as its two largest drivers—bankruptcy/restructuring and merger & acquisition (M&A)—are currently performing at lower than expected levels. The counter-cyclical restructuring business has suffered as low interest rates and easy financing conditions around the world have kept corporate default rates well below historical averages. While M&A has recovered from the recession, deal counts and aggregate size remain well below the previous cycle’s activity. In addition to these two headwinds, FTI has suffered from lower overall corporate activity (such as litigation), which has been subdued by low economic growth rates worldwide, putting pressure on billing rates across the industry.
We find it unlikely that all three of these activities will remain stagnant indefinitely. Based on our practice of normalizing operating results over economic and industry cycles, we avoid extrapolating FTI’s current cash flows in our valuation model. We instead assume the firm’s organic growth and consultant utilization rates will rebound closer to the firm’s historical average based on past cycles. We think the firm’s consistent cash flow and manageable financial risk allow us to wait patiently for operating results to normalize.
The operating environment for most small-cap businesses did not change meaningfully during the quarter. Company management commentaries and outlooks were consistent with recent quarters, with many firms expecting 2013 results to be similar to 2012. As noted in previous commentaries, and supported by recent operating results, we believe the profit cycle has reached a plateau. We form our opinion on the profit cycle by analyzing the operating results of the hundreds of small-cap businesses that we routinely follow. In essence, we attempt to see the economy and profit cycle through the eyes of the companies we analyze. We believe our methodology of using these primary sources is more accurate and timely than relying on aggregated government data, which can be initially inaccurate (later revised) and stale.
While we consider ourselves bottom-up investors, we believe understanding the current condition of the economy and the profit cycle is important, as it helps us determine the normalized cash flow of a business—an essential component of our valuation process. Although all businesses are unique and have specific variables influencing profits, the profit cycle of an individual business is often correlated to trends in the broader economy and total corporate profits. For example, when aggregate profits and margins are extraordinarily high, as they are now, most businesses we follow are also reporting above average profits. Conversely, when aggregate profits and margins are low, as they were in 2009, we expect many of the companies we follow to generate below average profits. Our view on corporate profits helps us avoid the dangers of extrapolating the peaks and troughs of profit cycles, and we think improves the accuracy of our normalized cash flow assumption and, ultimately, the accuracy of our valuation.
Throughout each quarter, as we review and analyze hundreds of small cap earnings reports and conference calls, we document results and commentary that we find insightful. Next, we decipher this information to identify common themes and trends prevalent throughout business and the economy. This information is vital in forming our opinion on the location and direction of the current profit cycle. We believe this process enables us to communicate our economic and profit cycle beliefs using actual business results and management commentary, instead of broad market generalizations.
Organic growth is sluggish across a variety of industries
The Scotts Miracle-Gro Co. (lawn and garden products) commented, “So until the broader consumer feels better and starts opening their wallet with more frequency no matter where they shop, then we still believe the unit volume growth will be tough to get in the core business.” In addition to slow organic growth trends, Cloud Peak Energy Inc. (coal producer) noted energy demand was flat: “While 2013 U.S. electricity generation is flat compared to last year, coal generation is up by 11%. This almost exactly matches a 13% drop in natural gas power generation this year.” Lastly, Park Electrochemical Corp. (advanced materials for printed circuits) summarized the inconsistent and sluggish environment in a recent call to investors stating, “We sure like to put three or four good months together, but we were feeling encouraged after June-July and then August just wasn't there for us. And I have a feeling this has something to do with the new normal, they call it, this new economy that we created for ourselves with more like a European-based economy in the U.S. with high unemployment, anemic growth, very significant debt that nobody knows how to pay off.”
Credit and interest rate sensitive businesses, such as housing and auto, are displaying improving trends
While business trends overall were stagnant, results varied between and within industries. For example, Lennar Corp. (homebuilder) reported strong third quarter results with revenues from home sales increasing 55%. Although homebuilders generated strong sales growth, several homebuilders acknowledged higher mortgage rates are slowing incoming orders. Lennar stated, “Clearly, interest rates have moved higher, and mortgage rates have moved from their unprecedented low point towards more normalized levels. Accordingly, over the past couple of months, we've experienced a slowdown in our sales pace and traffic in our community, as the consumer has adjusted to the change in the interest rate environment.”
