4th Quarter 2013 Commentary - ASTON/River Road Select Value Fund
Fourth Quarter 2013
Spectacular Year for Stocks
Stocks surged during the fourth quarter of 2013, capping one of the best annual market performances on record. Fueled by unprecedented liquidity, improving global growth, low inflation, and an emerging belief that the Federal Reserve would exit its quantitative easing (QE) bond purchase program in an orderly fashion, the broad market S&P 500 Index soared 10.5% during the fourth quarter, finishing the year up 32.4%. This represents that index’s best year since 1997 and its eleventh-best annual performance since 1926.
The macroeconomic-driven market that has dominated since the end of the financial crisis finally began to fade in 2013. Intra-stock correlations declined, market breadth improved, and volatility dropped to its lowest level since 2006. By year-end, the S&P 500 had advanced 565 market days without at least a 10% correction, representing the longest rally since 2008 and the seventh-longest since 1930.
Small-cap stocks delivered robust returns during the fourth quarter, but lagged large-caps for the first time since the third quarter of 2012. Small-caps led by a wide margin for the full year, however, with the small-cap oriented Russell 2000 Index gaining 38.8%. It was the fourth-best year on record (since 1979) for the Russell 2000, and its best since 2003. The small/mid-cap Russell 2500 Index returned 36.8% for the year, also its fourth best annual return on record.
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.
When stocks rise substantially, lower quality and higher beta (volatility) stocks typically outperform. Although this dynamic is usually reserved for the early stages of a recovery, it was a persistent theme (with the exception of 2011) throughout the current cycle. Within the Fund’s Russell 2500 Value Index benchmark, the highest beta stocks outperformed the lowest beta by an enormous margin. The picture was more mixed from a quality perspective, with low quality generally outperforming. Stocks paying a dividend also lagged by a wide margin.
High Beta Fallout
The Fund noticeably lagged its benchmark during the fourth quarter, adding to underperformance for 2013 after a positive first half of the year. The final month of the quarter was especially difficult as stocks (particularly those in more cyclical sectors) delivered a final surge. The highest-beta, lowest-quality stocks within the benchmark dominated in December, with most of those factors leading by a three-to-one margin.
The sectors with the lowest contribution to relative returns during the quarter were Consumer Discretionary and Industrials as both sectors suffered from poor stock selection. Retailers Big Lots and Rent-A-Center within Discretionary were among the top-three individual detractors having posted double-digit losses, joined by diagnostic medical testing firm Myriad Genetics.
Big Lots fell sharply as third quarter earnings came in below expectations and management announced several strategic changes to the business, including the liquidation of its recently acquired Canadian operations. The new management team is focused on pursuing e-commerce, increasing consistency in consumables, rolling out its furniture financing program, and adding freezers/coolers to half of its store base. Although we believe this is a proper strategy to drive traffic and create more stability in operating results, it does introduce execution risk.
Rent-A-Center is the largest rent-to-own (RTO) retailer in the United States. In early October, its largest competitor (Aaron’s, another portfolio holding) reduced third quarter guidance due to weakness in its core RTO customer base, heightening investor concerns for Rent-A-Center. The company then reported its own disappointing third quarter results later in the month, and lowered full-year guidance for the third consecutive quarter. Core same-store sales fell due to increased promotions and product deflation in electronics. Management is encouraged by the second consecutive quarter of increased traffic growth, however, and indicated that pricing recently stabilized, which should provide momentum going into 2014.
Shares of new holding Myriad fell after the Centers for Medicare & Medicaid Services (CMS) unexpectedly cut the reimbursement rate for the company’s flagship hereditary breast and ovarian cancer test by 40%. This cut was a surprise as other competitors recently entered the market with tests priced well above the new reimbursement rates. CMS did not follow its normal pricing protocols prior to its announcement and opened up a public comment period ending in late January, meaning the price cut could be subject to a positive revision. We made the Fund’s initial purchase, and added toward our target position size, during this period of uncertainty.
Consumer Discretionary and Materials were the sectors that detracted the most from relative returns for the full year. Within the latter sector, we believed that miners Pan American Silver and AuRico Gold offered a margin of safety given that the price we paid for their reserves (including the cash costs to pull the precious metals out of the ground) were at a substantial discount to the spot price of silver and gold. Despite both companies having strong balance sheets, their share prices declined with the rest of their peers when the price of silver and gold plunged in 2013. We sold Pan American during the third quarter and halted the portfolio’s accumulation of AuRico prior to it reaching our target position size. Also within Materials, the unexpected collapse of one of the two cartels that controlled the global potash market negatively affected Intrepid Potash, the largest U.S. potash producer. Intrepid still holds a significant freight cost advantage over competitors and there have been indications that the two members of the fractured cartel may resolve their differences in the near term. We lowered our conviction and trimmed the position.
