4th Quarter 2013 Commentary - ASTON/River Road Independent Value Fund
4th Quarter 2013
Small-cap stocks delivered robust returns during the fourth quarter, but lagged large-caps for the first time since the third quarter of 2012. The small-cap oriented Russell 2000 Index gained 8.7% versus 10.2% for the large-cap dominated Russell 1000 Index. For 2013, small-caps led large-caps by a wide margin, with the Russell 2000 up 38.8% versus 33.1% for the Russell 1000. It was the fourth-best calendar year on record (since 1979) for the Russell 2000 Index and the single-best since 2003.
Historically, such robust small-cap returns are reserved for the years immediately following a recession, when stocks are emerging from a bear market. It is highly unusual to see such strong performance four years into a recovery, particularly when profit growth is weak and forward expectations are declining. It was also a notably consistent year. According to Furey Research Partners, there have only been four other years since 1950 in which small-caps posted positive returns in all four quarters AND at least an 8% return in three of those four quarters.
The Fund posted modest gains during the quarter, but trailed its Russell 2000 Value Index benchmark. The same was true for performance for all of 2013. The portfolio’s cash hit record levels again during the quarter—increasing from 64% to 67% by the end of December—as we view most high-quality small-cap stocks as expensive. As a reminder, holding cash is not an attempt to time the market but is a direct reflection of the value, or lack thereof, we are finding in small-caps and our 300-name potential buy list.
Mining Stocks Decline
Among individual holdings, gold mining stocks New Gold and AuRico Gold were two of the Fund’s three worst performers. New Gold experienced production issues at two of its mines during the third quarter that caused it to lower overall production and increase cash cost guidance. Cash costs remain well below the current gold price, however, allowing the firm to maintain its profitability and solid balance sheet. We believe New Gold trades at a substantial discount to the replacement cost of its owned gold reserves. AuRico’s quarterly operating results were in line with expectations, as annual production and cash cost guidance remained unchanged. We believe its shares declined due to weakness in the precious metal mining industry, not company-specific reasons. Commercial production at its largest mine began in October, and we expect cash costs to decline, free cash flow to increase, and production growth to remain elevated for the next three years.
Another negative contributor was FLIR Systems, a market leading supplier of infrared technology. FLIR reported disappointing operating results and lowered earnings guidance for 2013 during the period. The company experienced weakness in orders from its U.S. Government funded customers. Although the firm continued to generate meaningful cash flow and maintained an investment grade balance sheet, we nevertheless reduced the portfolio’s position as its stock traded above our valuation.
Holdings in precious metals mining firms AuRico Gold, Pan American Silver, and New Gold were the biggest individual detractors from performance for 2013. Falling metal prices and weakening sentiment towards mining companies caused this industry to severely underperform the overall market during the year. For example, the Market Vectors Gold Miners ETF (GDX) declined 54% and the Global X Silver Miners ETF (SIL) fell 50%. We used this opportunity to purchase high-quality, profitable mining companies with strong balance sheets at what we believe to be substantial discounts to the replacement value of their assets. Purchases and position sizes of the miners increased throughout the year, resulting in a declining average cost basis and an improved discount-to-value.
Business Services Strong
Call center operator Sykes Enterprises and billing software firm CSG Systems International within the Technology sector were the top two contributors to performance during the quarter. Sykes reported strong third quarter results, including accelerating revenue growth from an increase in new and existing client programs. Its near-term outlook continued to be strong, with near double-digit revenue growth expected for its fourth quarter. Despite the stock’s sharp appreciation the last six months, it continued to trade at a discount to our assessed valuation.
CSG recently renewed its contract with Comcast and does not have another major contract renewal until 2017. With a large portion of revenue under contract, the company should continue to generate consistent operating results and abundant free cash flow. Management reiterated its operating targets during the quarter and expects to return a sizeable portion of its free cash flow to shareholders through dividends and stock buybacks.