Similar to residential construction, auto sales are benefiting from historically low interest rates and easier credit terms. According to Automotive News, the average new-vehicle loan reached 65 months during the quarter. Furthermore, the use of leases and subprime loans also increased year-over-year. While comparisons are becoming tougher, Kennametal Inc. (manufacturer of tooling systems) noted that auto production for the year is expected to grow moderately: “NAFTA light vehicle production is expected to increase modestly at 4.5% in calendar year 2013 to 16.1 million units.”
However, most consumer businesses are reporting a more challenging operating environment
As median real household income remains in decline, higher spending on homes and autos left less disposable income for other purchases. Church & Dwight Co. Inc. (consumer products) recently reduced its organic growth forecast for the year. Management stated, “The latest forecast of weak GDP growth, continuing high unemployment and weak same-store sales by major retailers provide little hope for significant near-term improvement in the U.S. economy. In fact, of the 14 categories that Church & Dwight operates in, five incurred lower category dollar sales in the second quarter versus the prior year, and five more had category growth of less than 2% versus the prior year. Now all consumer packages companies are fighting these headwinds.” Although Target Corp. (discount retailer) is not on our possible buy list, they provided a good summary of the trends and health of the consumer: “As we monitor the economy and consumer sentiment, we continue to see a mix of signals in which emerging optimism is balanced with continuing challenges. This year's payroll tax increase continues to affect spending, particularly among lower and moderate income households, and household formation in younger demographic groups remains stubbornly negative. Recent job growth numbers have been encouraging, but labor force participation and income growth remain weak. And, while emerging strength in the housing and automotive sectors is a long-term positive, the near-term spending on these big-ticket items is crowding out other spending, particularly in today's environment in which access to consumer credit remains tight.”
Results of consumer businesses also vary based on demographics
Higher asset prices appear to be benefiting businesses that sell to wealthier consumers. Ruth’s Hospitality Group Inc. (restaurant operator) caters to higher income consumers and generated impressive same store sales last quarter: “We're pleased to note that thus far in the third quarter, our comparable sales are currently up in the low-to-mid single digits, which is running over 5.9% sales growth than last year's third quarter.” PetSmart Inc.’s (pet supply retailer) commentary illustrates how they are benefiting from higher-end consumer spending: “In terms of sales, we continued to see strength in our super-premium natural foods following the expansion of that space in the first quarter with new formulations in both dog and cat across top channel exclusive brands.”
Consumer businesses catering to the middle class face a more difficult environment
Brinker International Inc. (restaurant) noted, “This quarter we continued to see a fairly lethargic category and some of the macroeconomic elements aren't quite as good as we hoped they'd be at this point in time. While we remain optimistic that the back half of the calendar year will contain improvements in key metrics like consumer confidence and employment, the restaurant industry isn't recovering as fast as we had hoped.” Darden Restaurants Inc. communicated a similar trend noting, “Olive Garden same restaurant guest counts declined 3.8% during the first quarter. This summer's sharp spike down in comparable sales within casual dining follows what I think we all know were some pronounced spikes up and down this past winter and spring, and so we've concluded that as the sluggish and uneven economic recovery we've been experiencing for some time now persists, we can expect appreciably greater sales volatility in our industry.”
Spending by lower income and younger consumers appears weak
Along with suffering from stagnant real wages, lower income and younger consumers are less likely to benefit from rising home and stock prices. Rent-A-Center Inc. (rent-to-own retailer) stated in its last quarterly call, “In contrast to the healthy gains in stock and home values enjoyed by the upper-income households, lower-income households have had stagnant or declining income and little or no increases in their household wealth.” Target Corp. confirmed this trend noting, “While overall consumer confidence statistics have improved this year, it's notable that optimism among lower-income households is lagging behind.” International Speedway Corp. (NASCAR/motorsports) gave an insightful description, “While overall the U.S. economy continues to remain resilient, recent figures released by governmental agencies and retailers such as Walmart, whose second quarter stated customers are curbing their spending, show a potentially concerning picture of the economy emerging. Even as consumer spending is fueling the economic recovery, mid-to-lower income households are being left behind while higher-end households are seemingly doing well. Essentially, we're seeing a bit of split economy underscoring the unevenness of the recovery.” Younger consumers are also struggling as they suffer from above average unemployment and are less likely to benefit from asset inflation. Abercrombie & Fitch Co. commented, “The reasons for the weak traffic we've seen in the U.S. are not entirely clear. Our best theory is that while consumers in general are feeling better about the overall economic environment, it is less the case for the young consumer.”