Asset Sales, Acquisitions, and Activist Investors
Technology was the top contributing sector in the portfolio during the quarter owing to strong stock selection. Top individual contributors overall included DST Systems, Heartland Express, and Outerwall.
Mutual fund shareholder accounting services provider DST reported another strong quarter by delivering total account growth, margin improvement, and share repurchases at favorable prices. Management continued to monetize non-core assets during the quarter with the sale of shares of trust bank State Street, distributions from private equity, and the sale of real estate assets. We estimate the company to have roughly $1.2 billion of remaining non-core assets, almost half of which is State Street common stock. We trimmed the position as its discount-to-Absolute Value narrowed.
Regional trucker Heartland Express announced the acquisition of Gordon Trucking, a privately held short-to-medium haul West Coast operator. This strategic deal fills a geographic gap that would likely have taken Heartland 20 years to build organically, and came at an attractive price. The acquisition reinforced our already high conviction in management’s commitment to shareholder orientation. We increased our target Absolute Value.
Outerwall is a provider of automated retail kiosks for home video rental (Redbox) and coin-counting (Coinstar). Activist investors Jana Partners disclosed a stake in the firm early in the quarter, sending shares sharply higher. Management later reported third quarter results that beat expectations, announced incremental share repurchases, and committed to return 75% to 100% of annual free cash flow to shareholders. Finally, management discontinued three money-losing New Venture concepts and identified additional cost reductions, both of which we expect to contribute to earnings and free cash flow. We raised our Absolute Value, our conviction, and the position size to reflect increased confidence in the management team.
The portfolio benefited from two major themes during 2013, the underperformance of bond-like equities (REITs and Utilities, which represent a large portion of the benchmark) and a record level of merger and acquisition (M&A) activity. Both factors supported both absolute and relative performance. Underweight positions in real estate investment trusts (REITs) and Utilities delivered nearly three percentage points of outperformance. Although overall M&A was down, the Fund experienced a record level of eight total transactions during the year. These included four takeovers, two strategic acquisitions, and two major asset sales. The multiples paid for acquisitions were well below 2006 levels (and often below our own conservative assumptions), but the stocks affected by these transactions outperformed by more than five percentage points.
Lofty valuations in our small-cap universe resulted in a decrease in the number of holdings for the quarter and full year, and an increase in the portfolio’s cash position. The Fund held 72 positions at year-end, down from the 81 held at the beginning of the year.
During the quarter, six new holdings were purchased and nine were sold from the portfolio. Among the new positions were two Technology firms (Sykes Enterprises and Blackhawk Network Holdings), an area in which the portfolio continued to be significantly overweight relative to historical trends. New positions also included the previously mentioned medical testing company (Myriad Genetics), a real estate management company (Forest City Enterprises), an apparel retailer (Stage Stores), and a chemical pesticide manufacturer (American Vanguard). Among the companies sold, six had achieved their Absolute Value price targets and three sold due to either accumulated losses and/or a negative change in our fundamental outlook.
The largest year-over-year changes in the portfolio’s sector positioning were declines in both Consumer Staples and Industrials. With the sale of long-term holding Harris Teeter Supermarkets, the portfolio’s Consumer Staples exposure dropped to its lowest absolute and relative level since the Fund’s inception. The decline in Industrials was partly related to GEO Group’s conversion into a REIT, which reclassified the firm as a Financials stock. From a relative perspective, the stake in Financials also remains near an all-time low.
Overall, 2013 served as a humbling reminder of why we do not forecast market returns for a living! Although we correctly anticipated a few important fundamental trends (most notably small-cap profit growth coming in well below consensus expectations), we were far too conservative in our expectation for market returns, anticipating year-end returns in the mid to high single-digit range.
The reason we were off the mark in 2013 was a failure to anticipate the huge rise in equity multiples. At the beginning of the year, we stated “there is a bit of room for multiple expansion if the debt ceiling hurdle is successfully cleared and the euro zone remains stable.” According to FactSet, the forward price/earnings ratio for the Russell 2500 Index soared, despite (according to Barclays) the weakest growth in small-cap pre-tax earnings since the 2008-09 downturn and one of the weakest years for any non-recessionary period.