Despite its tough year, silver mining company Pan American Silver was among the top performers during the fourth quarter. Operating results improved with better-than-expected production. Costs declined due to higher by-product production and lower production expenses at its higher-cost mines. We think the firm continues to possess one of the strongest balance sheets in the mining industry with $420 million in cash and $700 million in net working capital. We increased the portfolio’s position as our calculated valuation stabilized.
The top three contributors for the year were CSG Systems, WPX Energy, and Sykes Enterprises.
As noted earlier, the Fund’s cash stake increased to record levels as the average valuation metrics of our potential buy list increased again during the quarter, and remained elevated with a price/earnings ratio of 24x and price/sales ratio of 2x. Throughout the quarter, we continued our rotation out of overvalued stocks into those that we believe are attractively priced, but considered out-of-favor. We expect to maintain this contrarian positioning until we believe small-cap prices accurately reflect their underlying risks.
The largest new position added during the quarter was the aforementioned New Gold. The company is an intermediate gold miner with four operating properties and three development-stage projects. The firm has a strong balance sheet and liquidity position, with sizeable cash holdings and a favorable long-term debt structure. Its cost structure is much lower than the industry average, which is especially desirable in today’s price environment, allowing the company to generate cash even if the gold price continues to decline.
Management’s approach to mine development is also appealing. Like its producing mines, New Gold’s development projects are expected to have below-average production costs and be viable projects at current metal prices. It expects to execute its development plans in a disciplined manner that will not jeopardize its strong balance sheet. Despite the high quality of New Gold’s balance sheet and operations, the firm’s stock sold off sharply the past year along with the rest of the mining sector. At its current price, we believe its shares trade at a meaningful discount to the replacement cost of its asset base in the private market.
Although the Portfolio’s precious metal mining position reduced equity returns this year, we believe this is one of the few areas in the small-cap market representing value. We increased the portfolio’s precious metal miner position throughout the year as prices became more attractive. The fund began 2013 with a 4% weight in miners and ended the year with an 11% weight. As the number of high-quality small cap miners that meet our buy criteria is limited, we are not currently purchasing additional miner positions. With their strong balance sheets, we believe the miners currently in the portfolio will survive and eventually prosper through the industry’s natural, yet volatile, commodity cycle.
The operating environment for the majority of small-cap businesses we follow remained consistent with the first three quarters of 2013. Strength in housing, auto, aerospace, and higher-end retail continued, while most businesses catering to the middle- and lower-class struggled. While corporate profit growth is slow, overall profits and margins remain healthy. Recent economic reports suggest U.S. economic conditions have improved, and we remain alert to possible changes in the small-cap operating environment. However, our observations continue to indicate little change in organic revenue and earnings growth, with most businesses we follow expecting 2014 to be similar to 2013.
Despite a year of slow growth and inconsistent operating results, small-cap stock prices soared to record highs in 2013. Revenue and earnings growth trailed prices considerably, resulting in expanding equity valuations. In the investment industry, this phenomenon is often referred to as “multiple expansion.” We define multiple expansion as investors’ willingness to pay higher prices for equities without a commensurate increase in underlying business revenues and earnings capabilities. Although multiple expansion has been noticeable throughout the current market cycle, it increased considerably in 2013. According to Bloomberg, the amount of earnings per share generated by the Russell 2000 was practically unchanged ($28.87 in 2013 versus $28.65 in 2012). Considering the sharp rise in stock prices, along with stagnant earnings growth, the trailing price/earnings multiple (P/E) of the Russell 2000 increased from 29.6x in 2012 to 40.3x in 2013. While we use a bottom-up approach to form our opinion on the attractiveness of small-cap stocks, we believe the Russell 2000’s valuation multiples support our position that small-caps are very expensive.