Organic growth remains slow throughout other sectors in the economy, including healthcare
The U.S. healthcare industry has shown flat-to-negative demand trends for several quarters. Healthcare conglomerate Johnson & Johnson commented, “Even primary care physician visits are down in the low single digits. We’ve got multiple, consecutive quarters now with those types of trends.” This pattern continued in the second quarter, as evidenced by Conmed Corp.’s (manufacturer of orthopedic and surgical products) experience, “As we follow second quarter healthcare utilization trends, we are seeing major hospital companies report flat or lower adjusted admissions and flat commercial admissions.” Owens & Minor Inc. (distributor to hospitals) echoes the rest of the industry in expecting these trends to continue in the near future: “So, we don’t see really any change in utilization going into the last half of the year.” This prolonged weak demand trend has caused providers to pull back on capital spending, as characterized by Stryker Corp. (medical device manufacturer): “Hospitals seem somewhat cautious on some of their more deferrable capital purchases, but that’s a very consistent trend we’ve seen throughout the year.” SAIC (IT services) also noted sluggish hospital spending: “We saw a slowdown in hospital IT spending, which we believe was attributed to lower government Medicaid and Medicare reimbursements to hospitals, arising out of sequestration cuts.”
Cyclical businesses, such as industrials and mining, are also reporting slow growth
Fastenal Co. (industrial and construction supplies) commented, “I think the main story is slow sales growth, and we believe that's really caused by a few things. One is the slow economic condition, it's very slow out there from an industrial side.” Sluggish revenue growth at CLARCOR Inc. (filtration products) is expected to continue: “I would characterize our backlog right now as essentially flat from the end of last calendar year.” Blount International Inc. (timber harvesting and power equipment) mentioned, “In the second quarter, as I said, we continued to be challenged by global economic conditions. We experienced slower demand in all of our regions. The sales for the second quarter were down 8% compared to the second quarter 2012.” Joy Global Inc. (mining equipment) summarized its current operating environment stating, “Most mined commodities are in or near supply surplus for the first time in over a decade. This is primarily the result of the post-recession economic recovery falling short of expectations. The Eurozone is just starting to recover from a multi-year recession, China growth has slowed and growth in the U.S. remains sluggish.” One bright spot in industrial demand was in aerospace, with higher commercial orders offsetting lower defense spending. Esterline Technologies Corp. (aerospace and defense parts) noted, “Our commercial aerospace markets remain a major source of strength with continued solid OEM build rates, particularly for single-aisle jets and generally stable aftermarket. Defense markets, however, continue to be impacted by budget uncertainty.”
Commentary from transportation companies indicates volume growth is sluggish
While we seldom own transportation companies, we like to follow the industry as it gives us a better understanding of volume growth of goods flowing throughout the economy. CSX Corp. (railroad) notes, “Overall revenue was up slightly on 1% volume growth.” Union Pacific Corp.’s (railroad) results were slightly weaker, “In the second quarter volume was down about one percent compared to last year as strong growth in chemicals and solid gains in automotive were offset by declines in intermodal and ag.” Norfolk Southern Corp.’s (railroad) volumes were slightly higher: “Overall volumes were up 2% as increases in intermodal and merchandise traffic up 5% and 2% respectively were partly offset by the 4% decline in coal volume.” Trucking companies noticed similar trends. Arkansas Best Corp. reported, “ABF's quarterly tonnage per day increased by 1.6% compared to last year's second quarter.” We found Forward Air Corp.’s comments regarding the inconsistency of demand interesting: “And typically in the past we could pinpoint weak areas. What we experience today is across the board. I mean, our Southwest region will be booming and then all of a sudden, it'll go soft. And that's comparable with all our other regions for the most part. So it's really across the board, sporadic, nothing you can put your finger on, nothing that you can say, okay, we're going to be heavy or we're going to be light out of a certain region, it's just really difficult to pinpoint.”