The disconnect between stock prices and corporate profits in 2013 is still hard to believe. The lesson we learned is that it is difficult to translate a fundamental-based forecast into a price expectation in a world where historical fundamental relationships have been rendered irrelevant by the presence of unprecedented monetary stimulus—a pattern that may well be repeated in 2014.
Today, small-cap valuations are extremely unattractive, with our calculated discount-to-Absolute Value measure for the portfolio at 85%. This is one and a half standard deviations above median and represents the very high end of its historical range. External measures also show small/mid-caps to be richly valued. Whether examining earnings or cash flow, most measures are at or above peak 2008 levels. Valuation measures also show small-caps as expensive relative to large-caps, which should serve to mute the relative performance of small-caps in 2014.
The challenge with valuations in this environment is one of absolute versus relative analysis. Stocks are expensive on an absolute basis, but what is the appropriate discount on a stock when the risk-free rate is essentially zero? Perhaps an 85% discount is more comparable to 75% or 80% in a normalized rate environment. If this is the case, why are deal multiples so low? We admittedly do not have all these answers, but our investment discipline and valuation models are firmly anchored to an Absolute Value approach that has stood the test of time over many decades and market cycles. We further believe that those investors who choose to ignore market history are doomed to repeat it—and history through the lens of small-cap valuations says “look out below.”
While it is difficult for us, philosophically, to anticipate positive returns in the face of historically high valuations and relatively weak growth expectations, the weight of our analysis supports a modest but positive outlook for small-caps. Tilting us from what, under normal circumstances, would be a modestly negative outlook is the combination of continued outflows from bonds, the strong likelihood for continued low rates, investors’ surprisingly positive reaction to the QE taper, and the complete absence of inflation. Similarly, we believe the probability of a major, bear market-type correction in 2014 is low without a significant negative surprise in growth, corporate profits, and/or inflation. Additionally, the new and dovish Fed Chairperson is likely to (similar to her predecessor) backstop any growth scare not accompanied by inflation.
Investor confidence borders on euphoric while CEO confidence remains relatively weak. If global growth continues to improve even modestly, however, we believe CEO confidence will also improve based on fewer uncertainties at home and abroad. This should lead to a meaningful improvement in M&A activity and capital spending, both of which would be positive for small-caps and the portfolio.
Last year, we stated that “… the biggest potential catalyst for stocks in 2013…is a rout of the government bond market.” We stated that the bubble in government bonds was so massive that a significant rise in rates had the potential to spark a massive outflow of liquidity into stocks, blowing away any otherwise rational equity valuation or forecast model. While we would not classify outflows in the bond market as a rout (that title belongs to gold), outflows have undoubtedly been a significant catalyst for equity performance and rational absolute valuations have indeed been exceeded. This is a powerful trend that we see continuing in 2014, keeping valuations elevated for an extended period even if bond outflows diminish compared to 2013 levels.
We expect a number of other “wild card” themes to play out in 2014. After a nearly five year losing streak, we think value looks attractive relative to growth, that volatility will pick up in 2014, and that a meaningful correction at some point during the year is highly probable. The current rally is very long in the tooth, which should favor lower-beta stocks over the very highest that have dominated during much of the current cycle. Similarly, we expect higher quality stocks to outperform the lowest quality, as rates continue to creep higher.
Admittedly, our conviction in this year’s market return outlook is unusually low—anticipating returns in these uncharted waters is a bit of a crapshoot. Many of our themes strike us as a bit self-serving, as most favor the portfolio and our Absolute Value approach. We only hope that our history of identifying themes that do not support our strategy or the broader small-cap market adds credibility to the objectivity of this analysis.
River Road Asset Management
As of December 31, 2013, Big Lots comprised 2.62% of the portfolio’s assets, Rent-A-Center – 1.99%, Aaron’s – 1.94%, Myriad Genetics – 1.52%, Pan American Silver – 0.00%, AuRico Gold – 0.54%, Intrepid Potash – 0.56%, DST Systems – 1.43%, Heartland Express – 1.48%, Outerwall – 1.62%, Sykes Enterprises – 0.82%, Blackhawk Network Holdings – 0.15%, Forest City Enterprises – 1.36%, Stage Stores – 1.10%, American Vanguard – 0.65%, and Geo Group – 1.74%.
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.