Multiple expansion is often present during periods of sharply rising asset prices or periods of asset inflation. Asset inflation occurs when investors pay higher prices for assets that have not changed in quantity or quality. Like other forms of inflation, asset inflation can influence decision making by altering expectations of future price trends. For instance, when the price of a product or service increases, demand often declines as certain consumers substitute the product or service with a less expensive alternative, while others forgo making the purchase entirely. Asset inflation differs in that it is seductive and can cause investors to seek, rather than avoid, rising prices as the pressure builds to buy inflating assets before prices rise even further. For example, as bond prices rose toward their peaks in 2012 and yields fell (10-year US Treasury bonds yielded 1.4% in July 2012), investors poured $402 billion into bond funds. The asset inflation winds shifted in 2013 as investors switched their focus from accepting record low yields for bonds to paying record high prices for equities. As equity prices rose sharply in 2013, inflows into equity funds reached $162 billion, while investors fleeing the fixed income party withdrew $67 billion from bond funds.
The effects of asset inflation often extend beyond financial markets. Corporate actions such as stock buybacks, merger and acquisition (M&A) activity, and initial public offerings (IPOs) often increase during periods of asset inflation. The Wall Street Journal recently reported, “U.S. companies in the S&P 500-stock Index bought back $128.2 billion of their own shares in the third quarter.” The last time buybacks reached such lofty levels was in 2007, near the peak of the previous market cycle. M&A activity also increased in 2013, but remains below the last peak seen in 2007. IPOs, however, are breaking new records as sellers of businesses rush to take advantage of the increase in appetite for equities. According to Dow Jones, there were 229 IPOs in the U.S. in 2013, raising $61.7 billion, up 31% from 2012. Similar to buybacks, this was the largest amount since 2007. As was the case in the previous market cycle, we believe asset inflation has once again found its way into the boardroom and is influencing the decision making of corporations.
Companies may also experience elevated fluctuations in demand during periods of sharply rising asset prices, as asset inflation can magnify the cyclicality of the economic cycle. In fact, during the quarter, government reports suggested economic trends are improving. Although we have not noticed a measurable change in the operating results of the businesses we follow, we acknowledge the potential near-term effects from persistent and rising levels of asset inflation. However, as was proven over the past two profit cycles, we believe incremental economic growth founded on asset inflation is unsustainable. During the previous profit cycle (2003 through 2007), U.S. equity markets increased in value by $8.85 trillion. This increase, along with rising housing prices and rapid credit growth, enhanced economic activity and corporate profits. In 2008, as the private credit growth boom turned to bust, profits declined sharply and asset inflation vanished along with $8.2 trillion of stock market value. Given the sharp rise and fall of asset prices over the past two market cycles, along with the large booms and busts in corporate profits, we believe it is important to consider how asset inflation may influence the economy and business operating results. Our valuation methodology attempts to take external factors, such as asset inflation, into consideration by normalizing a business’s free cash flow over a profit cycle. By doing so, we believe we are able to avoid extrapolating unusually high or low profit margins that may be influenced by rapidly rising or falling asset prices.
In addition to affecting individual investors, corporations, and the economy, asset inflation can influence the decision making of professional investors. Since most professional investors are judged relative to a benchmark, when asset inflation invades a particular asset class or investment style, the pressure on the asset manager to participate can be immense. Maintaining a structured investment discipline in such an environment becomes increasingly difficult as prices vault higher. Buy and sell disciplines are especially susceptible to becoming compromised. In order to keep up with the herd and avoid underperforming, managers may feel pressured to include assets that are not in line with their investment philosophies but are participating in the rising price environment. Additionally, managers may adjust their opinions on what an asset is worth in order to justify holding an overvalued asset that is performing well. While such violations of buy and sell disciplines may allow professional investors to benefit from rising prices in the near term, we believe such actions are shortsighted and can significantly increase the risk of permanent loss of capital.