The domestic energy industry reported mixed results
Companies focused on oil have benefited from elevated prices. Conversely, with the price of natural gas trading below its full cost of production, results remain depressed for businesses reliant on natural gas production. Baker Hughes Inc. (energy service provider) noted in a recent presentation, “U.S. natural gas prices, frankly, remain too low for any meaningful development to take place.” The lack of drilling for natural gas has reduced the number of rigs in operation. According to Baker Hughes, the number of rigs searching for natural gas and oil has declined 5.6% year-over-year, with rigs searching for oil declining 3.4% and rigs searching for natural gas down 13.6% (as of Sept 27). Comments from service providers, such as Unit Corp., support the declining rig count data: “It's been a very challenging rig market this year. You know, we feel optimistic we'll get some contracts for two or three more rigs to go up, and then out of the blue an operator will lay down two or three rigs.” Assuming a stable pricing environment, we are not expecting a major shift in spending in the domestic energy sector, with slightly higher expenditures on oil exploration being more than offset by weakness in natural gas drilling.
Technology results varied but overall are flattish
Autodesk Inc. (software) stated, “While the challenges in some of our end markets have led us to lower our third quarter revenue forecast, we're taking action to rekindle growth.” Plexus Corp. (contract manufacturer) noted similar challenges: “And then finally, we have to recognize that the growth environment is more challenged right now with the economic malaise around the world.” While others, such as Ingram Micro Inc. (product distributor), saw a more stable environment stating, “For the second half of the year, we see the demand environment across all regions remaining relatively stable from where it is today.” Flextronics International Ltd.’s (contract manufacturer) description of business was common: “But on average I view it as a pretty stable – and the same thing with servers and storage, you started with server and storage. It's been very, very flat; it was slightly up this last quarter. So, nothing very inspiring and nothing that we can see that's going to move our needle that much.”
Low interest rates, rising asset prices, and unconventional monetary policy aid the financial industry
Fifth Street Finance Corp. (lender to small- and medium-sized businesses) discussed the impact from the Federal Reserve’s policies noting, “The sugar high from loose monetary policy from global central banks continues to support risk assets, despite recent comments from the Federal Reserve about a potential tapering of quantitative easing.” FTI Consulting Inc. commented on the easy credit conditions it is witnessing in the corporate lending market: “To give this some perspective, during the first half of 2013, approximately $790 billion of speculative grade loans and high yield bonds were issued. This compares to $445 billion in the first half of 2012 and $990 billion in all of 2012. All of this refinancing activity and the easy money policy of the Fed have sustained up default rates at historically low levels.” Rising real estate prices have helped many banks, such as Washington Federal Inc., which noted, “Improving asset quality trends and increasing real estate values combined with decreasing loans outstanding resulted in zero provision for loan losses during the quarter.” While an improving real estate market has benefited results, recent increases in interest rates are slowing mortgage originations as indicated by Wells Fargo: “While our mortgage business continued to generate strong results in the second quarter, we expect mortgage revenue to decline in the third quarter with declines in mortgages and originations.”
The operating environment in international markets remains challenging
Europe remained soft as indicated by H.B. Fuller Co. (industrial adhesives): “I think everyone recognizes that economic conditions in the broader European region remain stagnant, an indicator showing market conditions flat to down in many countries. It's not impossible to grow the business under these conditions, as we showed in 2011 and 2012, but it's certainly more difficult.” Albemarle Corp. (specialty chemicals) noted broader weakness: “60% of our sales are outside the U.S. and the sluggishness in emerging economies, particularly China, impacted demand for products. Demand in Europe remained well below historical norms.” Faro Technologies Inc. (measurement device manufacturer) had similar comments: “Sales growth for the quarter at 2% was lower than our expectations. We're continuing to face economic headwinds, particularly in Europe and Asia as we have been highlighting over the last few quarters. Auto sales in Europe were at their lowest levels in two decades. Industrial output in China and Japan continues to slow, and credit markets are tight in countries like India.” Kennametal points out weakness in emerging markets relative to developed and the headwind from government spending in the U.S.: “From a geographic perspective, the general outlook is essentially unchanged according to IHS Global Insight. However, underlying growth patterns has shifted to reflect the slightly more upbeat view of developed economies and a bit more downbeat view of big emerging markets. In the U.S., there have been multiple headwinds and it has been difficult for the economy to gain momentum. The government spending sequester is expected to hold back growth through the end of calendar year 2013.”
Many companies expect little change in the near-term
Forward Air Corp. (transportation) touched the potential for a second half recovery, “I think it would be extremely difficult to say that, for anyone to say, gee, we're going to have not only us, but the industry in general is going to have a strong second half. We all hope for it obviously, but you certainly won't hear it come out of my mouth.” Snap-on Inc. (tools) is also experiencing little change: “Now at a macro level, we haven't seen much change in the external environment from the last two quarters.” Many backlogs and order rates suggest current trends will continue. AMETEK, Inc. (electric instruments and motors) noted a flat backlog, “The book-to-bill ratio in the quarter was 1.02. Sales in the quarter were up 6% to $878.8 million. Organic sales were flat.”
Considering most companies are expecting the current operating environment to persist, few businesses are announcing major expansions in capacity or labor
Brown & Brown Inc. (insurance broker) mentioned, “The economy – we're seeing a jobless return or expansion in many of our clients. So, there – excuse me; there is – there are lots of people who are hesitant to add additional people until they absolutely need to. So the example that I like to give is this, and their sales may be going up, but they're just hesitant to add additional head count initially.” Cintas Corp. (uniform rentals) touched on the unevenness of hiring, “We mentioned that there was a modest improvement in net add/stops. This is not the first time we've seen a nice uptick in net add/stops only to be followed by a downturn and as we've talked about quite often in the last couple years, this employment picture is so bumpy and inconsistent that we're certainly hesitant to say that there's momentum.” Several businesses mentioned the possible impact of the Affordable Care Act. Arthur J. Gallagher & Co. (insurance broker) commented on how businesses are preparing, “On the benefits side, the Affordable Care Act continues to keep our consultants very busy. Having the employer mandate move back to 2015 has not really slowed the amount of help our clients need.” Cullen/Frost Bankers Inc. (regional bank) summed up the uncertainty in the labor market and the Affordable Care Act by saying, “While we're seeing some positive signs in the economy, much uncertainty remains over government regulation, spending, the deficit, dysfunction in Washington, and the outlook for jobs. The inconsistent implementation and ongoing lack of clarity surrounding the federal healthcare law illustrates how government regulation can adversely impact job growth, particularly among small businesses.”
The disconnect between small cap prices and the profit cycle grows
In summary, the majority of operating results and management comments that we reviewed and analyzed this quarter are consistent with what we witnessed the past year—inconsistent and sluggish. Despite a business environment that lacks clarity and direction, the small-cap investment environment remains exuberant and decisively higher (Russell 2000 has gained 30% the past year). With operating results stagnating and small-cap prices soaring, we believe there is a growing disconnect between price and fundamentals. As this disconnect widens, we believe the risk of meaningful losses in small-caps is increasing. Although we acknowledge the current investment environment may continue and that by holding a large cash position we could incur meaningful opportunity cost, we remain committed to our investment discipline and refuse to overpay. Therefore, we expect cash levels to remain high until conditions change and our opportunity set improves. Moreover, we are avoiding many of the stocks and industries that are performing well and have increased positions in areas that are out-of-favor and performing poorly—increasing the disconnect with the benchmark further. While it is an uncomfortable positioning, we believe it is the right course of action given the increasingly expensive small-cap market combined with an unsupportive fundamental backdrop. In conclusion, we believe it is more important than ever to think independently and avoid investment risks that appear nonexistent today but, in our opinion, have increased considerably with price.
River Road Asset Management
As of September 30, 2013, AuRico Gold comprised 3.47% of the portfolio's assets, Pan American Silver – 2.21%, Aaron’s – 2.92%, CSG Systems International – 3.70%, Sykes Enterprises – 3.43%, FLIR Systems – 1.18%, FTI Consulting – 0.98%, Owens & Minor – 0.95%, and Unit Corp. – 1.60%. The remaining companies referenced (or quoted) in this commentary were not held in the Fund’s portfolio.
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.