We call the risk of violating a structured investment discipline “capitulation risk,” and we take this risk very seriously. We have found that during periods of elevated asset inflation, the temptation to assume capitulation risk increases. We believe capitulation risk was noticeable in 2013, as valuations of many high-quality small-cap businesses reached levels that we believe cannot be justified based on reasonable valuation assumptions. We are not altering, and have no plans to alter, our investment discipline in order to keep pace with sharply rising prices. In fact, as small-cap prices rose throughout the year, several of the portfolio’s holdings exceeded our business appraisals and were either reduced or sold. Meanwhile, purchases were limited as most high-quality small-cap stocks have reached valuation levels that we believe are unjustifiable and, in some cases, irresponsible. Given the current level of asset inflation we are experiencing, we think it is extremely important to avoid capitulation risk and remain steadfast in our commitment to the Independent Value investment discipline.
With equity prices and capitulation risk on the rise, an increasing number of commentators recently questioned if current levels of asset inflation have reached extreme levels. Specifically, some observers asked, “Are U.S. equities in a bubble?” There were many differing views—though most policy makers and investors opined that equities are not in a bubble. Most noteworthy members of the “non-bubble camp” are current and former Federal Reserve members. In November 2013, soon-to-be Fed Chairman, Janet Yellen, acknowledged that equity prices have increased “robustly” but noted she believed stock prices were not in “bubble-like conditions.” Earlier in the year, Ben Bernanke stated, “I don’t see much evidence of an equity bubble.” Last, but certainly not least, Alan Greenspan, who presided over two extraordinary asset bubbles during his tenure as Fed Chairman, recently said, “This does not have the characteristics, as far as I’m concerned, of a stock market bubble.” Given the Federal Reserve’s record on spotting asset bubbles, the above quotes are not surprising to us. In fact, we believe the Federal Reserve, through its use of ultra-loose monetary policy, has created and encouraged asset inflation; therefore, we do not expect Fed members to be the first to acknowledge or guard investors against its dangers.
We are not waiting for the Federal Reserve or financial market commentators to alert us of asset bubbles. It is our responsibility to identify excessive asset inflation within our asset class and to protect the portfolio from its dangers. Asset inflation and asset bubbles are not new to us. In the past 15 years, we have navigated through two asset bubbles—technology and housing. Instead of participating, or capitulating, we successfully relied on our investment discipline to avoid falling victim to the temptations of asset inflation. We believe this cycle is no different, and we have not altered our strategy or objectives. While those denying that equities are currently in a bubble may disagree, from a bottom-up perspective, we believe most small-cap businesses we analyze are overpriced, and in some cases significantly. It is our belief that many small cap businesses will not generate sufficient future free cash flows to justify current prices. Therefore, we believe investing in small-cap stocks at today’s prices will likely result in insufficient future returns and possibly meaningful loss of capital. As was the case in past cycles of inflated equity prices, we believe asset inflation is transient and prices will ultimately reflect the true value of underlying businesses.
In summary, we will not capitulate and succumb to the pressures associated with rapidly rising asset prices. We have not allowed asset inflation to influence our valuation methodology or our buy and sell discipline. During the year, we sold holdings that exceeded our valuations and refused to overpay for increasingly expensive small-cap stocks. We believe small-cap prices are very expensive and that in order to meet our investment objective, our best option is to remain patient. We are aware our contrarian positioning may continue to harm relative results but believe our positioning is appropriate given current conditions and the potential for meaningful loss of capital. We do not know when volatility and opportunity will return, but we are confident it will. The Fund remains positioned in a manner that will allow us to act decisively once we see that investors are adequately compensated for assuming risk. In order to achieve our goal of generating attractive absolute returns over a market cycle, limiting losses is essential. To do this, we must refrain from overpaying during periods of excessive speculation and asset inflation.
River Road Asset Management
As of December 31, 2013, New Gold comprised 1.71% of the portfolio's assets, AuRico Gold – 3.20%, FLIR Systems – 0.30%, Pan American Silver – 4.13%, Sykes Enterprises – 3.72%, CSG Systems International – 2.91%, and WPX Energy – 3.43%.
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.